Featuring: LEBANON | ECUADOR | PERU | ANGOLA | SANCTIONS
In this edition: Under heavy international pressure, Lebanon took a step toward forming a new government, but odds for game-changing reforms remain slim; Ecuador unveiled an agreement with the IMF on a new program, finalizing its sovereign debt exchange; Peru passed Belgium as the most deadly COVID-19 hotspot globally; the Paris Club officially granted Angola debt service freeze for 2020; in our GEM Corporates series, we discuss the risk of sanctions – an ever-present danger for markets.
Market Overview
Investors are now left asking themselves how the Fed might react to further asset turbulence. The Fed’s weekly balance sheet data was up by 0.4% to $7.07 trillion while the three corporate facilities announced earlier this year have largely underwhelmed, but in part have solidified the Fed put in credit markets. In the June sell-off, the Fed was particularly responsive and stepped up asset purchases in credit by $40 million to $275 million/daily. The current run-rate of purchases is only $27 million a day, so the question is how reactive the central bank will be to renewed market weakness. The pain threshold is low after all. This brings us to the current sell-off which struck after the S&P posted an all-time high. The tech sell-off saw Apple fall by its largest one-day decline since March 16th as the VIX climbed 7ppts and smooths the volatility kink prior to the election. Needless to say, bulls will still argue that trend lines have not been breached (just yet). Real yields hit a new low of -1.12%, which dragged U.S. corporate credit real yields deeper into negative territory and increased the appeal of EM further. U.S. 5y5y inflation swaps may well have retreated from 2.20% to 2.08% but still do little to change the upward trend that we are seeing. This seems to have taken center stage, more so than U.S. election odds converging as we enter the final eight weeks, Fauci’s expectation of a vaccine by December and indeed the rapid RMB appreciation with fewer data shocks as Citi’s EM Surprise Index remains well in positive territory. Speaking of EM’s attractiveness, the EMBI as the benchmark for EM Sovereign Credit posted its largest weekly gain since the first week of June (+1.6%), which coincided with the highest weekly inflow in 2020 (+$2.5bn). Lebanon, Ecuador and Ethiopia all outperformed as Serbia, Suriname and Abu Dhabi lagged in the rally. The focus into next week (aside from the U.S. holiday) will be on South Africa’s GDP and China’s export growth, followed by inflation out of Brazil, Chile, Hungary, Mexico and Romania. This will be followed by Turkey’s current account release on Friday, after a weak inflation reading sent the lira to all-time lows. We would also expect some focus on Peru’s rate decision as well as guidance on future policy stimulus after the “Reactiva Peru” program ends, while Malaysia is expected to keep rates unchanged.
The prompt appointment of a new Prime Minister supports government formation efforts in Lebanon, but hurdles to material reforms and real political change remain formidable
Event: Mustapha Adib, Lebanon’s ambassador to Germany since 2013, was chosen this week as Prime Minister-designate and tasked with forming a new government. He will have to achieve that in the context of an unprecedented crisis in all spheres of society and within the confines of Lebanon’s notoriously complex sect-based political system, a remnant of the civil war that ended in 1990.
Gramercy Commentary: The PM-designate was named just hours ahead of French President Macron’s second visit to Beirut in the one month since a large explosion at the port killed hundreds and devastated large areas of the city. Under heavy external pressure amid Lebanon’s raging economic, social and humanitarian crises, Adib’s appointment happened very promptly, especially for Lebanon standards. However, getting all relevant political actors to agree on the composition of the new cabinet will likely take weeks or even months, and there is no guarantee that the process will be successful. President Macron, who is leading international diplomatic efforts on Lebanon, has clearly outlined several conditions for unlocking additional financial assistance by the international community beyond humanitarian relief efforts that have contributed just a few hundred million dollars, a tiny amount relative to Lebanon’s needs. Those conditions include a forensic audit of the Central Bank, immediate reforms in the power sector, and, above all, the appointment of a government that has the ability and willingness to start implementing reforms while the country prepares for early elections within 12 months. If such an interim government under Adib is formed successfully, there should be sufficient political will to deliver on the French demands in order to unlock some (albeit modest) financial assistance from the international community while negotiations with the IMF and sovereign bondholders resume. This being said, a government under PM Adib is not a game-changer for Lebanon, in our view. We think that the deep reforms required to address the country’s underlying structural problems remain unlikely due to a variety of reasons. PM-designate Adib is part of Lebanon’s political and economic establishment, i.e. the “old regime” that the protest movement in the streets vehemently rejects. As such, he is clearly not a catalyst for a “restart” of Lebanon’s broken political and economic model. Furthermore, within the existing dysfunctional political system, any profound far-reaching reforms will continue to face significant hurdles. Last but not least, Adib’s political mentor, former PM Najib Mikati (2011-14), is considered relatively friendly to Hezbollah, which does not bode well for financial support from Saudi Arabia/the Gulf Cooperation Council (GCC). As such, we remain of the view that the structural political and/or economic changes required to stabilize the political environment, re-start the economy, and unlock large-scale bilateral and multilateral support will remain elusive, at least until potential early elections within 12 months (if international demands are fulfilled).
Ecuador formally completed its distressed debt exchange after reaching a staff-level agreement on a new IMF program; S&P and Fitch upgraded the sovereign rating to B- Stable, from SD/RD
Event: The government reached a staff-level agreement with the IMF over a new funding program before the September 1 settlement deadline for the restructured sovereign bonds and the new 2030, 2035, and 2040 securities have now started trading. S&P and Fitch adjusted their sovereign ratings to B- (Stable). While acknowledging the economic and political challenges that Ecuador continues to face, both agencies see materially lower risk of default over the next two to three years.
Gramercy Commentary: The size and disbursement schedule of the new IMF program came as a positive surprise to markets. Consensus expectations gravitated around a shorter and significantly smaller program than the $6.5 billion exceptional access 27-month Extended Fund Facility (EFF) granted to Ecuador. The size of the program amounts to around 650% of Ecuador’s IMF quota, which reflects the very strong goodwill towards President Lenin Moreno’s Administration at the Fund and among its main shareholders. Most notably the U.S. disbursements under the new EFF will be front-loaded, with $4 billion expected before year-end. Those funds, together with some pending loans from China, will likely be sufficient to plug the large external financing needs this year and allow the authorities to muddle through the crucial next six months until presidential and congressional elections take place in February 2021. The full details of the reforms that Ecuador has committed to implement are not known yet, but implementation of the program will certainly require difficult political decisions after the elections, which makes them the predominant credit driver going forward. Covering this year’s large external funding gap in Ecuador’s vulnerable dollarized economy means that a deeper crisis will likely be avoided. All else being equal, this improves the odds that a market-friendly presidential candidate who favors orthodox economic policy will be elected in 2021. Guillermo Lasso, a banker and the leader of the liberal center-right party, CREO, who narrowly lost to Moreno in 2017, appears to be the frontrunner on the right side of the political spectrum. However, the populist challenge from former President Rafael Correa’s party (regardless of whether Correa himself is legally allowed to run as vice-presidential candidate) and/or the indigenous political forces will be very strong, especially in the context of massive disruptions due to COVID-19 and the already weak economic conditions pre-pandemic. Considering this, we expect the upcoming elections to be very competitive and highly binary in terms of credit implications. Ecuador’s bonds have reacted quite positively to continuing cooperation with the IMF under a robust program, but spreads over the coming six months will be a function of the elections outlook and market expectations about economic policy after the new administration takes office in May 2021.
Peru passes Belgium as most deadly COVID-19 hotspot globally
Event: Peru has passed Belgium to have the highest number of deaths per capita in the world from COVID-19 (86 deaths per 100,000 people). The news comes a week after Peru’s strict lockdown measures resulted in the world’s deepest economic contraction in 2Q20, with a 30.2% year-on-year decline in GDP.
Gramercy Commentary: Peru is a great example of the profound challenges and difficult tradeoffs EM governments face in managing the COVID-19 crisis. The country was one of the first in Latin America to institute a lockdown as early as mid-March and the President mobilized the army to enforce it. However, due to the very large size of the informal economy (7 out of 10 workers are engaged in the unofficial sector) and lack of social safety buffers, lockdown measures have proven extremely difficult to enforce. Furthermore, as some formal measures eased in July, cases have surged and officials have had to delay the full reopening of the economy further. Peru’s experience highlights that even as some countries (China, Korea, Hong Kong) attempt to reopen to business and travel, COVID-19 still has lethal consequences in many emerging markets. This is especially true for countries like Peru, which have large informal economies and a significant portion of the population relaying on daily wages.
Angola gets debt service relief from the Paris Club
Event: This week, the Paris Club confirmed that Angola would be one of 73 countries to receive debt service relief through its Debt Service Suspension Initiative (DSSI). Angola will receive relief on payments due from May 1st to December 31st, 2020, an estimated USD$310 million in short-term liquidity relief. Notwithstanding the debt service relief, Angola’s sovereign rating was downgraded on Friday to CCC from B- by Fitch, reflecting the profound challenges this credit faces over the medium-term
Gramercy Commentary: Angola faced a sudden triple economic shock from COVID-19: a precipitous drop in oil prices, a reduction in crude production, and a global pandemic. The country has been negotiating debt relief terms with the World Bank, the IMF, and China (its largest creditor) since March. The Paris Club announcement is a positive sign for Angola as it looks to manage its very large debt service burden (government interest to revenue ratio stands at an unsustainable 40%). Negotiations with China are key as they could result in a far more material $2.3 billion in debt service deferment this year. As a reminder, the G20 members, including China, and the Paris Club have been working since April on implementing a freeze on debt service payments by the world’s poorest countries through the end of 2020 in order to free up funds to fight COVID-19 and mitigate its economic impact. While temporary deferment of debt service certainly helps governments in their attempts to manage the fallout from the pandemic, we are of the opinion that such measures are unlikely to be sufficient to avoid debt distress by the most vulnerable issuers. Sovereigns that entered the current crisis with already challenged credit profiles and inadequate buffers are likely to require more material forms of debt relief, involving both official and private sector creditors, in our view.
Global emerging market corporates in focus: Sanctions – unclear and ever-present danger
The threat of sanctions still looms large for issuers in some of the world’s largest economies. These restrictions can be difficult to predict and, in the worst cases, the effects may seem almost impossible to mitigate. Sanctions are not new – they have been used by governments around the world for many decades. However, with the world now much better connected than before, the impact of new restrictions can reverberate far beyond the primary targets. In addition, sanctions can sometimes be imposed on corporates that may have had little direct involvement with the infractions leading to these sanctions.
By introducing sanctions, authorities are usually seeking some form of change. This may be the reversal of an annexation, a change in a court ruling, severance of ties with previously-sanctioned entities or even a change in administration. Sanctions can also be introduced as a consequence for contravening international agreements or local laws. Having said this, these restrictions can have many more unintended consequences for investors in emerging market corporates. Here are just a few examples:
- Increased market volatility: The almost-instantaneous effect of some recent sanctions edicts has been to drive prices of the securities issued by the named companies downwards. Other issuers viewed as ‘at risk’ have also seen their securities trade down. Such price changes clearly have little to do with the fundamentals of the issuers, but may impact portfolio performance. Sanctions may also effect input or output prices of companies that may appear unrelated if major participants in the markets those companies rely on are no longer able to operate.
- Changes in benchmark composition: Where sanctions impede access to global bond markets, issuers may be unable to replace maturing liabilities. Thus, benchmark index weights may change over time as these issuers’ existing bonds mature. Some issuers have all but exited the Eurobond market as a result of sanctions – benchmark index weights are now at or close to zero. Where sanctions impact issuers’ ability to make payments on existing instruments and restrict trading activity, such securities may need to be excluded from various indices.
- Changes in funding sources: Sanctions may increase refinancing risks for corporates no longer able to access global debt markets. Inability to access equity markets may also add to bond investors’ concerns. Where there are no other funding sources available, the probability of default may increase even where sanctions do not bar issuers from making payments on existing notes.
- Reduced liquidity of instruments: Market makers may be unable or unwilling to trade certain securities even when these instruments continue to be serviced by issuers. This is because sanctions may be interpreted differently by market participants, with some (understandably) choosing to err on the side of caution.
- Increased compliance costs: The reputational and financial impact of failing to comply with restrictions put in place can be very significant. For this reason, it is vital to ensure compliance with these sanctions by having the right legal and regulatory personnel in place and by using employing rigorous investment screens. This increases costs for money managers but these expenses are clearly essential.
- Deeper discounts, higher risk premiums: The threat of sanctions can linger for weeks, months or even years, and while concerns about this remain unaddressed, securities may trade at discounts to pre-sanctions threat levels. Valuations may be dictated by these restrictions rather than a company’s fundamentals.
- Shift from global to local: Sanctions likely contributed to one leading Russian bank’s decision to sell its interests in another country and refocus on its domestic market. Sanctions have also led companies to ring-fence businesses in countries where restrictions are imposed where disposals may be impossible or undesirable. Companies may focus more on local markets not just in their daily operations but also when it comes to funding – sanctions may inadvertently lead to deeper local funding markets. There can also be more widespread use of local rating agencies when sanctions are imposed.
- Increased state involvement at companies on sanctions lists: Governments may become sources of funding (directly or indirectly) or may help orchestrate ownership changes when sanctions are imposed. Thus, even companies which were not previously linked to their relevant governments may become state-owned.
Sanctions make our markets even more unpredictable. Global alliances are constantly being tested – any and all eventualities must be carefully thought out. This supports the case for active portfolio management.
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.