Monday Musings: September 27, 2021

Sep 27, 2021

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Public Trust Credit Team
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Approaching funding deadline and possible U.S. default is beginning to look a lot like 2011

On August 5, 2011, S&P Global Ratings cut the rating of the US Sovereign from ‘AAA’ to “AA+’. This rating action was the first and only time an NRSRO has downgraded the U.S. and surprisingly the U.S. did not even need to default for it to happen. When announcing the reason for the downgrade, the agency said “more broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.” 

Sound familiar? The U.S. must pass a funding resolution and raise the debt ceiling this week to keep the government operating and avoid a possible U.S. default next month. The current situation in Congress looks very familiar to the 2011 fiasco, and we still view the prospect of default as unlikely. One question, though, is if a downgrade even matters. With the benefit of hindsight, the U.S. government’s downgrade had little impact on the cost of debt for the country. The U.S. remains the de facto risk-free rate and reserve currency, trillions have been borrowed since at next to nothing, and the yield on the 10-year treasury is below 1.50%. So does a downgrade of the U.S. matter? We believe it is complicated; while it is unlikely that a downgrade would have a material impact on the cost of borrowing for the country, there are downstream impacts that could lead to downgrades in U.S. companies that are anchored to the sovereign rating.

Inflation once again leads investor concerns in Bank of America survey, but new developments have pushed China to number two

According to the monthly fixed-income investor survey published by Bank of America, inflation remains the number one concern among credit investors which, despite a cooling in the month over month rate inflation, is rather unsurprising as inflation still stands well-above-average compared to the last cycle. However, the tech crackdown and looming Evergrande default has moved China into the number two spot among those polled. Beijing’s crackdown on tech companies has mostly spooked equity investors but when coupled with the default and bankruptcy of China’s most indebted property company, many investors from all asset classes are beginning to wonder if there are cracks in China’s economic recovery. Just a few years ago it seemed unlikely that China would let a company like Evergrande fail, but now it appears it could happen any minute as the company missed its payment over the weekend. While we believe Evergrande default is unlikely to spread contagion outside of China, the country remains the largest holder of U.S. public debt and an important market for most large U.S. corporates, so we believe the concern to be a continued due diligence item.

Energy market supply/demand dislocations exacerbate cyclical inflationary pressures

World natural gas prices have climbed dramatically over the past several months with prompt month futures prices 200-300+% higher than the same time last year depending on the price point. The pricing pressures appear to be most acute in Europe which receives most of its supply from Russia. However, Russia has traditionally used gas supply as a political weapon, and they appear to be doing so again in order to pressure governments to approve the Nord Stream 2 pipeline. Due to disruptions in alternative supplies including wind and coal firepower, tight supply is being largely felt. Natural gas, coal, and nuclear are drivers of baseload power generation across the continent, but the transition to cleaner fuels has shown some of the current structural deficiencies. Weaker wind power production and decommissioned coal plants have increased Europe’s reliance on gas at the same time that demand from idled industrial production is now coming back online. 

Unfortunately, the problem is not limited to Europe. Northern hemisphere neighbors rely on natural gas for approximately 40% of domestic baseload generation. With winter approaching, historically low storage, and delayed supply responses, future prices are not expected to decline meaningfully until next spring/summer. In Asia and South America, elevated natural gas input costs will drive higher prices for industrial output.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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