Overreaction Clock, No Landing Edition

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Good morning. It’s suddenly earnings season: Pepsi, where things have been a bit shaky lately, reports this morning. Delta and Domino come Thursday, followed by JPMorgan and Wells Fargo on Friday. So we will know more about the US economy by the end of the week. We expect the news to be pretty good. If you disagree, please email us: [email protected] and [email protected].

Overreaction clock

Yesterday’s letter noted that the long end of the Treasury curve has risen and wondered if this reflects (a) declining recession risks (b) resurgence of inflationary risks (c) higher expected volatility or (d) a combination of all three. After the letter was released, the 10-year Treasury broke 4% for the first time since August. The two-year yield also rose (a fact we should have mentioned yesterday). This gives additional weight to option (b). The point is that the two-year period, now at 3.99%, says the Federal Reserve doesn’t really have much room to cut before it gets some kind of inflation scare.

Bloomberg’s Ye Xie and Michael Mackenzie framed this as the market starting to fear again a “no-land scenario”: growth and inflation persist, and the Fed is either stuck where it is or has to hike rates. They cite macroeconomic luminaries Larry Summers and Mohamed El-Erian warning the Fed not to overreach with rate cuts if it hasn’t already. UBS’s Jason Draho notes that last week’s jobs numbers and other data suggest an economy operating at “a high level” and sees a resurgence of inflation as a real risk for 2025. He is one of many analysts pointing to the inflection economic of Citigroup. surprise index as proof that things have changed recently. It shows that economic indicators are surprisingly up, mostly, for the first time since April:

From now on, no-landing talks come in measured tones and lots of qualifications. The caution will dissolve if Thursday’s CPI inflation report for September shows no improvement from August.

It will come as no surprise to readers that Unhedged (house motto: calm down) doesn’t see much to worry about, nor will it be overly concerned about a bumpy CPI report. The main reasons to see an overheating economy and inflation backlash (outside of a single monthly jobs report) are higher oil prices and signs of a recovery in China. Rising oil prices are a geopolitical fact, and no one knows whether the war in the Middle East will get better or worse. Fortunately, other commodities – most notably copper – have not followed oil in the past week. China’s stock rally is based on a weakened market that was promised a fiscal stimulus that has yet to materialize, rather than a shift in economic fundamentals.

Those of us who have learned to drive in freezing climates know not to overreact to a bit of skid: it only makes the skid worse. Better to backtrack until your wheels regain traction. Over the next few quarters, markets will slide back and forth between inflation fears (this month) and slowdown fears (last month). Do not turn the wheel too hard.

Sukuk

The Maldives is one of too many developing countries at loggerheads with its financiers. His brush with default made headlines in the Financial Times. But if India had not intervened, the country would not have defaulted on sovereign bonds, but instead on a sovereign sukuk. That would have been a first.

A sukuk is an Islamic financial instrument with cash flows that closely resemble those of a bond. Islamic law prohibits the collection or payment of interest. Sukuk allow issuers to circumvent the ban; they typically sell investors a certificate and use the proceeds to buy an asset, and the investor is compensated with income payments generated by the asset.

There are many types of sukuk, but they can generally be divided into “asset-backed” and “asset-based”. In asset-backed issues, investors hold the underlying assets until the maturity of the sukuk, often with a cap on their returns and a minimum return guarantee. In asset-backed issues, investors own an intermediary entity or enter into a leasing agreement, closely mimicking a bond. The market price of asset-backed sukuk is based more on the issuer’s creditworthiness than the value of the underlying asset, and, barring default, lenders are insulated from changes in the asset’s value. But both types have payment schedules similar to a bond. From Mohamed Damak of S&P Global:

(There are) periodic distributions of funds. . . similar to a coupon, paid periodically. There is no ‘interest’, but this is often replaced by a ‘lease’ fee, and at the maturity of a transaction, the sukuk sponsor would assume the obligation and ownership of the assets, for consideration that would be equivalent. to the director.

Sukuk appeared 25 years ago in Malaysia and Bahrain. They have become popular: in 2024, sukuk worth $102.9 billion were issued.

Saudi Arabia is the main issuer this year:

Like bonds, sukuk have varying tenors and are denominated in both local and global currencies. Many sovereigns issue them together with bonds. Arthur D Little’s Nawaf Almaskati notes that these are useful for investors seeking exposure to Muslim economies. Investors believe that “this is going to be a hot market for years to come. There is a lot of liquidity in Islamic banks and institutions. . . and in recent years, the issuance and documentation of sukuk has been fairly standardised,” he says.

But new investors should be aware of a few things. There is a captive demand for sukuk as many Muslim investors will only invest in Sharia-compliant instruments. So yields tend to be lower than for equivalent bonds – but often just barely. It can be difficult to compare sukuk and bonds (Almaskati has a good approach here), but Saudi sovereign bonds and sukuk of similar tenors travel together:

On the flip side of lower yields, sukuk have relatively low default rates. Since 2000, there have been only 62 defaults in sukuk totaling about $5 billion – none of which came from sovereign borrowers and only 12 of which were denominated in dollars. This may be due to compliance hurdles faced by sukuk issuers. But the low default trend can be set to change. While the Maldives avoided default, indebted African sovereigns began issuing local currency sukuk to raise capital cheaper than is available in bond markets and to obtain financing from the UAE.

Importantly, the Accounting and Auditing Organization for Islamic Financial Institutions, the Shariah financial watchdog, recently proposed a controversial rule change. AAOIFI wants to limit asset-backed sukuk in favor of asset-backed sukuk, making sukuk look less like bonds. This could make sukuk less attractive to foreign investors and put a pause on issuance next year as “the people structuring the sukuk find a way to restore the fixed income features” while complying with the new ruling, says S&P Global’s Damak.

(Reiterate)

A good read

Female author.

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