Sovereign Credit Is Deteriorating At A Record Pace

Culminating with the tipping of the UK's numerous real estate fund "dominoes" and the subsequent fallout in the wake Brexit, Fitch has been on a ratings-slashing spree, having cut the credit ratings on 14 nations so far in 2016, most recently that of the United Kingdom - a record downgrade pace for the rating agency. As the FT reports the majority of those 14 nations are concentrated in the Middle East and Africa: areas that have the most exposure to slumping commodity prices and declining nominal exports. Fitch also downgraded the UK citing falling oil prices, a stronger US dollar and Britain’s pending exit from the EU.

The decline in global sovereign ratings highlights the sensitivity to geopolitical shocks felt by the world economy as a result of sluggish growth and rising debts, Fitch notes.

Fitch's competitor S&P has cut 16 sovereign ratings, a number only exceed once prior and that was during the EU turmoil in 2011. Moody's registered 14 downgrades in 2016, up 4 from this same period last year.

"So far this year, S&P has downgraded 16 sovereigns — a half-year figure only exceeded once, at the height of the eurozone crisis in 2011. Moody’s has downgraded 24, compared with 10 at the same point last year."

On Europe, Fitch had this to say: “Europe’s political backdrop could have negative implications for sovereign ratings . . . Comparatively high government debt levels are observed in several eurozone sovereigns, and are likely to remain effective rating constraints.”

Not even Saudi Arabia was safe. Fitch downgraded the kingdom on April 12, 2016 citing weakness in oil prices. The downgrade took place after oil had already rebounded roughly 40% from the February low. Fitch also stated their target for oil at the time of the downgrade was $35 for 2016 and $45 for 2017.

To be sure, timing of downgrades is not something the ratings agencies are known for.

Neither is competence. The role of credit rating agencies has been questioned in recent years — with some accusing them of biased ratings and irrelevance. However, their decisions remain crucial to investors subject to mandates that determine what sort of assets they can own. “I see parallels between the downgrades in peripheral Europe during the eurozone crisis and what is happening in emerging markets right now,” said Bhanu Baweja, emerging market strategist at UBS."

Nonetheless the rates still provide a template of how other credit managers think, even if the warnings are largely and when it comes to purchasing decisions, completely ignored, drowned out instead by the actions of central banks. In today's new normal, in the midst of low yields and high leverage, there is a major "crowding" effect as investors turn to those places which still provide some relatively higher yield, regardless of underlying fundamentals and if better yields are to be found in sovereigns with insurmountable debt, then that's where "other people's money" will head for. After all, the thinking goes, by the time the sovereign defaults, it will be someone else's problem.

As FT reports:

It’s a very strange time — the credit is undoubtedly weakening but investors are still crowding in because there are so few places to find positive yields.” The crowding has caused the average borrowing rate of emerging markets calculated by JP Morgan's index of EM bond yields to fall to a two-year low of 5.25 per cent. “The problem is growth,” said Mr Baweja. “It is so weak that leverage is increasing and credit is weakening. This doesn’t mean there is a crisis but it does mean we haven’t seen the last of the downgrades.

The full list of downgrades YTD:

 

A 2014 white paper by Heitor Almeida and company reviewed the real effect of Sovereign rating downgrades. Almeida finds that downgrades only exacerbate the financing issue that sovereigns find themselves in when a downgrade happens. Almeida says "We find sovereign downgrades lead to greater increases in the cost of debt and greater decreases in investment and leverage of firms that are at the sovereign bound relative to similar firms that are below the bound."  The paper also noted an increase in corporate downgrades the month of and in the months following a sovereign downgrade.

 

Then again, 2014 was long ago.  Now that $11 trillion in debt trades at a negative yield, the worse the sovereign, the more attractive its higher yielding bonds. Of course, they are yielding more for a reason, but when the world is floating on a sea of $15 trillion in excess liquidity, who needs to bother with such trivialities.