Assets That Could Be Floored by the Ceiling
Much continues to be written on the US debt ceiling, from coverage of the political negotiations to calculations of the X date when the government will be unable to spend more. Yet apart from general anxiety about the prospect of a default, technical or otherwise, little has been devoted to the practical near-term implications for portfolios. Here, then, we highlight three areas on which we will be focused over the coming weeks and months.
First, we note the risks facing T-bills, which are widely used for cash management. Recent experience has shown that these traditionally ‘safe’ instruments can sell off dramatically around expected X dates; Figure 1 shows how the yield on a one-month T-bill has jumped recently. A similar pattern was evident amid the debt discussions in 2011 and 2013. Given the potential for the X date to keep being pushed further out through temporary measures, we would be wary of holding concentrations of T-bills maturing in any given month.
Second, many strategies will be exposed to a generalised risk-off shock if the probability of a settlement ebbs. When the US credit rating was downgraded in 2011, for example, there were five-sigma moves in both equities and bonds, with international markets not immune (Figure 2).
Third, equities that are particularly sensitive to government spending – such as healthcare and industrials – could be especially negatively affected if the ceiling is not raised. Again, this was the case around previous debt-limit deadlines.1
Figure 1. T-Bills Yield Curve
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Source: Bloomberg; as of 19 May 2022.
Figure 2. Market Moves Around US Downgrade in 2011
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Source: Bloomberg; period covered is 27 July 2011 to 10 August 2011.
What VIX Can and Can’t Tell You
Given the uncertainty around the US debt ceiling, it’s possible to look at measures of market volatility and tell two very different stories.
- Investors are shrugging: the VIX Index of options-implied S&P 500 volatility is muted (Figure 3).
- Investors are panicking: open interest for VIX calls has reached its highest level since 2018 (Figure 4).
Both interpretations may owe more to the structure of volatility trading than to investors’ sentiment. For example, the low VIX readings can be attributed to the recent low realised volatility of the S&P 500 (also shown in Figure 3). The apparently very high demand for protection through VIX calls, meanwhile, can be seen primarily as a function of the broader longer-term trend towards buying options (also illustrated by Figure 4), which is not necessarily related to any specific current situation
Figure 3. VIX Index and Realised S&P 500 Volatility
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Source: Man AHL; as of 17 May 2023.
Figure 4. Open Interest in VIX Calls
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Source: Bloomberg; as of 19 May 2023.
What’s Next for Turkey?
Turkey’s politics have rarely stoked market euphoria in recent years, but the days before this month’s election seemed to challenge the pessimism that had long weighed on the country’s assets. As polls suggested that President Erdogan might lose, Turkish stocks gained 6.7% and spreads on credit-default swaps for five-year Turkish bonds tightened by 50 basis points in the two trading days before the vote (Figure 5). As it happened, Erdogan did not reach the necessary 50% threshold and so now faces a second round of voting; those spreads duly widened by 150 basis points. Could optimism return before the next round?
We don’t think so – and not just because Erdogan is expected to win. We continue to see Turkey as a fundamentally deteriorating story. The official inflation rate is above 40%2 as Erdogan’s policies of running the economy above potential (including through booming credit conditions) continue to fuel price pressure. The current-account deficit remains sizeable, with no viable plan in place to reduce it, in our view. And foreign reserves continue to dwindle, with net reserves estimated to be highly negative.3
We believed that market participants had become overly bullish based purely on the preelection polls. Yet even if Erdogan had lost the election, or does lose in the second round, the country’s economic problems seem to us to be intractable in the short to medium term. Turkish spreads and rates could therefore continue to widen even if the opposition wins the next vote, and could materially underperform if Erdogan prevails.
Figure 5. Turkey Five-Year Credit Default Swaps
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Source: Bloomberg; as of 22 May 2023.
With contribution from: Oliver Whitehead (Head of Investment Risk, Man AHL); Fedor Gorokhovik (Senior Quant, Man AHL); and Ehsan Bashi (Portfolio Manager, Man GLG).
1. Source: Goldman Sachs; as of May 2023.
2. Source: Bloomberg; as of 18 May 2023.
3. Goldman Sachs and Haver Analytics calculate Turkey’s net foreign assets excluding swaps to be almost -$75 billion, as of May 2023.
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