Reacting to a Norwegian Warning

Tue, 2017/09/05 - 1:57pm | Your editor
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Here is something to worry about besides the risks of a confrontation with nuclear weapons between Kim and Trump. The Norwegian wealth fund has decided that it will only buy corporate bonds denominated in dollars, sterling, or euros, and for a term of no more than 10 years under its new performance benchmark published yesterday. So the managers of the oil wealth investments are forced to avoid bonds denominated in other currencies, even the Norwegian one, as they place some of Norway's $990 bn portfolio. Behind this Viking move, is the realization that the gains from broad international diversification are not worth the risk for bonds and fixed income investment. It is not the same as for equities, where diversification cuts risks.

“For an investor with 70% in an internationally diversified portfolio, there is little reduction in risk to be obtained by diversifying his bond holdings across a large number of currencies,” the fund wrote in its letter yesterday to the Oslo Minister of Finance, published in today's Financial Times. What works for stocks does not work for fixed income, writes another mentor yesterday:

“In most major markets, credit growth and property prices, which often tend to be destabilising, have been reasonably well-behaved relative to nominal GDP growth. The situation in smaller advanced economies, such as Canada and Australia, and a number of EMs [emerging markets] is different. They have experienced more intense expansionary financing phases. There is evidence tha the EM credit cycle is in a state of excess and thant some EM economies, including China, are now at high risk of financial crisis.

“The vulnerability of the EMs is deepened by large overseas holdings of their debt and their extensive issuance of FX-denominated securities. Some 25% of EM debt is foreign-owned, while EM external FX-debt stood at around 12% of GDP in 2016, up from 10% in 2007, although lower than the peak of [over] 18% before the 1997 Asian Crisis. Dollar debt in the past played a big role in EM crises, either as a trigger of a sudden capital flow 'stop' or as an amplifier. The combination of depreciation [vs] the US dollar and higher US dollar interest rates has proved a poisonous cocktail.

“That said, it could be argued that the EMs are better protected against 'sudden stops' in capital inflows than in the past. Flexible exchange rates are more common, and current account deficits have fallen in a number of economies, partly because of cyclical reasons. The shortfalls in Argentina, South Africa, Turkey, and Egypt remain [a] concern.

“Countries have accumulated sizeable FX war chests, although these have recently begun to fall. Oil exporters' FX reserves have dropped to a 10 year low.

“The threat of EM trauma is increasingly pertinent from a global perspectives. The EMs today account for almost 60% of global GDP, 36% of world exports, and 86% of the global population. Since the [global financial crisis] their contribution to global growth has been [about] 80%.

“Financial globalisation has made asset markets increasingly inter-dependent. About 70-80% of equity and foreign exchange returns in both advanced and emerging market economies are attributiona to international factors. Financial spill-overs are the norm, not the exception. The is evidence of [more] spill-overs from EMs equity and foreign exchange markets. Between 30% and 40% of the variation in advanced and EMs economies stock returns and exchange rate fluctuations can now be explained by EMs financial markets.”

So writes Russell Jones today in a note on financial fragility and excess, published by from London. Given that we have just recommended buying a fund invested in high-risk emerging markets and other below-prime debt, I am quoting Mr Jones to explain my logic. We are exposed to this paper even if we are not investing to get its high yields. So with a well-managed closed and fund trading (as they do) at a discount from net-asset value, at least we are getting some of the yield from the global exposure to high-risk paper. More for paid subscribers from Germany, Australia, Brazil, Canada, Britain, Mexico, the Dutch Antilles, Israel,  India, and two items from Colombia.

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