Market report March 2019

23.04.2019 * reading time: 15min


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United States: almost one-third of fiscal expenditure is not covered by receipts.

Many developed economies are still struggling with the challenge of a very high or rising level of indebtedness. In the United States, the federal budget deficit reached 29% of expenditures in the first quarter of the current fiscal year (October – December 2018), compared to 23% in the previous year. Total revenues increased by 0.2%, with income from corporation tax falling by almost 15%, and individual income taxes by 4.2% as a result of tax cuts started in 2018. This was offset by higher tax revenues from wages, excise duties and customs, after the introduction of various tariffs. Total expenditure increased by 9.6 percent, fueled by much higher interest payments and an increase in spending on military and social security. These quarterly trends have important implications for fiscal outlook. First, in times of a dynamically growing economy with record low unemployment, almost 30 percent of federal expenditures are not covered by receipts. This leaves the economy on track to add more than 6 percent of GDP to total debt by the end of the tax year. In the event of an economic slowdown or recession, the resulting fall in revenues and increase in expenditure may result in a further sharp increase in both ratios. Secondly, a large part of the current federal budget consists of compulsory expenditure on entitlement programs that are likely to increase in the future. Demographic factors will increase the payment of social benefits in the coming years. With the increase of interest rates from historically low to more normal levels, the cost of covering future budget deficits and refinancing of the past will continue to increase in current trends. Rising interest rates combined with existing debt levels and constant high financial needs are likely to increase spending to finance outstanding public debt.

East Asia: recent measures to mitigate China’s policy may drive further growth in domestic debt.

In the fourth quarter of 2018, GDP growth in China decreased to 6.4%, the lowest level since 1990. There was a lower growth in the services sector, especially in the real estate and retail and wholesale subsectors. In the face of strong internal and external problems, concerns about the risk of a sharp slowdown in the Chinese economy have increased.

In recent months, the Chinese authorities have introduced a number of measures to launch cash and liquidity funds in order to maintain a high level of growth. In January, the central bank reduced the reserve requirement of banks for the fifth time in 12 months. Earlier, he also raised bank loans, in particular loans to small and micro enterprises, in efforts to stimulate lending growth. In addition, the reduction of local government bonds was eased to increase infrastructure investments.

Although these measures will provide support for short-term growth, they can further increase already high levels of domestic debt. Data from the Bank for International Settlements (BIS) show that the indebtedness of non-financial corporations in China reached 155 percent of GDP in the second quarter of 2018. Given the slowdown in growth and high external uncertainty, there is an increased risk of unstructured deleveraging process in the future, with potentially negative consequences for real business operations.

Western Asia: low oil prices are forcing countries exporting oil to extend debt financing.

The drop in oil prices since 2014 has changed the fiscal situation of the major oil producers in the region, namely the member states of the Gulf Cooperation Council (GCC). When diversifying sources of income through the introduction of VAT, GCC countries also use more options for debt financing to compensate for budgetary shortages. In Saudi Arabia, the level of public debt increased sharply from 1.6% of GDP in 2014 to around 18% in 2018. Despite the pressures on fiscal balances, GCC countries have maintained an increase in spending on health, education and infrastructure, which are considered necessary for sustainable development through economic diversification.

Part of the growing fiscal needs in the region was financed by the issue of Sukuk papers, which are compatible with Sharia. Because Islamic principles prohibit interest payments, Sukuk returns are linked to the profits generated by basic material assets. In the case of Sukuk issued by governments, hedging assets are related to public projects. Saudi Arabia has raised 7 billion Saudi Riyal (SAR) each month in Sukuk, equivalent to $ 1.8 billion in January and SAR 9.4 billion ($ 2.5 billion) in February 2019. Bahrain is expected on international capital markets , Qatar, Saudi Arabia and Turkey will be active in the emissions of Sukuk. In addition to Western Asia, the active issuers of Sukuk are Malaysia and Indonesia. In February, Indonesia completed the innovative global emission of green Sukuk, raising USD 2 billion.

Russian Federation: public finances in the Russian Federation remain stable.

Among the economies of the Commonwealth of Independent States (CIS), the Russian Federation maintains a relatively low level of public debt since 2006, partly due to the continuing current account surpluses. At the end of 2017, the public debt-to-GDP ratio was around 12.6%. However, the debt of some regional governments remains a problem. Recent policies, including the adoption of the fiscal rule, have further strengthened public finances. At the beginning of February, Moody’s raised the country’s rating to the investment level. The needs of public loans are modest, and even if the United States imposes further sanctions on Russian sovereign debt, the required funds can be obtained domestically.
The total external debt of the Russian Federation has been decreasing since 2014, when access to foreign financial markets was limited by international sanctions and fell to the lowest level of 10 years, amounting to approximately USD 450 billion. At the same time, the country has accumulated huge sovereign international assets that can serve as a cushion against external shocks. On the other hand, some CIS energy importers, including Belarus and Ukraine, face a relatively high level of public debt (over 70% of GDP in the case of Ukraine) and a schedule for paying external debt for 2019-2020. For some of the smaller CIS economies, such as Armenia and Kyrgyzstan, the sharp rise in public and external debt from 2014 may be a medium-term risk.

Global problems: leveraged loans growth – financial risk and consequences for efficiency.

As discussed in the World Economic Situation and Perspectives 2019, high indebtedness has become a key element of the global economy. In the last decade, the level of indebtedness has clearly increased in all countries and sectors, fueled by a very loose monetary policy in major economies. Public and private debt have reached historical highs in many countries. According to the United Nations Conference on Trade and Development (UNCTAD), global debt is almost one third higher than in 2008 and more than three times greater than global gross domestic product (GDP).
In the face of signals that global growth has reached the highest level and with uncertainty about the monetary policy trajectory of the United States Federal Reserve (Fed), high global debt is not in itself only a financial risk, but also a source of sensitivity in the event of a downturn. Faster than expected increase in interest rates and a sudden increase in global financing costs pose a risk to debt and financial stability. While high levels of corporate debt may intensify the economic slowdown, high sovereign debt limits the fiscal policy space, hindering policy response and potentially delaying recovery. These aspects are particularly important because global growth was strongly dependent on the extraordinary easing of monetary policy and short-term expectations for asset growth. This increased the financial risk by strengthening behavior related to seeking income and encouraging financial activities such as mergers and acquisitions (M & A) and repurchase of shares rather than production investments.
The level of issue of leveraged loans is shown in the graph: the left scale in USD billion, the right scale of the figure is the following years:


The continued growth of leveraged loans in several developed countries is increasingly seen as a potential risk to financial stability. The term “leveraged loans” is used to describe syndicated loans with variable interest rates granted to companies that already have a high level of debt in relation to profits and a low credit rating. After the collapse during the global financial crisis, leveraged loans have recently revived in the United States and Europe, especially in the United Kingdom of Great Britain and Northern Ireland. The current total size of the global leveraged loan market is around $ 1.3 trillion, more than double the amount of ten years ago. In the United States, it exceeds the size of the corporate high yield bond market.
The increase in leveraged loans was supported by investors’ searches, and more recently the prospects of higher interest rates. In 2017 and 2018, the global emission of leveraged loans reached the pre-crisis level close to USD 700 billion annually (see Figure 1). The expansion of leveraged loans was facilitated by increased securitization due to secured credit obligations (CLO), a financial instrument in which payments from many companies are combined and then sold to investors in various tranches. Recent changes in the US loan enforcement procedures have made it easier for banks to enter different CLO tranches on the market. At the same time, companies with high indebtedness are attracted to this type of financing, which is generally more flexible than bonds.

There are growing concerns about the growing risk in the leveraged loan market and the consequences for financial stability in the event of a sudden change in investors’ moods. The growing demand of investors, combined with the growing number of companies willing to incur higher debts, led to deterioration of the underwriting and credit quality standards of these loans. For example, the share of so-called leveraged loans in the “covenant lite” – in which investors do not require borrowers to maintain certain financial ratios – has steadily increased in recent years, reaching record levels of around 80 per cent of total emissions (Figure 2). In addition, the majority of new issues of leveraged loans are used to change the financing structures of enterprises (refinance their debt), instead of financing new production investments. Finally, the leverage of borrowers has also recently increased. For example, the share of leveraged loans granted to companies with debt to profit ratios equal to or higher than 6 reached around 30 percent in 2018, the highest level since the global financial crisis.
This shows the growing tolerance for investors’ risk in the corporate debt market. In particular, these trends in leveraged loans contain similarities to the subprime mortgage market before the crisis.
The chart below shows the share of covenant-lite loans in total leveraged loans:

In the face of growing corporate financial leverage and lower credit quality, slower economic growth and higher interest rates can significantly increase the difficulties of debt transfer companies. The increase in bankruptcies, loan defaults and market losses may trigger sales and trigger a downward spiral of prices and a breakdown in liquidity. Given the highly interconnected financial systems, this can have wider financial and economic implications. However, in contrast to pre-crisis mortgage loans, leveraged loans currently do not have significant re-securitization rates (“securitization of securitization”). They also include a certain degree of investor protection, as they are located in the upper part of the loan structure of asset-backed companies. In addition, the banking system is better prepared to deal with wider financial consequences than before the global financial crisis, with better capitalization of banks and less reliance on short-term financing. Thus, while leveraged loans may not trigger a widespread financial meltdown, it can certainly aggravate the economic downturn, especially given its growing importance for M & A funding, dividend payments and share repurchase.

The expansion of leveraged loans may also have an impact on productivity growth. These loans constitute an important source of financing for companies undergoing temporary economic and financial difficulties, but they may also maintain poorly managed and inefficient companies on the market. This may prevent a more dynamic and effective reallocation of resources, thus limiting the increase in efficiency. In recent years, the spread of the so-called “zombie companies” – confirms the constant problems with fulfilling obligations in terms of interest payments – is constantly growing in developed countries. Although it is difficult to establish a direct relationship between leveraged loans and productivity growth, recent evidence indicates that reduced financial pressure and lower interest rates are associated with a higher advantage of such companies. In a broader sense, while the observed slowdown in productivity growth was mainly related to such factors as technological changes, demography and trade, the role of monetary policy deserves further attention. To manage future crises, it is necessary to better understand the short and medium-term implications of the ultra easing monetary policy for the enterprise sector.


The Cold War climate prevails in the gold market: for the first time in 50 years, central banks have bought over 640 tons of gold last year, almost twice as many as in 2017, and most since 1971, when US President Richard Nixon closed the Gold Standard era . An interesting fact is that the European central banks, along with the Asian ones, were the most aggressive in shopping: is it a fear of the euro crisis and currency wars? The reform of the credit and finance standards from the Basel 3 plan de facto enables banks to convert gold into cash in the balance sheets of large banking groups. From 29 March this year, by the BIS decision, gold in the portfolio of commercial and business banks becomes a cash equivalent and therefore “without risk”. In fact, this is the first “re-monetization of gold” since the Bretton Woods agreement: technicians call it “gold re-monetization,” a process that is opposite to Nixon’s “demonatization” of gold.
The BIS operation has the full approval of the FED, the ECB, the Bundesbank, the Bank of England and the Bank of France, the G-5 of the great global monetary powers. In 2016, when new banking system rules were defined in the Basel 3 package, the Central Banks Committee introduced a norm of epochal importance that no one ever openly discussed in public. In practice, gold in “physical” ingots – and therefore not in a “synthetic” form, such as certificates – is once again considered by regulators as equivalent to the dollar and the euro in terms of asset security, thus eliminating the obligation to weigh the risk increase for absorption purposes capital, as is the case for any other financial asset, excluding (for now) government bonds of the euro area.
The turning point is not trivial for the gold market and the very role of national gold reserves. The result is significant: thanks to Basel 3’s new provisions, gold receives the same status, which is now recognized for government bonds in bank balance sheets. The question arises: Is the promotion of gold a prerequisite for applying the risk weighting factor to government bonds held by banks? After the emergence of the debt crisis in 2008, the purpose of regulatory authorities was in fact twofold: requiring the banking system to hold adequate assets to cover the growing risk of credit growth. The focus is primarily on government bonds, which according to current rules can be maintained by banks without affecting their assets. The problem mainly concerns low-rated countries, such as Italy, Spain, Portugal and Greece, which are observed after the debt crisis of 2011.
In 2018, the monetary authorities of each continent bought as much as 641 tons of gold bars, but above all in Europe: this is the highest level since 1971. The maneuver is unprecedented and must be seen as a phenomenon of repatriation of gold ingots entrusted in the so-called custody. Seven thousand tons of gold reserves were withdrawn from central banks by the New York Federal Reserve treasury, and 400 tons were secretly released by the Bank of England. In recent years, but especially in 2018, the jump in gold prices should be large. On the contrary, gold ended 2018 with a general decline of 7%. How to explain it?
While the central banks collected “real” gold bars behind the scenes, they also made short sales and coordinated the offer of hundreds of tonnes of “synthetic gold” on the London and New York stock exchanges, where 90% of metal trade takes place precious: surplus supply of gold derivatives obviously contributed to lower the price, forcing investors to liquidate positions in order to limit the large ones generated in futures contracts. Thus, the more the price of forward contracts fell, the more investors sold “synthetic gold”, causing downward spirals used by central banks to buy physical gold at ever lower prices.
China, India, Russia and Turkey virtually doubled their gold reserves over the past five years. Moscow, to buy gold, even sold the last 20% of US government bonds that it had in foreign currency reserves.


In the last week of March, the British Prime Minister Theresa May has lost another important vote on Brexit in the Parliament. This was the third attempt to vote for Brexit and ended with another failure. The Brexit process has so far been the political and economic nightmare of Great Britain, and the situation is full of constant conflicts and uncertainty.
The market most associated with the ups and downs (mainly downs) of Brexit negotiations is the British Sterling, which is still fluctuating along with the changing expectations and events related to the withdrawal of Great Britain from the European Union.
A condition for Brexit to pass through the House of Commons is whether the government will succeed in replacing the emergency mechanism for Northern Ireland (the so-called backstop) with a new, alternative record.

Reversed yield curve in the US

In March 2019, the difference between three-month and 10-year yields turned out negative for the first time since August 2007, going down to minus 1 basis point, after information from the Federal Reserve regarding its expectations regarding further interest rate increases. Other measurements have also dropped. The difference between the two- and ten-year margins dropped below 10 basis points for the first time this year. This is the main indicator observed by investors who turned back – short-term profitability increased above long-term profitability – which occurred before each recession since the Second World War. In March, the yield curve in the US reversed.

The April market report will be released in the first week of May.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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