Peruvian Puff Pepper
This week, we talk a little bit about the technicals of the market before talking about the sluggish Peruvian economy.
Welcome to the Global Capitalist - A newsletter on emerging and frontier markets viewed through the lens of history and culture.
Hey everyone — Welcome back. I wanted to quickly talk about the bond markets and the Federal Reserve before discussing the Peruvian economy.
Thanks again for your continued support!
Last Week Briefing:
The U.A.E. and Israel brokered a historic peace agreement last Thursday, halting the annexation of the West Bank and paving the way for Israel’s recognition in the region.
Jimmy Lai, a prominent Hong Kong media mogul and head of Apple Media, was arrested last week for “Conspiring with a Foreign Power.” His company, Apple Digital, rose over 300% the following trading day as investors showed solidarity with Lai. He would be released later in the week.
Russia officially receives more Euros than U.S. dollars for their Chinese-destined exports.
Chinese President Xi Jinping calls for a nationwide food rationing, stemming from a devastating crop shortage in the country.
Fishing For Yield
Last week, the Federal Reserve announced it has purchased another $61 million in corporate debt for the week ending August 12th. This continues the Fed’s automatic bond-purchasing program in response to the economic fallout from the coronavirus. At the end of July, the Fed reported they held over $3.6 billion in corporate debt, an unprecedented move as they seek to cushion the blow against the bond market and more broadly, the economy. As per the CARES Act, the Fed has the capacity to take on another $500 billion in corporate debt.
As the Fed continues to carry out these protective measures, investors are growing skeptical of the kind of names being added to their balance sheet. For instance, the Federal Reserve purchased $1.3 billion in bonds issued by companies like Apple, Verizon, and Disney. The coverage surrounding these purchases would indicate some sort of sinister alliance between the Federal Reserve, the U.S. treasury, and our largest corporations and financial institutions. I mean surely, Apple is in no fragile condition. In reality, we are seeing the Fed intervene in our markets because the capital markets play an integral role in the function and wellbeing of our economy. Bond yields, which have already been low for over a decade, are compressing further, distorting the utility of our capital markets.
What do you mean?
People will often assert that the stock market is not the economy. To an extent, that’s true! The stock market is traditionally characterized by the 500 largest companies listed on American exchanges while the economy is the larger aggregate of all of the transactions that occur within a market. So yes, the stock market is not the economy but it represents a chunk of the transactions that comprise the economy — similar to how the foreign exchange and credit markets represent different baskets of transactions that occur in their respective parts of the economy.
Jerome Powell — Federal Reserve Chairman
Properly functioning capital markets are instrumental to a developed country. These markets allow for companies, individuals, and institutions to attain financing through equity or debt issuance. Similarly, capital markets can be a vehicle in which investors (individuals, businesses, or institutions) can partake in the wealth created and/or transferred from these transactions by purchasing securities like stocks or bonds. Investors seek cash dividends, or interest from bonds while seeking capital appreciation from their stocks. Put those together, and that’s what we call a diversified portfolio. Every American retiree, in one way or another, relies upon a diversified portfolio to carry them through retirement. However, as bond yields continue to fall, investors have found it more difficult to plan out their retirement years.
Too Much Wand Waving
If you owned $100,000 worth of 10-year U.S. Treasury bond in 2000, you would’ve collected $6,000-$7,000 per year in interest. Not bad, right?
Fast forward to today, a 10-year U.S. treasury bond yields a measly 0.57%, or $570 per year, assuming you hold a $100,000 position. What happened?
Following the catastrophe of the 2008 Global Financial Crisis, the Fed revealed a laundry list of new, unprecedented bond purchasing programs. Previously, the Federal Reserve was barred from keeping non-treasury securities on their balance sheet. However, the economic crisis was so dire that they were given access to a plethora of new inventory. Bond yields plummeted as credit became significantly cheaper from lowered interest rates and massive bond purchases.
This has, as you could probably guess, caused some issues in the realm of portfolio management. The credit markets, in a nutshell, are very simple: the riskier the debt, the higher the interest (yield). The collective compression of yield has forced the hand of fund managers (think: pension plans, Social Security, school endowments) towards riskier instruments in order to meet growth assumptions and distribution requirements. As a consequence, capital allocators and fixed-income fund managers have eschewed buying debt from blue-chip names in favor of buying debt from riskier names in industries such as cruises or airlines with the goal of reaping that higher yield. However, economists and institutions are concerned about whether or not these investors are being properly compensated for the risk they’re assuming.
Approximately 50% of the assets held in the three largest ‘Investment Grade’ bond ETFs (which hold a collective $120 billion in assets) are rated BBB. In other words, these funds hold debt that is on the fence of being labeled “junk” or “high yield” should their financial condition worsen. Also, ‘Junk’ debt isn’t allowed to be held in an ‘Investment Grade’ portfolio. So, if a company’s debt was downgraded to ‘Junk’ from ‘Investment Grade’ they would be forced to sell out of that position. When coronavirus halted all economic activity, all of this BBB-rated debt was at risk of being demoted to junk. To prevent an enormous selloff in our debt markets, the Federal Reserve stepped in to backstop the strength of these companies. Most of the debt securities that would’ve been downgraded to ‘Junk’ remained in the portfolio, and debt securities remained relatively safe… For now.
Debt = riskier; Yields = Lower
The CARES Act of 2020 revealed that the Federal Reserve had a $500 billion corporate credit facility used to help keep interest rates low and provide necessary liquidity. The reduction of risk in the credit markets has effectively compressed the yield of all fixed income securities. Just last week, a junk offering from Ball Corporation sold at a mere 2.87% yield. For context, investment grade bonds averaged a 6% annual return from 2002-2010. Investors have been pacified with a booming stock market, but as we all know, stocks do not, and can not defy gravity. There will come a day, if it is not here already, in which low interest rates will threaten the financial viability of some of the largest funds and financial institutions. What’s more, the Federal Reserve’s swelling balance sheet has economists wondering how all of this will deflate in the near future.
In summary, the Federal Reserve has backstopped the bond market because the bond market has broader economic implications. We certainly don’t want our senior citizens returning back to the workforce because their bond allocation has failed to serve their role in their portfolio. The broader economic implications from cheaper credit, however, should continue to distort the risk-reward tradeoff in our capital markets for quite some time.
Too much negativity: Can you name three countries in which their 10-year sovereign bond has a negative yield?
Answer at the bottom.
Back to the Frontier
It’s been a rough 2020 for our friends in Peru.
Back in April, FTSE Russell, one of the largest index providers in the world, demoted the country from ‘Emerging Market’ to ‘Frontier Market’ status. While the index’s decision to boot Peru isn’t necessarily tied to its economy, the demotion certainly has economic implications. The S&P/BVA Peru General Index is down 10% YTD and nearly 40% of assets have flowed out of the Peru All Shares ETF over the last year. In February, the Peruvian economy fell as much as 40% versus the same period a year ago. Diego Macera, the head of the Peruvian Economy Institute, predicts Peru will not see growth for another two years.
To add insult to injury, Peru has suffered from a rampant outbreak of coronavirus, despite being one of the first countries to implement lockdown. In fact, Peru maintained lockdown from March 13th until July 1st. The decision to end the lockdown was widely controversial as coronavirus cases were (and are) continuing to rise. As I write this, Peru has tallied the sixth most coronavirus cases of all countries across the globe.
Peru is the 49th largest economy by nominal GDP. The country celebrated one of the more dominant economies of the early 2010’s, notching 5.8% average annual growth from 2010-2014. This growth, however, would prove to be unsustainable as the country remained reliant upon their commodities exports. In 2011, 30% of Peru’s GDP was derived from their booming exports. Today, Peru has reduced its dependence upon exports (Exports are now 24% of GDP) although they have maintained their export prowess. Peru is the 10th biggest exporter of gold, the 14th largest exporter of silver, and the 2nd largest exporter of copper in the world. Besides that, the country exports over $5 billion per year in petroleum, lead, and calcium.
In 2020, services dominate the majority of Peruvian economic output, comprising over 50% of gross domestic product. These services range from more unsophisticated sectors such as tourism or manufacturing to more dynamic, disruptive services such as FinTech or telecommunications. In fact, TechCrunch reported that in February there were an estimated 120 FinTech startups looking to capture the market of 14 million unbanked people. By “banking” this market, these Peruvian startups can partake in the burgeoning FinTech landscape across the developing world. Business Insider Intelligence estimates that Latin America’s FinTech industry could reach a $150 billion valuation by 2021. I should also mention, the Peruvian government has been instrumental in buoying their nation’s startup sector. Incubators such as Innóvate Perú (government subsidized incubator), Wayra Peru (British-based global incubator), and StartUp Peru (similar to StartUp Chile) have guided the first nibbles of foreign capital. In 2019, US$11 million flowed into Peruvian startups, a 24% increase from the year prior and a new all-time high.
As I mentioned earlier, the Peru General Index (representative of the Lima Bourse) has fallen 10% on the year. The underperformance in Peru’s equity markets can be traced back to a multitude of factors but is mainly tied to the country’s slipping status as an emerging market. You see, being included in the MSCI Emerging Market index means increased liquidity in securities and a plethora of new, foreign capital. What’s interesting to me is that MSCI cited the index’s concentration in mining stocks as a peril to the economic viability of the nation. This is especially peculiar, given the recent spike in the price of gold, silver, and copper and the resurgence in mining stocks. Peru, given their resource capabilities, should be able to capitalize on the rising prices of commodities. Even better, Peru should be able to retrieve their status as an emerging market given a rebound in the share price of its largest companies.
Auld Lang Syne: Peruvians celebrate New Years Eve by sporting what peculiar garment?
Answer at the bottom.
Too Much Negativity: As of August 2020, these are the countries with a negatively yielding 10 year sovereign bond:
Auld Lang Syne: Peruvians like to celebrate New Year’s Eve by wearing yellow underwear. This is known to be a good luck charm, but only if you wear them inside out.
The Global Capitalist
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**None of this should be perceived as investment advice. Do your own research or speak with an advisor before investing in emerging markets.**