Daily Comment (June 21, 2017)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EDT] In the overnight news:

MSCI opens up for China: The index producer has been reluctant to add domestic shares of Chinese companies due to numerous concerns, including capital controls, lack of accounting transparency, etc.  This is something of a big deal, but also not.  Chinese shares are already in the MSCI EM indices; in fact, China currently represents 28.6% of the index.  However, the companies in this share of the index are internationally traded and generally follow Western accounting rules.  The domestic “A-shares” will only add 0.7% of new Chinese shares to the index.  So, in actual money terms, it’s not a huge deal.  However, it is another signal, similar to the CNY’s inclusion in SDRs, that China is joining the major economies on an equal scale.

GOP holds two seats: In the sixth Georgia Congressional district, Karen Handel, a veteran Republican politician, fended off a well-funded[1] young Democrat named Jon Ossoff.  Given that the GOP has held this seat for four decades, this was the expected outcome and the win wasn’t huge—Handel won 51.9% to 48.1%.  Meanwhile, in South Carolina, Republican Ralph Norman defeated Democrat Archie Parnell 51.1% to 47.9%, holding the seat vacated by Mick Mulvaney.  The win was narrower than his predecessor’s 20-point margin but still a comfortable win. Although the president remains a divisive figure, these two elections suggest that discomfort with the president probably isn’t enough to change control of Congress.  The problem for the Democrat Party is a path to increase popularity.  The leadership, tied closely to parts of Wall Street and Silicon Valley, wants to run as center-left technocrats.  The rest of the party wants to go hard left, becoming a “Corbyn/Sanders” party.  We believe the broader issue is that we are seeing a restructuring of the coalitions that form both parties and therefore navigating the landscape will become increasingly difficult.

A Saudi shakeup: Saudi King Salman announced that Crown Prince Nayef was demoted and he has elevated his son, former Deputy Crown Prince Salman, to crown prince.  Nayef will also lose his important power base of interior minister; this ministry oversees domestic security and counter-terrorism and was the base of power for the late King Abdallah.  The new interior minister will be Prince Abdulaziz bin Saud bin Nayef, a nephew of the ousted crown prince.   The decision was apparently approved by 31 of the 34 members of the Allegiance Council, which oversees succession.

This decision has three elements of risk.  First, CP Salman is very young and has conducted an aggressive foreign policy.  He has managed the war in Yemen and is a hardliner with Iran.  His appointment to next in line for the throne suggests that Saudi foreign policy will likely become increasingly bellicose.  Second, the king’s appointment of his son as successor raises the problem of primogeniture.  The founder of Saudi Arabia, Ibn Saud, unified most of the Arabian Peninsula through war and marriage.  At the time of his death, he reportedly had at least 44 sons, 22 wives and four known prominent concubines.  His successor was his oldest son, Saud, who proved to be a feckless spendthrift and was ousted in a royal coup.  Ibn Saud never made it completely clear how he wanted succession to occur.  By appointing his oldest son, if the kingdom had followed primogeniture, Saud could have then selected his oldest son, leaving 43 sons of Ibn Saud out of kingly succession.  The ouster of Saud instead created a system where the kingship would transfer to the sons of Ibn Saud.  Although there are some available (albeit elderly) sons of Saud remaining, the royal family has agreed that the time has come for the grandsons of Ibn Saud to take control.  That was the reason Nayef was made crown prince.[2]  By selecting his son as the next crown prince, Salman has introduced the precedent of primogeniture.  According to reports, the Allegiance Council considers this appointment as a “one-off” but, now that it has occurred, the precedent of the next king selecting one of his sons is in place.  If such an event occurs, the potential for a civil war of sorts within the royal family increases.  Third, why now?  It is quite possible that the king’s health is failing and he wanted to open the path of the throne to his favorite son before he died.  King Salman is old (81 years) and there have been unconfirmed reports he suffers from dementia.  If Salman passes soon, his controversial decision to elevate his son could become contentious.[3]

A century with Argentina: The South American country recently sold $2.75 bn of 100-year bonds with a coupon of 7.125%, giving it an annual yield of 7.9%.  It had a bid/cover ratio of 3.5x.  On the surface, this bond sale is amazing.  Argentina has defaulted eight times since its independence in 1816.  However, the risks may not be as large as they seem.  First, the duration on a 100-year bond isn’t significantly different from a 30-year bond.  There will be very little principal paid for years.  Second, given the high coupon, an initial investor recoups his investment in about 12 years.  So, as long as Argentina doesn’t default during that time, an investor should at least get paid back the initial stake.  On the downside, it is dollar-denominated paper, which almost guarantees the bonds will face default at some point in the next century.  However, we doubt any of today’s buyers care; they are simply looking for a high coupon.  This is one of the problems that comes with low policy rates; investors become tempted by debt that carries a higher yield with a high probability of default.

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[1] Total spending in this election topped $50 mm.

[2] He had another attractive feature: no sons!

[3] For more background, see WGR, 1/20/15, Saudi Succession, and WGR, 5/11/15, The Next Generation.