September 26 – October 1, 2015

What stood out the most over the past week was 1) the coverage of the increasing withdrawal of petrol dollars from the world investment markets, 2) the withdrawal of funds from emerging market securities, and 3) the rising spreads in corporate bonds.

First, it was only a matter of time with oil prices running below production costs for many of the world’s oil nations that their sovereign wealth funds (SWFs) would take a hit.  Surplus dollars are no longer being generated for many of the oil producing nations that ordinarily would then circulate those dollars into the world investment markets and asset classes. Rather, for many of these countries all of their oil revenues now must go towards paying for government commitments and in many cases countries are having to draw down from their SWFs.

As Simeon Kerr highlighted in the Financial Times, the Saudi Arabian Monetary Agency (Sama) which has seen its foreign reserves reduced by nearly $73bn since oil prices began their decline last year has pulled between $50bn-$70bn from global asset managers over the past six months.[i]  Sama is just one instance – consider that Saudi Arabia has the lowest marginal production costs per barrel at around $21 per barrel.[ii]  On a larger scale, consider that according to the Sovereign Wealth Fund Institute “nearly 60 per cent of the $7.3tn in global SWF assets is derived from oil and gas revenues.[iii]”  As covered by the Financial Times’ Lex column, “two-thirds of oil-dependent funds based outside North America expect outright withdrawals if the oil price stays below $40 a barrel for two years. Not just Saudi Arabia but Russia, too, has already raided its wealth funds to shore up an ailing economy.  Norway, the largest and most transparent of SWFs, expects its pension fund to have net outflows from next year as oil revenues go towards propping up the fiscal budget.[iv]”  Further, “a quarter of the remaining SWF assets belong to China,[v]” which is having its own economic issues with at least $150bn of capital leaving the country in August alone.[vi]  Global asset managers – hedge funds, private equity, etc. – will have challenges with redemption requests for sometimes illiquid assets and will experience a new dynamic with one of their primary funding mechanisms.  Granted, the withdrawn money doesn’t just ‘disappear’ from the world economy – it should find its way into consumer’s pockets via reduced energy costs – it is likely that this money will not be as accessible for asset managers if oil costs remained depressed.

Second, also related to SWFs withdrawing funds from global asset managers, they along with many other investors are pulling money from more volatile emerging markets.  China has the world spooked at the moment and most emerging markets are highly exposed to declining Chinese demand for raw materials.  As Carolyn Cui pointed out in the Wall Street Journal, global investors are estimated to have pulled $40bn from EM stocks and bonds during the current quarter, the most for a quarter since the depths of 2008.[vii]  Further, the world and many companies from developing countries are anxiously watching the FED and European Central Bank for changes in interest rates, especially considering that “companies from developing countries quadrupled their borrowing to well over $18tn last year from about $4tn in 2004, with Chinese firms accounting for a major share of that” and many of the borrowings are in dollars and euros.[viii]

Third, as covered by Mike Cherney in the Wall Street Journal, the “spread” between investment grade corporate bonds (rated BBB- and higher) and US Treasury securities have been steadily increasing.[ix]  For the first time since the financial crisis in 2007 and 2008 spreads have widened in two consecutive years.  As of September 24, US investment-grade corporate bonds yielded 162 basis points (bp) more than Treasurys.  That spread was at 131 bp at the end of 2014 and 114 bp at the end of 2013.  Worse, spreads in junk-bonds started moving sharply higher in 2014 as oil prices collapsed from 382 bp at the end of 2013 to 588 bp as of September 24, 2015.  As Krishna Memani – CIO at Oppenheimer Funds – so aptly put it “…the fact that spreads have been widening since the middle of 2014 is a very worrisome trend.[x]”  Further, as covered by Eric Platt and Nicole Bullock at the Financial Times, “as borrowing costs rise and defaults have accelerated, investors have withdrawn more than $14bn from junk bond funds since the middle of April. The yield on the BofA Merrill Lynch high yield index has climbed to 7.98% from 6.52% a year ago…  Already in 2015, more US companies have defaulted than at any time since 2009… S&P analysts expect the default rate to nearly double to 2.9% by June 2016 from June 2014.[xi]”  Capital (read debt) intensive companies are in a hurt, specifically companies whose fortunes are tied to commodities, which make up a meaningful portion of the US junk-rated companies.  US junk-rated companies EBITDA tumbled 39.3% in Q2 from a year earlier – the greatest decline in 15 years.  “The slide in earning has also elevated leverage to its highest level in almost 15 years. The debt burden of high-yield companies climbed to 4.82 times trailing 12-month earnings at the end of Q2.[xii]

Other Interesting Articles

The Economist

BloombergBusiness: Macerich Sells Mall Interests to GIC, Heitman for $2.3 Billion 9/30

NYT: As Banks Retreat, Private Equity Rushes to Buy Troubled Home Mortgages

National Real Estate Investor: Borrowers Push for More Interest Only Loans 9/23

InvestmentNews: How Nick Schorsch lost his mojo

End Notes

[i] Kerr, Simeon. “Saudi Arabia Withdraws Overseas Funds – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[ii] Conca, James. “U.S. Winning Oil War Against Saudi Arabia.” Forbes. Forbes Magazine, 22 July 2015. Web. 02 Oct. 2015.

[iii] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[iv] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[v] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[vi] “Flow Dynamics: Capital Flight from China.” The Economist. The Economist Newspaper Ltd., 19 Sept. 2015. Web. 20 Sept. 2015.

[vii] Carolyn Cui. “Investors Pull About $40 Billion From Emerging Markets in Current Quarter.” WSJ. Dow Jones & Company, Inc., 29 Sept. 2015. Web. 30 Sept. 2015.

[viii] Carolyn Cui. “Investors Pull About $40 Billion From Emerging Markets in Current Quarter.” WSJ. Dow Jones & Company, Inc., 29 Sept. 2015. Web. 30 Sept. 2015.

[ix] Cherney, Mike. “U.S. Bonds Flash Warning Sign.” WSJ. Dow Jones & Company, Inc., 27 Sept. 2015. Web. 28 Sept. 2015.

[x] Cherney, Mike. “U.S. Bonds Flash Warning Sign.” WSJ. Dow Jones & Company, Inc., 27 Sept. 2015. Web. 28 Sept. 2015.

[xi] Platt, Eric, and Nicole Bullock. “US Junk Bonds Cracking after Debt Binge.” Financial Times. The Financial Times, Ltd., 29 Sept. 2015. Web. 30 Sept. 2015.

[xii] Platt, Eric, and Nicole Bullock. “US Junk Bonds Cracking after Debt Binge.” Financial Times. The Financial Times, Ltd., 29 Sept. 2015. Web. 30 Sept. 2015.

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