Global Macro Investing

The importance of country balance sheet analysis

Originally published in the December 2012/January 2013 issue

Ithuba Capital is a global macro discretionary fund which principally invests in sovereign credits, rates and FX. We believe markets still focus too much on predicting the next GDP figure and not enough on analysing country balance sheets, how they will evolve over time and potential policy responses. Our analytical process is built around the twin pillars of country balance sheet analysis and understanding policymakers’ reaction functions. This is designed to identify strong risk/reward macro opportunities in the post financial crisis market environment.

Balance sheet analysis
Ithuba analyses country balance sheets both in terms of the sustainability of public and private sector debt, and also external debt. Financial sector capitalisation and risk of contingent liabilities to the government are also key. In relation to this, buffers to absorb balance sheet shocks between sectors are also important (for example, in the future the ESM may be directly able to recapitalise EMU banks).

Evaluating QE and balance sheets
Balance sheet analysis is crucial when analysing the effects of quantitative easing (QE). It’s not possible to separate one from the other when evaluating the specific and broader impact of unorthodox policy. Put simply, the impact of monetary policy depends on the state of country balance sheets and the overall policy mix. The shorter-term context of this is the fiscal-monetary policy mix. The long-term context is the post balance sheet recession “financial cycle”, as opposed to the business cycle, and the extent to which leverage and asset prices have re-coupled with fundamentals.

The financial market implications of unorthodox monetary policy differ significantly depending on the extent of fiscal and balance sheet headwinds. In this context, QE is no panacea. Having said that, the recent move to “unconventional-unconventional” Fed policy whereby it commits to keep rates at very low levels even when unemployment has fallen significantly and inflation has risen somewhat above its long-term goal is nevertheless important. This is because it is consistent with the message that even if balance sheet or fiscal headwinds ease policy will remain very loose. This has important ramifications for the spill-over of unorthodox monetary policy to global markets.

QE in a global context
As a consequence of unorthodox central bank policy, at the end of 2012 our G3 policy accommodation measures are at or close to record looseness across the nominal and real rates space and central bank balance sheet size. Importantly, accommodative monetary policy is occurring at the same time as fiscal policymaker-driven balance sheet repair in Europe (Spanish banking recaps), whilst in the US private sector leverage has also fallen. This increases the probability of both financial markets and macro (growth) spill-over to the rest of the world.

In an emerging markets context, stronger balance sheet fundamentals at the same time as unorthodox G3 monetary policy will continue to exert a significant impact on emerging markets. Associated inflows mean stronger emerging market (EM) currencies than they otherwise would be at this point in the global cycle and correspondingly looser monetary policy for any given level of targeted monetary conditions. Strong inflows in turn are pushing EM towards “regime change”, whereby monetary policymakers adopt increasingly unorthodox targets or tools.

Balance sheets and debt supply
Inflows into EM also occur at a time of relatively constrained debt supply. This is a direct function of lower debt levels. Average gross EM sovereign debt issuance in 2013 is 8% of GDP compared to 25% in developed markets. Risk of EM being “crowded out” of markets by developed markets (DM) is offset both by the impact of QE on the largest markets (e.g., the US, whereby the Fed will buy the majority of net issuance) and by higher quality EM fundamentals (at the moment).

The two main points to emphasise are:

(1) EM supply will remain relatively limited during 2013 against the backdrop of very loose developed market monetary policy – this is a function of stronger balance sheets.
(2) DM supply will be partly digested by policymakers (QE and likely outright monetary transactions, or OMT). This is a function of the policy response.

Implications for global macro investing
The discussion so far underlines that country balance sheet analysis is pivotal in evaluating the efficacy of unorthodox policy and its spill-over to global markets and macro. More broadly, the implications for global macro investing are:

• Don’t overemphasize month-to-month cyclical data (to the extent to which this is a function of balance sheets and the policy response).
• Focus on country balance sheet analysis, both from a static vulnerability perspective and in terms of potential shocks.
• Understand how balance sheet fundamentals impact monetary policy effectiveness and/or, constrain fiscal policy flexibility.
• Investigate how policymakers will react in different balance sheet risk scenarios.
• Play secular themes based on balance sheet differentiation (or vulnerability to shocks).

This necessarily implies both a heavy focus on quantitative country fundamentals as well as on a more qualitative analysis of policymaker reaction functions. Both are at the heart of Ithuba’s investment process. This also means time spent on the road maintaining a dialogue with policymakers globally and their advisors.

Understanding country balance sheets, in conjunction with policymakers’ reaction functions, is also pivotal for identifying opportunities. From a thematic perspective, for example, this is with respect to G3 unorthodox policy spill-over to emerging markets and the extent to which it impacts the policy, macro and market environment there. From a bottom-up perspective it helps determine relative supply/demand for sovereign debt and how regime change at the local level will impact markets.

The bottom line is that country balance sheet analysis should be at the heart of the global macro investment process.

Martin Blum is managing partner and portfolio manager at Ithuba Capital. He co-founded the Ithuba Macro Opportunities Fund in October 2010 and also manages the company’s long-only European Periphery fixed income mandate.