Overreaction watch, no-landing version | USAEMALL.com

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Good morning. Suddenly it is earnings season: Pepsi, where things have been a bit shaky lately, reports this morning. Delta and Domino’s come on Thursday, followed by JPMorgan and Wells Fargo on Friday. So we’ll know a bit more about the US economy by week’s end. We expect the news to be pretty good. If you disagree, email us: robert.armstrong@ft.com and aiden.reiter@ft.com. 

Overreaction watch

Yesterday’s letter noted that the long end of the Treasury curve has been rising, and wondered whether this reflected (a) falling recession risks (b) resurgent inflation risks (c) higher expected volatility, or (d) a mix of all three. After the letter went out, the 10-year Treasury broke 4 per cent for the first time since August. The two-year yield has been rising briskly too (a fact we should have mentioned yesterday). This lends some additional weight to option (b). The idea is that the two-year, now at 3.99 per cent, is saying that the Federal Reserve doesn’t actually have too much more room to cut before we get some sort of inflation scare.

Bloomberg’s Ye Xie and Michael Mackenzie framed this as the market starting to fear a “no-landing scenario” again: growth and inflation persist, and the Fed is either stuck where it is or has to raise rates. They quote macro eminences Larry Summers and Mohamed El-Erian warning the Fed against getting ahead of itself with rate cuts, if it hasn’t already. Jason Draho of UBS notes that last week’s jobs numbers and other data are suggestive of an economy running at “an elevated level”, and sees resurgent inflation as a live risk for 2025. He is one of many analysts pointing at the inflection in Citigroup’s economic surprise index as evidence that things have changed recently. It shows that economic indicators are surprising to the upside more often than not for the first time since April:

As of now, no-landing talk comes in measured tones and with plenty of qualifications. The caution will dissolve if Thursday’s CPI inflation report for September shows no improvement over that of August.

It will not surprise readers that Unhedged (house motto: calm down) does not see much to worry about, and won’t be too worried by an uneven CPI report, either. The main reasons to see an overheating economy and resurgent inflation (outside of a single monthly jobs report) are a higher oil price and signs of a recovery in China. The oil price jump is a geopolitical fact, and no one knows if the war in the Middle East will get better or worse. Happily, other commodities — most importantly copper — have not followed oil up in the past week. The equity rally in China is based on a washed-out market that has been promised fiscal stimulus that has not yet been delivered, rather than a change in economic fundamentals.

Those of us who learned to drive in icy climates know not to overreact to a little bit of skidding: it just makes the skid worse. Better to turn into the skid until your wheels regain traction. In the next few quarters, markets will slide back and forth between fears of inflation (this month) and fears of a slowdown (last month). Don’t turn the wheel too hard.

Sukuk

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

A sukuk is an Islamic financial instrument with cash flows that look a lot like that of a bond. Islamic law prohibits the collection or payment of interest. Sukuk allow issuers to get around the prohibition; they typically sell investors a certificate and use the proceeds to buy an asset, and the investor is compensated with payments of revenue generated by the asset.

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

[There are] periodic distributions of funds . . . similar to a coupon, paid on a periodic basis. There is no actual “interest”, but that is often substituted for a “lease” charge, and at the maturity of a transaction, the sponsor of the sukuk would undertake the obligation and ownership of the assets, at a consideration that would be equivalent to the principal.

Sukuk emerged 25 years ago in Malaysia and Bahrain. They’ve become popular: $102.9bn worth of sukuk have been issued in 2024.

Saudi Arabia is the leading issuer this year: 

Like bonds, sukuk have various tenors and are denominated in both local and global currencies. Many sovereigns issue them alongside bonds. Nawaf Almaskati at Arthur D Little notes that they are useful for investors who want exposure to Muslim economies. Investors think “this will be a hot market in 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 captive demand for sukuk, as many Muslim investors will only invest in Shariah-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 the lower yields, sukuk have relatively low default rates. Since 2000, there have only been 62 sukuk defaults totalling about $5bn — none of which were from sovereign borrowers, and only 12 of which were dollar-denominated. That may be down to the compliance hurdles sukuk issuers face. But the low default trend may be set to change. While the Maldives avoided default, indebted African sovereigns have started to issue local currency sukuk to get cheaper capital than is available in bond markets, and to draw financing from the UAE.

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

(Reiter)

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