Daily Comment (April 30, 2019)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] As we bid goodbye to April, there’s a new emperor in Japan and the IS leader re-emerges. China’s PMI data (see below) came in a bit light.[1] On the other hand, Europe’s GDP came in better than expected.[2] Here is what we are watching:

Spanish elections, some thoughts: The center-left has struggled in Europe recently, so the improved fortunes in Spain have raised some hopes of a recovery. Here is what we noticed. First, a key factor in the Socialists’ resurgence was a fracture on the right. The center-right lost votes to Vox, the hard-right anti-immigrant party.[3] Centrist parties have struggled with the rise of populism in recent years; for example, in Germany, the AfD has made strides against the CDU and has been pulling the CDU in a rightward direction. The Popular Party in Spain tried to hold on by moving to the right but the gambit failed. The Socialists were better able to maintain solidarity, mostly by suggesting that not voting for the center-left was implicit support for Vox.[4] The problem is that this outcome was probably unique to Spain and may have been an accident of timing and may not be repeatable. In other words, there doesn’t appear to be anything magical about what Sanchez did to win; he may have simply gotten lucky. Second, Sanchez did offer a more leftist platform, calling for a reversal of austerity and a higher minimum wage. So, in essence, his win was due to the right fracturing and a shift to more populist positions. Without the first, the second probably wouldn’t have mattered.

The return of Baghdadi: The leader of Islamic State (which, in reality, no longer exists) was seen in a video released by the group yesterday. This is the first time in five years that he has been seen in this format. Although there have been rumors of his demise, he appears to be on this side of the earthly pale.[5] IS has lost its caliphate, but it is rapidly becoming a global terrorist organization, similar to al Qaeda.[6] This will require different tactics compared to attacking a specific land target; look for the same strategies that were used against al Qaeda to be applied here, such as tracking money flows and counterterrorist activities.

Infrastructure? Senate Minority Leader Schumer and Speaker Pelosi are scheduled to meet with President Trump to discuss infrastructure.[7] Although infrastructure spending is attractive in the abstract, we haven’t seen much action on this issue because the two parties are divided on their methods of achieving public investment. Initially, the administration wanted public/private partnerships to fund infrastructure spending. Unfortunately, opportunities for large projects with such mechanisms are limited because a steady stream of revenue must be generated in order for them to work. Much of public investment does not generate direct cash flows. President Trump is said to favor direct public investment as do Pelosi and Schumer.[8] However, the latter want to force the president to raise taxes to fund the project, which is a non-starter as 2020 looms. In addition, Trump’s position is at odds with GOP legislators, who want to spend less, not more, especially with the debt ceiling looming in the fall.[9] So, we expect a lot of media coverage but see little chance of progress.

Oil bounce: Oil prices are lifting today on reports that Saudi Arabia wants to extend production cuts into year-end.[10] Meanwhile, Iran has indicated it will ignore U.S. sanctions and continue to export oil by evading such measures.[11]

A peace accord between Kosovo and Serbia: Two decades after a conflict that led to the separation of Kosovo from Serbia, the two sides are nearing an accord in which the latter will formally recognize the existence of the former.[12] If a deal can be reached, it would create conditions where Serbia could potentially join the EU. It would also mean Serbia no longer blocks Kosovo from joining the UN. Still, a deal isn’t certain. To make it work, there may need to be a swap of land, which is fraught with risk.[13] And, Russia would not be keen on Serbia joining the EU and perhaps being pulled from its orbit.

Equities and flows: Although equity markets continue to grind higher, flows from investors continue to move in the opposite direction. Lipper reports that both equity ETFs and mutual funds reported outflows last week, while fixed income enjoyed new flows.[14]

Reflections on serial defaulters:There are some nations that engage in sovereign defaults on a seemingly regular basis. Argentina is the most notable but isn’t alone. Early in my career,[15] I worked as a country risk analyst and had a front row seat to the latter stages of the Latin American debt workout. I was part of a massive debt/equity swap program that saw my commercial bank shed hundreds of millions of non-performing sovereign loans. As the process wound down, I remember thinking that these defaulters would be denied access to the credit markets for decades. Yet, in less than five years, most of them were borrowing again. Although I had chalked up that development to P.T. Barnum’s observation that “a sucker is born every minute,” it turns out there is good reason to invest in the “borrow, default, return” cycle. A recent paper by Josefin Meyer, Carmen Reinhart and Christoph Trebesch supports the idea that it is profitable to lend to serial defaulters.[16] However, as one would expect, such lending carries much higher risk.[17] The trick is to get a return commensurate with the risk, which usually means putting money in the country when it is in its most dire state.

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