Featuring: Turkey | Belarus | Lebanon | Israel & UAE | the iMPACT OF gOVERNMENTS ON em cORPORATES
In this edition: Turkey announces an offshore hydrocarbon discovery, but any positive credit impact will be felt only over the medium/long-term; Belarus’ political crisis is set to intensify; Lebanon’s political, economic, and humanitarian situation continues to deteriorate; Israel and UAE normalize relations, boding well for trade and cooperation. We also discuss how the expanding influence of governments in the COVID context is likely to impact corporate issuers going forward.
Market Overview
FOMC minutes kept fixed income markets on the back-foot. Specific commentary from the Federal Reserve on introducing forward guidance or inflation averaging in September was less than concrete. We query whether plateauing economic data is keeping the Fed dovish, or indeed whether they are seeking an overshoot in inflation to make up for undershooting (as an opportunistic reflation strategy). Less can be said for the exuberance in equities and while the Nasdaq and S&P have made fresh highs once again, the looming question comes down to breadth. The ratio of U.S. banks to the S&P reached all-time lows and only serves to inspire bears further as a key segment of the index is failing to participate in the rally. Nevertheless, FX trends reversed after FOMC minutes and put the brakes on USD weakness, rates eventually unwound the bear steepening from the previous week and 10 year real yields were once again below -1.0%. With U.S. Treasuries ending the week 2-6bp tighter and term premia in 2s10s retreating below 50bp, the return profile for EM credit remained in check. Some profit taking into summer illiquidity saw EM credit spreads widen 5-11bp, where Sri Lanka, Suriname and Ukraine outperformed as Lebanon, Argentina and Angola were particularly volatile. Aside from U.S. political trends and awaiting U.S. engagement on China trade talks, the EM calendar is again active. Central bank decisions from Israel (Monday) and Hungary (Tuesday) come with inflation prints from Brazil and South Africa. This will be followed by South Korea’s rate decision and Mexico’s Banxico minutes on Thursday as the Jackson Hole event kicks off in earnest. We expect some further clarity around the Fed’s Framework Review in Powell’s update.
An offshore natural gas discovery in the Black sea not a credit game-changer for Turkey in the near-term, but has the potential for medium-term positive impact
Event: As he had promised, President Erdogan delivered “good news” to his nation on Friday, announcing an offshore natural gas discovery in the Black sea. At the same time, tensions with Greece, Cyprus and the EU over Turkey’s exportation efforts in the Eastern Mediterranean continue to run high and can escalate at any point. Meanwhile, the Central Bank (CBRT) kept its key monetary policy rate unchanged on Thursday and its dovish tone disappointed markets; however, CBRT has managed to deliver “backdoor tightening” of around 200bps over the last month.
Gramercy commentary: We think that the offshore natural gas discovery in the Black sea is unlikely to be an economic game-changer for Turkey in the near-term, despite the governments strong attempts to portray it as such. The development of the field will take years and require multi-billion USD investments: the administration has set 2023 as a target to start production, but we deem this highly ambitious. Independent experts are projecting 5-7 years period before commercial exploitation of the gas fields begins, which we believe is more realistic. This being said, if the find turns out to be larger than the 320bn cubic meters announced by President Erdogan this week and economically viable, it certainly has the potential to have a material impact over the medium-term by reducing Turkey’s structurally large Current Account deficit that is partially driven by the economy’s high reliance on imported energy. On the important topic of energy independence, Turkey is currently pursuing very aggressive exploration efforts in the Eastern Mediterranean as well, which is likely to continue to stoke high tensions with the EU, including potential military skirmishes with Greece in the areas where Turkish ships are performing seismic surveys near Greek islands and Cyprus. Greece, Cyprus and France will continue to push for EU sanctions on Turkey for its exploration activities near Greece’s border, while Germany has adopted a more cautious approach thus far. Tensions will remain high and the dispute can escalate at any point, adding more geopolitical risk premium to Turkish assets. In the meantime, CBRT’s decision to hold its main interest rate at 8.25% came as no surprise and we maintain our view that the Central Bank will resist rate hikes as long as not confronted with an episode of abrupt and severe TRY weakness beyond the 7.50 psychological level against the USD. The average cost of CBRT funding has increased by around 200bps since mid-July to 9.37% currently (112 bps above the policy rate) and there is scope for the effective funding rate of the Central Bank to increase further to as much as 12% if necessary. We believe this “backdoor tightening” will continue to be the policy of choice in order to stabilize the currency in the near-term in addition to other stopgap measures designed to reduce the incentive for local savers to switch into USD deposits (a major pressure point on the TRY). As such, as long as another exogenous shock for the Turkish economy does not materialize, we continue to expect a “muddle-through” scenario for the rest of 2020. This being said, we will be monitoring closely for signs of the key potential “crisis” triggers: loss of confidence in the banking system by local economic agents (i.e. deposit flight) and a decline in banking system external loan rollover rates (90% currently). Overall, we remain structurally cautious on Turkey’s economic and credit stories and prefer to explore tactical opportunities on market overreactions during recurring episodes of volatility.
Political crisis in Belarus looks set to escalate
Event: Street protests in Belarus against President Lukashenko that erupted over his allegedly rigged reelection on August 9 continue for a second week and have grown larger. Lukashenko has ordered his security forces to put an end to civil disobedience, which bodes for a significant crackdown given the unprecedented scale of protests and strikes across the country.
Gramercy commentary: President Lukashenko is undoubtedly facing the toughest challenge to his political reign that dates back to 1994, but we believe he retains a strong hold on power and is unlikely to be forced out of office in the near-term, setting the stage for what could become a prolonged (and increasingly violent) political stalemate in Belarus. Given the unprecedented scale of the protests, a return to political status quo in the country will require a very harsh crackdown by the authorities, likely leading to further economic, political and financial isolation. The situation on the ground is prone to material escalation, in our view. The key Western powers have strongly condemned police brutality against protestors, but thus far have refrained from any forceful measures against Belarus. The EU imposed sanctions on individuals involved in the crackdown (a rather symbolic move) and said it did not recognize the result of the disputed presidential election; however, Brussels has stopped short of not recognizing Lukashenko’s authority for the time being. As for Russia, the general tone has also been one of preferring to remain on the sidelines as the crisis develops. In our assessment, Russia has very low appetite for any sort of direct involvement (especially a military one), outside of the technical show of support for Lukashenko’s government, given the special relationship and various treaties that exist between the two countries. Russia will likely try to help prolong Lukashenko’s time in power via tacit support and will mediate with the opposition for an acceptable successor in case Lukashenko’s position becomes untenable. The Kremlin is wary of repeating with Belarus some of the mistakes made with Ukraine. Such mistakes are seen as having contributed to turning the majority of Ukraine’s population from reliably pro-Russian into staunchly pro-Western over the last 5-6 years. In addition, Russian elites are eager to avoid new sanctions from the West, so the hurdle for “adventurism” by President Putin in Belarus is high, in our view.
UN Tribunal finds no conclusive evidence of Hezbollah links to the 2005 assassination of Lebanese PM Hariri
Event: This week the UN Special Tribunal for Lebanon ruled that it found no conclusive evidence linking Hezbollah’s leadership and the Syrian Government to the assassination of Lebanon’s former Prime Minister, Rafik Hariri, in 2005. The Tribunal convicted one of four accused Hezbollah members standing trial and acquitted the other three.
Gramercy commentary: Like the recent devastating explosion at the port of Beirut, the Hariri assassination 15 years ago was a defining moment in Lebanese politics that unleashed political tensions among the country’s three main religious communities (Sunni, Shia, and Christian). The sectarian divide between these groups has defined Lebanese politics since the end of the civil war in 1990. The fact that a 15-year long investigation was not able to offer strong evidence convicting Hezbollah is likely a near-term positive for stability, as it limits the risks of sectarian violence in the short-term. In the wake of the ruling and following the resignation of Lebanon’s cabinet last week, one of the key questions around the country’s future trajectory is if and when a new government can be formed and what role Hezbollah (currently an important power broker) will continue to play in Lebanon’s political landscape going forward. We remain pessimistic about the country’s outlook, acknowledging that the situation on the ground is dire in all respects – political, economic and humanitarian. Meaningful political reform to address Lebanon’s dysfunctional power-sharing system and corruption by entrenched political elites remains unlikely, despite the incredibly acute social shock due to the economic freefall, COVID, and the Beirut explosion with damages estimated at up to a colossal 50-60% of Lebanon’s rapidly dwindling nominal GDP ($26 billion in 2020F). Without the political will to start tackling difficult reforms, and given Hezbollah’s strong influence in local politics, unlocking $11 billion of international funds pledged since 2018 and securing a potential IMF bailout package (~$15 billion) remain highly unlikely in the near-term. One positive catalyst for the defaulted sovereign bonds could be the formation of a “national unity government” before the end of 2020, led by Saad Hariri, son of the assassinated Rafik Hariri and himself a former PM. A new Hariri government will likely enjoy the support of both the West (U.S., France) and the GCC and will be seen by the market as the stepping stone toward unlocking large-scale bilateral and multilateral support. However, there will be serious roadblocks for the formation of such a government and any agreement will inevitably require a prolonged period of time in Lebanon’s political context, against a backdrop of an economic crisis spiraling out of control and a global pandemic; as such, credit risks remain firmly tilted to the downside, in our view.
Israel and UAE agree to normalize ties and establish diplomatic relations
Event: The UAE will become the third Arab nation after Egypt and Jordan to formally recognize Israel. In exchange, Israel will halt the annexation of Palestinian territories in the West Bank.
Gramercy commentary: The deal should benefit both Israel and the UAE materially over the long term, as normalized relations will boost trade and open the door to economic cooperation across the tourism, oil, and technology sectors among others over the coming years. Politically, the deal is significant for both Israeli PM Netanyahu and U.S. President Trump. In Israel, Netanyahu has struggled with domestic popularity, but a deal with the UAE will likely bolster his approval ratings and might increase odds that he pushes for snap elections by the end of the year. In the U.S., although the November elections will focus on the economy, COVID, and China, Trump’s ability to point to a “Middle East peace deal” (albeit not an Israeli-Palestinian one) where the Obama/Biden administration had failed will give him some additional ammunition in the realm of foreign policy, where Biden exhibits considerable strength.
Global Emerging Market Corporates in focus: In sovereigns we trust?
Governments around the world are getting bigger relative to their economies. Schemes worth trillions of U.S. dollars have been rolled out as authorities seek to curb the effects of the pandemic. Over the last few months, various authorities have had the power to decide where we go, where we eat, where and how we shop, who we meet and whether or not we go to work. COVID-19 monitoring efforts have also meant that what was previously considered private, such as one’s location and contact details, may now be disclosed to governments and/or designated groups seeking to control the spread of the virus.
The ever-expanding influence of governments has not been restricted to individuals. It has impacted corporates too. For issuers in sectors hard hit by the pandemic such as aviation, the state’s involvement has sometimes been the difference between being a going concern and a gone concern. Without government intervention, some issuers would not survive. In addition, funding markets may reopen to issuers that receive support, making it possible for these issuers to redeem maturing liabilities. It is clear that intervention can help reduce investors’ losses. Having said this, a state stepping in may not be unequivocally positive for bondholders.
In a previous weekly, we highlighted the current threat to dividend payments – even the IMF has called on banks to consider skipping these distributions. Government intervention in the form of capital injections or regulatory intervention through forbearance may mean issuers are unable to distribute profits to shareholders. For some deeply subordinated Tier 1 instruments, public sector injections of capital may trigger principal write-downs. This may occur where lenders would be considered non-viable without such capital boosts from the government. The local regulator is often charged with opining on the point of non-viability. There may be clearly defined triggers, or determination may be more subjective. In either case, state intervention may increase the risk of loss absorption for some subordinated securities.
Funding or capital provided by the government may come with other strings attached. Restrictions on management pay may be imposed. This can impact who a company is able to hire or retain. State involvement may leave top management open to increased scrutiny, with more time spent addressing public queries than would otherwise be the case. Governments can also require companies offered aid to refocus ambitions away from international markets to their domestic one. In these ways, government rescues may mean companies’ profiles change. This can have implications for investors’ returns.
Government objectives may not be clearly defined and can change over time when it comes to corporates. These objectives may not always align with those of bondholders, and there may be little investors can do to stop governments achieving their aims. Thus, state involvement may also lead to increased variability in bond performance, and therefore investor returns.
National, regional and local authorities play vital roles at many of the corporates in which we invest. Some issuers are inextricably linked to governments. This can apply where corporates were founded by some form of public sector edict, which may even require state ownership. Bond documentation, in those cases, may contain change of control language and governments and investors often (though not always) work together for the companies’ benefit. Where the state only steps in because of a crisis, the relationship with investors may be different. Self-help may well be preferred to government aid. Where this is not possible, it is vital that all parties are able to work together. One reason for this is that investors, including bondholders, can play an important role in such governments’ eventual exit from crisis-hit companies. The government-investor relationship can, and should, be mutually beneficial.
Please contact our Co-Heads of Sovereign Research with any questions:
Kathryn Exum, Senior Vice President, Sovereign Research Analyst
[email protected]
Petar Atanasov, Senior Vice President, Sovereign Research Analyst
[email protected]
This document is for informational purposes only. The information presented is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Gramercy may have current investment positions in the securities or sovereigns mentioned above. The information and opinions contained in this paper are as of the date of initial publication, derived from proprietary and nonproprietary sources deemed by Gramercy to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader. You should not rely on this presentation as the basis upon which to make an investment decision. Investment involves risk. There can be no assurance that investment objectives will be achieved. Investors must be prepared to bear the risk of a total loss of their investment. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. The information provided herein is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation.