The large economies the IMF aren't mentioning might be in trouble

The IMF has stated on many occasions over the past three years that highly indebted countries are at risk of a prolonged period of economic stagnation or a depression, but has never actually named the US, Japan, or France. This is not to say that these countries are not as vulnerable as Spain, Italy, or Greece, that the IMF has named, but the size and more complex nature of their economies make it less likely that the problem will materialise at a sovereign level. In these big economies the domino like impact will come with the default of state-owned enterprises and local governments. This is where investors need to be looking for the seeds of the next problem. IMF Sounds Alarm on Government Debt Burdens.

The following chart shows that while households have been responsible with their borrowing the US Government and the US as a whole economy has not yet seen the light.

What triggers the defaults is higher inflation because higher inflation damages underlying cashflows. The markets at the moment are euphoric with a belief that the inflation battle has been won. The battle over transitory inflation has been won, but the monetary policy played a negligible role in its defeat (the real reason the Federal Reserve found cause to cut rates this year). Prices for durable goods that were pushed up by the pandemic lockdowns have now fallen back with the supply chains restored, however, inflation has been high enough for long enough to elevate wages growth to a level not consistent with inflation returning to the central bank’s targets. IMF warns central banks of ‘uncomfortable truth’ in inflation fight

The following chart shows the reason inflation is at a real risk of not only being embedded above the Federal Reserve core PCQ quarterly inflation target of 2% but will shortly begin to rise. Not only is wages growth too strong but welfare payments have been increasing.

Interest Rates

All the action was at the short end of the US yield curve last week with the market shifting away from any expectation of further rate cuts. The move in the two-year yield from 4.28-4.38% supported a significant increase in the USD. The USD strength explains the narrow trading range of bonds in the 5 to 10-year part of the curve where foreign investors will hold their USD assets. The 10-year bond yield was unchanged on the week at 4.41%.

Bond yields declined modestly last week along the curve with a lack of economic data to shift rate expectations. The 2-year yield from 4.13 to 4.095% and the 10-year from 4.61 to 4.556%. The short end of the curve may get some direction from the monthly CPI data this week while the long end outcome will be steered by the US curve.

Major Credit Markets

US investment grade (IG) markets remain strong with balance sheets in a low state of leverage as many companies such as Apple have huge cash balances. US credit spread indexes remain near lows.

Broadly floating rate margins were unchanged over the week with the iTraxx increasing from +61 to +63bps. Woolworths issued $800m fixed rate bonds at the bottom of the expected range at +148bps on a book of $1.8bn. The big trade for the week was the Barclays dual tranche 10.5-year NC 5-year kangaroo Tier 2. This is the first Kangaroo Tier 2 from a UK Holdco since 2021 and a testament to the strong credit demand in Australia. The issue margin at 200bps was 25bp inside initial offer and then the bond tightened another 15bps in the secondary. The Bendigo issued a covered bond at 83bps (rated AAA) $750m to replace an existing covered late on Friday.

High Yield Markets

US high yield (HY) markets rallied again buoyed by good equity markets and a lack of new issuance helping secondary market support. Spreads are at lows. In recent weeks, the Automotive and Financial services sectors have performed well. YTD the best sectors have been Healthcare, Retail and Technology

Hybrid volumes were elevated by about $5m more per day than usual led by consistent selling across the major bank hybrid curve. The average major bank hybrid margin increased over the week by 0.21% to 2.07%. Selling was across the curve pushing all margins higher. CBA hybrids topped the turnover list, with CBAPM and CBAPG showing volumes 2x normal weekly levels. Interestingly ANZ hybrid volumes were below average weekly levels. Outside the major banks, most volumes were at average or lower levels. Nevertheless, selling was evident in the non-majors with most margins also moving wider.

Listed Hybrid Market

Hybrids: price weakness creates better value into dividend season

Bank hybrids pay quarterly dividends and coincidently, most are paid in a December/ March/June/September cycle. The ex-dividend dates being early in those months. As we reported in mid=September, demand for the dividend payers was strong in that month that after the ex-dividend date, prices did not appropriately drop. What should occur is the trading price should fall by the value of the cash dividend plus the franking credit. For example, a $1.00 cash dividend typically would have $0.42 of attached franking credits (note this would be for a 100% franked dividend, some hybrid dividends are franked less than 100%, such as ANZ hybrids). In this example the trading price should fall by $1.42. A fall by less than this amount is good for the holder. Further, as the ex-dividend date approaches, buying tends to be strong pushing prices higher. Hence buying hybrids 1-2 weeks before the ex-dividend dates, which is this week or next, can be opportune. The table below shows the upcoming dividends and ex-dates. Yields are also shown. Which to buy? Hybrids which are currently sitting above the margin curve as shown in the chart below are best value. These hybrids are highlighted in the dividend table.