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Market View

Lord Abbett experts discuss what’s behind the crises in the three areas—and the potential outcome of each.

As we mentioned in the previous Market View, three geographic locations came to dominate the investment conversation at midyear: China, Greece, and Puerto Rico. Developments in these three areas have caused volatility in global markets and engendered widespread uncertainty. With so many questions swirling around these far-flung points on the investing map, we asked three Lord Abbett experts to provide some perspective on each.
 

Table 1. Tracking a Trio of Trouble Spots

Source: OECD, World Bank, IE Economics, Bloomberg, McKinsey, and Moody’s.

 

China
Leah G. Traub, Ph.D., Partner & Portfolio Manager
China’s equity markets have been particularly volatile in recent months. The benchmark Shanghai Composite Index rose over 150% between July 2014 and mid-June 2015. The Shanghai market’s price-to-earnings (P/E) ratio averaged 32 in mid-June (57 if excluding banks)—well above other global equity markets. The rally was driven by policy easing, regulations to cool down the housing market, driving retail investors into equities, and, most important, an increase in leverage (i.e., buying stocks on margin). You could say that it was a bubble waiting to burst.

If that’s the case, the Chinese government may have provided the pinprick. Regulators took measures to cool down the market, including tightening margin requirements, increased supervision of over-the-counter (OTC) margin financing, and accelerating the pace of initial public offerings (IPOs) in order to increase the supply of shares. In addition, when the market first started declining in mid-June, the People’s Bank of China (PBC) at first tightened liquidity in the money markets, which gave the impression that the government was stepping back from its easing policy, further fueling the selloff. Another widely cited factor in the market decline was the fact that many speculators bought Chinese shares on the expectation that index provider MSCI would include Chinese A shares in its emerging-market equity benchmark at a significant weight during its index review in June. When MSCI delayed China’s inclusion, many speculators left.

The government became concerned about the rapid declines during the last week in June and began reversing some of the regulations. The PBC cut both the benchmark rate and reserve requirements on June 28. When this did not stem the selling, the government pulled out all the stops and reversed course on all of the tightening measures. Regulators relaxed margin requirements for brokerage accounts, and the PBC even provided liquidity to the main securities regulator to facilitate providing margin for stock purchases and for stock lending. IPOs were halted, and the government prohibited brokers and state-owned enterprises from selling shares from their proprietary accounts. In addition, an investment fund was set up to explicitly buy stocks. The market has finally started reacting to these measures, and, as of July 13, was up more than 13% from the recent low point on July 8.

What are the implications of these developments? Most economists who closely follow China think that the direct economic effects from the market selloff are limited. There is not much evidence to support a large wealth effect in China, and there were no indications of increased spending during the rally, making it unlikely that consumption will fall materially on the declines.

China’s financial stability is unlikely to be significantly affected either. Estimates of banks’ exposure to the equity market are 2–3 trillion Yuan, compared with 180 trillion Yuan in total assets on the banks’ collective balance sheet. However, it is hard to know just how interconnected the various segments of the financial market are, and with such a high use of leverage, it is likely that the government was worried that unknown, or unforeseen, exposure to equity-market losses could cause a larger problem.

The biggest implication of the current volatility is for the credibility of the Beijing government and the PBC. When the initial easing measures did not work to arrest the stock market declines, investors became worried that the government might have lost a bit of control over the financial markets and, by extension, the economy. It is important for domestic participants especially, as well as foreign participants, to still believe that the government can prevent a disorderly decline. The global markets have come to terms with slowing growth in China, but they are not prepared at all for a hard landing.

Greece
Zane Brown, Partner, Fixed Income Strategist
As we are often reminded, financial markets loathe uncertainty—but, unfortunately, Greece's direction and economic future remain uncertain. Developments in the situation have been rapid: On July 13, 2015, Bloomberg reported that Greece had sealed a new bailout for as much as €86 billion (US$96 billion) that will keep the country in the euro, subject to legislative approval in Greece and other eurozone nations, among other conditions. Even though an agreement is in place, there is still much work to be done before the bailout can be implemented. Meanwhile, Greece’s banks and stock market remained closed as of July 13.

While headlines suggest resolution between Greece and its creditors, the path to final agreement is fraught with opportunities for the parties involved to stumble and create new volatility. The proposal includes measures beyond those that were earlier rejected by Prime Minister Alexis Tsipras and the Greek bailout referendum that took place on July 5. The measure includes changes to labor laws, privatization of state-owned assets supervised by European institutions, and power to international technocrats to approve or veto laws in Athens. Such demands could provoke Tspiras to step down. Discussion of implementation of the final program could, however, fail at any point over debt forgiveness or debt re-profiling. In anticipation of such an event, German finance chief Wolfgang Schäuble penned a document describing a five-year “time-out” from the eurozone for Greece, the details of which are currently left to investor imagination. 

The market calm bestowed by headlines of a new bailout could be interrupted at a variety of points along the path of execution, creating a renewed “risk-off” trade, with consequences of a weaker euro, stronger U.S. Treasury prices, and the potential impact to equities and emerging market securities. Conversely, final resolution of a bailout agreement could strengthen the eurozone over the long term, reduce the growing influence of anti-austerity parties, and create investment opportunities elsewhere in Europe.   

Puerto Rico
Daniel S. Solender, CFA, Partner & Director
Puerto Rico’s long-standing fiscal challenges took a fresh turn on June 28, when the commonwealth’s governor, Alejandro Garcia Padilla, made comments that put even further stress on its $72 billion in municipal bonds. The governor said that Puerto Rico is “unable to pay” its municipal debt, and proposed a moratorium on making interest or principal payments for several years. Previously, Garcia Padilla had stated that paying off the debt was important, and that Puerto Rico planned to not miss any payments. The impact was felt swiftly in the Puerto Rico muni debt sector, as prices fell on many of the island’s tax-exempt securities.

We think high-yield muni investors should consider these points in regard to the situation:

  • Since there is some probability of a positive outcome from where the market is today, and because Puerto Rico represents such a large part of the high-yield municipal bond market, some exposure to the commonwealth’s debt is still appropriate for consideration in high-yield muni portfolios.  Investment managers can decide to underweight Puerto Rico, but not including Puerto Rico in a municipal high-yield bond fund would be similar to leaving out several of the largest stocks in the S&P 500® Index from a fund that invests in large-capitalization stocks. Both the high-yield muni and equity funds in our example would not have exposure to a large portion of the market that they are expected to target, based upon the indexes indicated in their respective prospectuses.
  • Puerto Rico bonds are trading at distressed prices, so any investment decision should be based upon the current value of the securities, rather than whether they will ever get back to par.
  • There are many different Puerto Rico issuers, and each will likely face different outcomes, so each has to be analyzed separately. For example, in addition to the general obligation bonds, there are bonds for the Aqueduct and Sewer Authority, along with others for the Power Authority. Some Puerto Rican muni issues may offer better value than others, and they do not all trade at the same prices.

What about the potential impact upon the broader U.S. municipal bond market? While Puerto Rico’s credit situation is currently isolated, it will not go unnoticed. First, in the few days immediately after the news, there were some outflows from high-yield municipal bonds, and this pushed market prices lower for some other high-yield sectors, such as tobacco settlement bonds. If the outflows are short-lived, then this is not a big deal; but the direction of fund flows will need to be watched. So far, outflows have not been even close to being large enough to cause any disruption. 

Second, although there aren’t other major municipal issuers currently facing a similar distressed situation, how the Puerto Rico situation is handled will set precedents. For example, a court decision to allow a general obligation pledge to be violated by allowing other government expenses to have priority over bond interest payments—even though the current bond structure does not allow it—could have a major impact upon future pricing for low-rated issuers in the sector. Therefore, it could affect borrowing costs for many other municipal-bond issuers. If the U.S. Congress approves a law allowing public corporations to declare Chapter 9 in Puerto Rico, that would entail changing the terms that the commonwealth used to borrow the money. Such legislation then would make it possible for Congress to change borrowing agreements after money has already been loaned for other bond deals in the future, which potentially makes bondholder security less certain for other distressed bonds.

This is important to consider, because these borrowers are not typical corporations. When interest costs go up, which can occur during the process of reaching a balanced budget, a government that issues muni debt either needs to cut some other service they are providing or they need to raise revenues, which means higher tax rates. These are not companies trying to be profitable but are instead governments and other public entities that provide essential services. Investor reaction also will need to be observed to see which type of interaction and resolutions Puerto Rico’s muni issuers and their creditors achieve, because the municipal bond market has not before faced a potential default of this magnitude.

One Final Thought
For those who follow the financial headlines, China, Greece, and Puerto Rico are not exactly so-called black swans (i.e., totally unexpected events or situations). Greece and Puerto Rico have been experiencing fiscal challenges for years, and concerns about a Chinese equity bubble have been mounting for months, so it’s not as though anyone was unaware or unalerted. Nonetheless, recent developments in these situations, as described by our experts, have surprised the global financial community and precipitated dramatic market moves.

Is there a way for investors to navigate a steady course through these sometimes treacherous waters? We’ll leave the last word to Zane Brown: “Active professional management can help investors avoid making emotional investment decisions, or embracing the herd mentality, or remaining too cautious when opportunities unfold. The resources and experience of active managers provide the capacity for rigorous credit analysis and may lead to opportunities that may not normally be available to individual investors.”

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

FOUR FACTORS THAT CONTROL GREECE’S FATE

videoHere are the issues that could influence the nation’s future—bailout or no.

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