Complex Made Simple

Risk, ruin and leveraged madness for the Arabian Gulf’s bond investors

Matein Khalid, veteran investor and Chief Investment Officer of Asas Capital in the DIFC gives an overview of the world's economy.

The Dow is down 700 points in the past two sessions – so my warning was priceless and prescient. For now… The IMF just warned about a “borrowing binge” by frontier markets with low junk/no ratings The US Treasury bond market has taken a steep hit in Thanksgiving week, with the yield on the 10 year T-bond note rising from 1.74% to 1.87%

Opinions expressed in this piece belong to the author and do not reflect the opinions or beliefs of AMEinfo. The author has expressly permitted for the piece to be published in its entirety on this platform. 

I was a tad unnerved by the thousands of views and hundreds of responses to my article that “This crazy bull market will crash and die in 2020”. Guess what? The Dow is down 700 points in the past two sessions – so my warning was priceless and prescient. For now…

When the world goes long greed, it is time to bail out. At 19.6 times earnings on the S&P 500 index, an euphoria peak means a 20% hit risk for me, when I would again load up on Big Tech/momentum darlings. Positioning in the futures markets is at levels last seen in September 2018 and July 2007 bubble peaks. So I think it is entirely rational for me to project a 300 point hit to the S&P 500 index sometime between now and March. My projected 2020 range for the big guy is 2600 – 3200.

Look at the fate of US retail stocks, down 70 – 80% from their peak. Softbank is another 50% short in Japan and the free fall has begun in the TSE as Masa-san’s $100 billion Vision Fund implodes. The $4 billion WeWorks write off is only the tip of the iceberg. So I reiterate my strategy call. Get real. Get derisked. Get out. El Torro is mucho loco and crazy bulls allow nobody to get out alive.

There is a speculative mania in the junkiest tranches of the emerging bond markets. Angola, a country with a 100% debt to GDP ratio and a collapsed currency vulnerable to oil/diamond export revenue swings, is now under an IMF bailout program. Yet Angola attracted $8 billion in bids for a $3 billion Eurobond new issue. Frothy? Insane. Will Angolan debt trade higher (spreads compress) in the secondary market? Yes – this market is obsessed with yield, not risk.

Read: The UK election and an anatomy of the coming sterling crisis!

Ironically, the IMF just warned about a “borrowing binge” by frontier markets with low junk/no ratings. This borrowing binge is the catalyst for the next sovereign debt servicing/default crisis in frontier markets whose debt has tripled to $200 billion since 2014. Scary? Scary as heck. I expect credit shocks here to trigger contagion on an intercontinental scale, like Mexico’s tesebonos default in 1994, the Russian rouble GKO default in 1998, Argentina’s sovereign debt meltdown in 2000 – and the Pacific Rim financial Armageddon in 1997-98.

A market where Poland now borrows money at negative yields. Uzbekistan is the current heartthrob of the Eurobond new issue market. Mark my words – the bubble’s bust will be as swift as it will be brutal. Zambia, Argentina, Bolivia, Ecuador and Lebanon are on the precipice of sovereign default but the leveraged money from the Gulf is flooding into EM debt. Leveraged EM debt is both farce and tragedy.

The US Treasury bond market has taken a steep hit in Thanksgiving week, with the yield on the 10 year T-bond note rising from 1.74% to 1.87%. The Treasury bond market is reacting to better economic data in China and Europe. This could be the onset of a new spasm of selling from real money/hedge funds, who are positioned to buy the ten-year Uncle Sam debt any time the 10 year yield rises to 1.95 – 2.10%.

While there is zero chance of a preemptive rate hike by the Powell Fed, Wall Street is way too complacent about inflation – and any nasty surprise will gut long duration bonds. There has been a quantum increase in leverage positioning in the Treasury bond futures market in Chicago. If inflation pops in 2020, expect an old-fashioned bloodbath in global debt.

Read: Sheikh Zayed inspired me to become a secret Emirati

As a student of credit cycles, I am stunned by the fact that the post-Lehman Obama/Tweeter in Chief economic expansion, goosed by Trump’s tax cuts, is the longest in American history.

True, growth is mediocre at 2% and the unemployment rate is the lowest since 1969, the year of Woodstock, the Apranet, the NASA moon landing and Richard Nixon replacing Lyndon B. Johnson in the White House as Pan Americana was quagmired in the rice paddies of Vietnam’s Mekong Delta.

This has been a benign, profitable environment to own leveraged corporate bonds, US high yield and leveraged GCC sukuk. A 30% leveraged return in the Aramco new issue Eurobond in four months is a far superior risk reward calculus for me than bidding for an IPO priced at 18 times earnings on the Tadawul.

The Aramco IPO will be a winner and at least 2 times oversubscribed and shares will rise up to 15% for a few weeks as long as Russia and the OPEC quota non-compliers play ball with Prince Abdelaziz in Vienna. Yet when 4.9 million retail investors scramble into a deal, I head for Disneyland.

When Fed Chairman Jay Powell lost his patience in January 2019 and later slashed the Fed Funds rate in three successive FOMC conclaves, I knew it was time to accumulate real estate investment trusts (REIT’s) with a vengeance as it would be another 20% total return year for the Nareit index, as it was. Prologis, Equinix and some Singapore puppies did far better than the index.

Read: The Saudi Aramco IPO and Brent crude oil prices will fly in December!

As mortgage rates plunge, Simple Simon/Credit Zeus led me to US homebuilder stocks. So I bought Lennar and DH Horton – check out the charts. As Ice Cube said, “aint nothin’ to it, gangsta rap made me do it!” Yet I can see the wicked witch of Wall Street’s broomstick haunt so many credit segments I track.

Credit spreads are too tight relative to the macro/funding risks I envisage in 2020. Contagion risk soars across the credit markets when risk aversion spikes from historically low levels in interest rates – and they have never been lower than now in centuries. As I scan real estate cap rates, high yield and IG corporate debt credit spreads, MBS/ABS spreads, I have an eerie déjà vu premonition for 2014, the monetary midpoint of this credit cycle when Dr. Yellen was in monetary tiptoe mode, gently signaling a QE exit.

With the Barclays Agg index up almost 10% in 2019, it was a party in the bond bazaar for most of my friends in the Gulf. Yet, the party is over now and waking up the next morning will be nasty. Leveraged debt investors in the Middle East, the trusting lambs being fleeced in 2020 at 0.4% a side private bank commission rates on a bond trade, plus fat lending margins, are going to perish when the party ends. They just do not know it yet.

Investors punting with the banks’s money remain utterly complacent about the scale of interest rate and credit risk in their leveraged bond portfolios. But then those who refuse to see are also incentivized to act blind, as the captains and kings of the UAE’s wealth management Mount Olympus brands will surely attest.

Credit is not just expensive but gone from the sublime to the ridiculous in most asset class constellations I track. Just as the S&P 500 index’s spectacular performance is based on multiple expansion rather than earnings growth, the debt markets have been elevated by credit spread compression, not fundamental financial risk improvement metrics.

In plain English, a leveraged, networked, hyper-kinetic daisy chain of speculative global hot money has led to wildly profitable bond market returns. The BB-CCC outperformance spreads signal only one thing – this is a speculative credit Frankenstein, not an improvement in corporate credit risk. So a bloodbath is inevitable.

Read: SAP shares are up 50% since my €82 buy conviction call in 2018!

Emerging markets debt (and equities/FX) is not a monolithic asset class. The dark alleys of the planet, the Third World, are divided by credit metrics, geopolitical nuances, funding risk, governance deficits, banking Ponzi schemes and leveraged debt pyramids.

Emerging market debt will encompass the good, the bad and the ugly next year. I see various country specific risks that spell defaults, restructurings and macro shocks simply not priced into current asset levels. The crystal ball of Matti-san rattles wildly on Indian shadow banks.

The GCC’s zombie banking, contractor/construction finance and retail/property malaise will deepen. Africa is deeply wounded by the slump in commodities, surge in systemic corruption and state capture, as the Gupta Triplets will testify when they win the Noble Economics Prize for looting South Africa blind.

Argentina faces a deep recession and Peronist misrule but the province of Buenos Aires could give us a fairy tale return once things go from terrible to just plain bad sometime in 2021, just as Lula’s Brazil C bonds did a seven bagger in 2003. Egypt will outperform the IMF targets but Pakistan will not. Sri Lanka’s debt to GDP ratio is unsustainable at 90% and the rupee can well tank to 240 against the dollar. Sadly, Moodys will downgrade South Africa to junk and precipitate another Rand debt crisis. Risk is a four letter word in the financial markets but then so is ruin.

Read: Lebanon: Ghosts, memories and monetary abyss