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Myopia Mistakes: Darlings to Dogs

It is easy to assume that the current conditions will continue and simply project forward. However, based on history, such an approach has the potential for disaster. A simple example is the real estate field whereby yesterday’s darlings in the form of “Class A” office buildings in gateway cities are often less than “Class A” today due to work-from-home vacancies, and the cost of retrofitting building to meet the ever-rising standards set by ESG requirements. In fact, it is hard to believe, but some buildings might have minimal value because of the cost and difficulty of refitting the buildings. Conversely, yesterday’s dogs in the form of hotels appear to be today’s darlings because of the shortage of supply relative to demand.

ESG Blowups

Continuing with the theme of ever-shifting views and conditions, the past couple weeks have seen a few thunderbolts in the ESG field with the State of Florida firing BlackRock based on its ESG activism, BlackRock being taken to task for not being sufficiently engaged on ESG issues particularly the “E” item in carbon neutral, and Vanguard disavowing its carbon neutral (i.e., the Net Zero Asset Manager initiative) pledge. A fair conclusion might be that major investment investors are in a no-win position. The response for some managers is to turn proxy voting over to underlying investors thereby insulate themselves from criticism. Our view is that we are in the early stages of this shift and that the Republican House is likely to weigh-in (the heavy donors of energy, tobacco, and defense firms have been targeted and are counter striking). Since proxy voting is labor-intensive, major investment advisors might provide alternative voting policies to underlying investors and thereby side-step this controversial topic. To learn about Egan-Jones Proxy services, schedule a meeting at calendly.com/ejproxy/book.

Sovereign Skepticism and Solace

In the past, when the US caught a cold, the emerging markets caught pneumonia; that is when the FED increased rates, the emerging markets went into a tailspin, with some countries defaulting. The most acute examples of this were the Asian and Latin American Crises. Sovereign investing outside of the major countries is complicated by the fact that outcomes are driven as much by politics and psychology as they are by pure economics.

For example, the Mexico crisis in 1994 occurred when Mexico’s debt to GDP was 28% while currently the debt to GDP for Italy is 150% . Some of the most successful sovereign investors are those like Elliott Management which after years of litigation with the government of Argentina over defaulted debt, was successful in securing a more palatable payout . The difficulty in assessing sovereign crisis is one of understanding its dynamics and exiting in time. For a history of the Asian and Latin America Crises, see Wikipedia, but a shorthand version is below:

1. Countries borrow (often short-term) from sources outside their countries typically in dollars.
2. The value of the dollar increases often prompted by an increase in rates by the FED and local currency values slipped
3. Countries use foreign currency reserves to support the value of the local currency, but soon exhausted those reserves and the currency value collapses
4. To stem capital flight, countries installed currency controls, increase interest rates, and or taxes, none of which address the underlying problem nor reverse the collapse of local currency values
5. With reduced local currency values, the cost of imported goods increase thereby causing political unrest and in extreme cases, an overthrow of the government,
6. The withdrawal of capital caused a local credit crunch and with it, increased bankruptcies,
7. A workout is structured often with IMF assistance or in the case of the Latin American crisis, Brady bonds
8. Per the IMF’s standard approach, crisis-struck nations reduce government spending, allow insolvent banks and financial institutions to fail, and aggressively raise interest rates. The reasoning was that these steps would restore confidence in the nations' fiscal solvency, penalize insolvent companies, and protect currency values.   

The pain from a credit crisis can be acute; Real GDP growth rate for Latin America was only 2.3 percent between 1980 and 1985, but in per capita terms the region experienced negative growth of almost 9 percent. Over the past decade, countries have become more careful about borrowing in currencies other than local currencies, but problems continue with Sri Lanka and Ukraine being the latest cases of having difficulty and seeking help from the IMF and others. 

BCG (i.e., Boston Consulting Group) dogs and stars matrix might be helpful to categorize some possible outcomes over the next couple of years combining growth and perceived risk (adjusted yields should be added).

Funding costs/ interest expense of nearly all sovereigns have increased with the overall increases in interest rates (perhaps the exception to this is Japan, which has not increased interest rates but more on Japan in future editions). Although interest expense and credit metrics have deteriorated, the developed countries have benefited from interventions of the central banks which via Quantitative Easing (QE), purchased securities of the central government and other securities to suppress interest rates and increase liquidity. 

As of early 2022, most central banks reversed course and are engaging in quantitative tightening (QT). Focusing on the larger countries, the U.K., China, and Japan probably deserve extra attention. Italy, Spain, and Portugal are likely to benefit from the creeping mutualization of its debt via the ECB. (For history buffs, the U.S. engaged in a similar process whereby the federal government backstopped the obligations of the states via the Compromise of 1790 .) 

The trick in sovereign investing in our opinion are sound credit analysis, sound value analysis, and early identification of likely catalysts.
 

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[1] Macrotrends.net - Mexico
[2] https://ec.europa - eurostat
[3] https://www.nytimes.com/2016/04/25/business/dealbook/how-argentina-settled-a-billion-dollar-debt-dispute-with-hedge funds.html#:~:text=Pollock%20and%20Mr.,of%20Elliott%20to%20his%20offices.&text=On%20Friday%2C%20Argentina%20paid%20all,bonds%2C%20according%20to%20the%20ministry.
[4] Wikipedia – Compromise of 1790