“Water, water, everywhere, nor any drop to drink.” - Samuel Taylor Coleridge

Jeleze Hattingh
Portfolio Manager

M Sc (Cum Laude), CFA, CMT

Environmental disasters are a costly business

At the time of writing, the Western Cape is in the grip of one of the worst droughts in decades. Slowly but surely the impact of potentially running out of water is starting to sink in – not only as it pertains to day-to-day living, but also the potential impact to the economy, agricultural sector and businesses in general. And this is not a South African phenomenon - numerous environmental disasters have rocked the globe over the past couple of months, with repercussions that investors are only slowly getting to grips with. We’ve seen devastating hurricanes (Harvey, Irma and Maria) that inflicted havoc across the Caribbean islands, the Florida peninsula and the Texas coastline, monsoon floods affecting millions in south Asia, and mudslides in Sierra Leone and the DRC killing hundreds.

Locally we saw a record breaking fire-storm in the Southern Cape that destroyed a large number of properties in its wake – the Knysna fire is now seen as the most severe wildfire in history since the so-called “Great Fire of 1869”. One of South Africa’s largest insurers, Santam, stated “this was by far the worst catastrophe event in South African insurance history, with Santam client claims totalling around R800 million”. Although insurance companies so far estimate the insured costs to be between R3bn and R4bn, the total cost is probably billions more if one were to take in account damage to uninsured property, seeing that more than 50% of the 1 060 houses that were destroyed, were not insured.

The true economic cost of the above natural disasters will only become clearer in the coming months, but estimates are already being bandied around. As demonstrated by the above quote, the first damage estimates following a natural disaster typically come from insurance companies, who have a good understanding of the extent of the cost of replacing insured goods like houses and cars. As an aside, insurance companies’ share prices are usually the first to take a beating when a disaster strikes – in the period between Hurricane Harvey dissipating and before Hurricane Irma made landfall, stock prices for insurance companies in the U.S. dropped as much as 16% as they braced for the bill. And the sell-off still looks fairly modest, if one takes into account that the latest estimated damage (for only the three hurricanes) are currently standing way over $500 billion already – with the potential to shave up to 1.0% off the U.S.’s GDP growth.

Examples of the impact of the hurricanes are below:

  • Hurricane Harvey:
    • Texas Governor Greg Abbott estimated the damage at $150 billion to $180 billion, calling it more costly than epic Hurricanes Katrina or Sandy, which devastated New Orleans in 2005 and New York City in 2012. Much of the recovery expenses will go to property damage, but the extensive flooding during Harvey means that vehicle losses will also be extremely costly with 300,000 to 500,000 vehicles destroyed in Houston alone.
    • Lloyd’s of London, the insurance market where members join together as syndicates to insure risks, has said that Hurricanes Harvey and Irma were likely to cost it at least $4.5 billion - that would more than wipe out this year’s profit and eat into capital.
  • Hurricane Irma:
    • According to research from Credit Suisse, the economic cost of Hurricane Irma could rise as high as $250 billion with insurance firms potentially on the hook for between $100 billion and $150 billion when the clean-up operation gets under way.
  • Hurricane Maria:
    • According to Moody’s Analytics, Hurricane Maria could cost Puerto Rico $45 billion to $95 billion in damage. The high end of the range represents almost an entire year’s economic output for Puerto Rico. To make matters worse, Puerto Rico’s economy was already struggling. The island has been in recession for 11 years and has filed for the largest municipal bankruptcy in U.S. history in May 2017 already.

The impact of natural disasters on insurance companies is just the tip of the ice-berg. The resultant increase in inequality is where the real problem lies.Post-disaster, people with insurance in place (as well as the means to pay a premium for labour and materials), tend to bounce back faster than those who do not - worsening entrenched inequalities which in turn lead to increased social upheaval and unrest.

An empty purse in the aftermath

Leaving the social impacts aside for a moment, the next point to be addressed on the back of these disasters is to figure out who will foot the bill. Even though the wealthy private sector will be able to recoup their losses from insurance companies (and their underlying investors), it only contributes a small amount to the post disaster recovery effort. The largest funding contributions are required to reconstruct crucial infrastructure and support the underinsured (and poor) portion of the affected population. This part will still need to be funded by national government or the respective municipalities themselves. This cost is; however, again passed on to either investors (directly through a potential blow-out in the cost of debt or even more serious default), or the man in the street (indirectly through redirection of available money in the fiscus or directly through an increase in levies and taxes).

Puerto Rico is a great example of how a country’s (or in this case, municipal state’s) existing bond holders can end up ultimately paying for a large portion of the costs. President Trump made a statement (post Hurricane Maria hitting the island) that Puerto Rico’s debt will have to be wiped out prior to the U.S. federal government stepping in with financial assistance: “They owe a lot of money to your friends on Wall Street and we’re going to have to wipe that out. You’re going to say goodbye to that, I don’t know if it’s Goldman Sachs, but whoever it is you can wave goodbye to that”. As a result, the Puerto Rican bonds crashed 34% to record lows due to investors’ fears that the bonds will not be repaid. Adding insult to injury, Trump’s Budget Director Mick Mulvaney reiterated that “we are not going to bail them out, we are not going to pay off those debts, we are not going to bail out those bond holders.”

It is fortunately not that easy to just “wipe out” $74 billion in municipal debt (most of it owned by retail investors), but regardless, even just alluding to it has provided a shock to investor faith in a market long considered a relative low risk investment. In a best case scenario, Puerto Rico will not default on their bonds, but their yields (and U.S. municipal bonds’ yields in general) will continue to rise, making it even more expensive and punitive for municipalities to fund themselves.

Instead of just dealing with the aftermath of what is deemed to be the “biggest catastrophe” in the island’s history, it also has to fight with bond holders and the U.S. federal government. As per a note from CreditSight, Puerto Rico will likely prioritize rebuilding expenses over debt obligations. If Puerto Rico were to get U.S. federal relief – which seems very unlikely even though extremely necessary - repayment of debt from the U.S. federal government is likely to take seniority over existing debt obligations.

So in summary, retail investors, holding positions in supposedly safe U.S. municipal bonds, will be picking up a large portion of the tab, one way or another.

Natural disasters vs man-made disasters

Natural disasters and their associated costs can’t necessarily be avoided. However, we are in the midst of a massive man-made disaster in the making… called the high yield bond market.

The Victorian English journalist Walter Bagehot once said that “John Law can stand anything but he can’t stand 2%”, implying that very low interest rates induce speculation, reckless investing and misallocation of capital. And that is exactly what is currently happening in the high yield bond market.

Since the Great Financial Crisis in 2007-2008, global central banks have deployed extreme and unconventional monetary policies, keeping short-term interest rates at record low levels and pushing long-term yields down through quantitative easing (“QE”) programs – the various central banks purchased over $14 trillion worth of government bonds! These extreme policies had the effect of driving all asset class prices to record highs, and in the process pushing investors out on the risk curve in a continuous chase for yield. There are now numerous signs of investors throwing caution to the wind in their desperation for higher yield.

For decades, U.S. Treasury Bonds have been treated as the ultimate safe haven and least risky asset class. Common economic theory holds that the “safer” the asset, the lower the return should be. However, during the past year we have seen over 60% of European high yield bonds (also called “Junk Bonds”) trade at yields lower than U.S. Treasury Bonds. One can argue that the European Central Bank (“ECB”) is behind this specific folly – and as long as they continue with their expanding QE programme, there will still be some short term opportunities for countries to raise cheap debt, and for speculators to make a quick buck in the EU bond market. But one can’t stress the timeframe of “short term” enough!

The actions of the ECB have led to the likes of Ireland selling its first ever 5 year bond with a negative yield and a coupon of 0%. This means Ireland is effectively being paid to borrow money, and does not have to make any interest payments at all. To put it into perspective, in 2012, in the midst of Europe’s sovereign debt crisis, Ireland issued a similar 5 year bond, but had to pay 5.5% to ensure that investors will finance their government. Fast forward 5 years later, and the yield is a negative -0.008% – great for Ireland, but potentially disastrous for the new investors!

Looking at the below graph, it is obvious that this is a very short term opportunity - during the previous two financial market corrections (and for that matter any risk-off period), the junk bond yields blew out to multiples of the safe haven U.S. bond yields. If a similar sell-off is to happen again, regardless of the reason behind it, it will lead to a bloodbath across the various bond markets.

As discussed earlier, global QE programmes have pushed investors far out on the curve in a search for yield, way past developed markets high yield bonds. One only has to look at investors’ recent willingness to buy Euro and Dollar bonds issued by the likes of Lebanon, Iraq, Ukraine and Egypt at yields of below 7%. In addition, look at the Ivory Coast that issued 16 year debt at 6.25% in the midst of a military uprising!

Taking the Lebanese 10 year USD Bond as an example: Lebanon is located in the war-torn Middle East and mired with governmental challenges, ranging from the militant group Hezbollah being based in the south of the country to the government not publishing GDP statistics since 2008. However, the risk premium that a rational investor would normally require to invest (given the geopolitical risk of the Middle East, the economic and governance issues, currency risk, to name but a few) seems to have disappeared, with their 10 year bond yields sitting at just 5.1% – implying a paper thin 2.6% risk premium!

According to Steven Bregman (the co-founder of Horizon Kinetics), the wild popularity of Exchange Traded Funds (“ETFs”) that offer investors exposure to emerging market bonds is just adding fuel to the high yield fire. Retail investors have ploughed billions of dollars into these ETFs in the search for yield. This has brought an influx of cash into the underlying bond markets, completely distorting the premium required for the inordinate amount of risk.

The distortion is visible in the South African bond market as well, where the lure of having some of the highest yields among emerging market peers is proving irresistible. For the year to the end of September 2017, foreign investors (both active and passive) have bought a net R69.5 billion of our local bonds, keeping yields lower than where they should trade given our country specific risks.

“History doesn’t repeat itself but it often rhymes” - Mark Twain

There is a famous saying “that the past always has a way of returning. Those who don’t learn, or can’t remember it, are doomed to repeat it.” One would have thought that investors have learnt and remembered the painful lessons from previous bond yield blowouts and country specific defaults, but unfortunately evidence currently points in the opposite direction.

The best example of how history’s lessons are being ignored is to look at Argentina, a serial defaulter of note:

  • Argentina has defaulted 8 times since independence in 1816, 5 times in the last 100 years and once since the turn of the century – the last one also the largest country specific default in history.
  • The 2001 default, pertaining to $100 billion worth of bonds, was only finally resolved in 2016.
  • An article published in The Economist in 2005 further pointed out that “No big Latin American government has ever fully repaid a 30-year bond”.

The below graph shows the demise of the Argentinian bonds during the 1998-2001 period leading to their last default – and it paints a pretty scary picture of complacency in the 3 years prior to the eventual blow-off!

Yet notwithstanding their history, Argentina managed to successfully re-enter the bond market - issuing $2.75 billion worth of 100 year bonds in the middle of June 2017 at a yield of 8%. And to highlight the ignorance of history even further, it was more than 3 times oversubscribed! As a prudent investor, one has to ask oneself whether the potential pain is worth a couple of points of short term gain…

The perfect storm

The above high yield craze is culminating with global central banks that have begun to unwind their extremely accommodative QE experiments, creating the makings of a perfect storm. The U.S. Federal Reserve (“Fed”) has raised rates twice this year already, and will soon start to unwind its massive bond book. As of October 2017, the Fed will stop reinvesting all of the money it receives when its assets mature, in the process gradually shrinking its $4.5 trillion balance sheet, whilst continuing to raise short term interest rates. Other central banks are due to follow soon, with the Bank of England expected to start raising interest rates before the end of 2017 and dialing back on their bond purchase programme. Given that today’s record high asset prices have been propped up by central banks’ expansive balance sheets, unwinding this is inevitably going to have some impact – likely reversing some of the asset price inflation in stocks, bonds, real estate, and other markets that these gigantic bouts of asset buying have caused.

Investors should be wise to remember that market corrections often begin in unexpected places and unpredictable ways. Even though investors can’t plan for natural disasters (except to take out insurance), investors should make sure that their funds are positioned as far as possible away from the man-made disasters. A blowoff in any risky asset class, albeit the perceived safe haven U.S. Municipal Bond market, the European High Yield market, or Emerging Bond markets, can very quickly lead to contagion in high yielding, high volatility markets like our local South African bond market. A move toward the exit by bond holders might turn into a stampede. And if that happens, it will be prudent to remember history’s lessons, and to have insisted on an adequate margin of safety before venturing into a heated market.