March 30, 2017 0851 GMT
One place to look for an answer is the markets. Even after being shunted into junk status by Standard & Poor’s, Brazil is most at risk of a further fall among the big emerging markets. Russia, Turkey and South Africa also look ripe for a downgrade, while frontier market Nigeria — abruptly removed from JPMorgan’s benchmark bond index this week — is crying out for one, bnymellon.com wrote.
We have rerun an exercise done this week by Simon Quijano-Evans of Commerzbank, who plotted US dollar prices of credit default swaps — a fast-moving gauge of perceived default risk — for selected countries against those countries’ average ratings at Standard & Poor’s and Moody’s, two of the big three rating agencies (the other being Fitch), which tend to move slowly.
The countries above the line are those that markets tell us are more risky than the rating agencies do. Those below the line are less risky.
Another place to look is in the macro numbers. Win Thin and colleagues at Brown Brothers Harriman use a weighted index composed of 15 macro and political indicators to produce their own implied rating model, which they say has been useful in predicting rating changes by the big three agencies.
BBH’s model suggests Brazil should be rated at BB-, or two notches deeper into junk than its new rating at S&P. This would put it three notches lower than Moody’s, where it is still one notch above junk, and four notches below Fitch, at two notches above junk.
BBH believes it is only a matter of time before the others follow S&P and downgrade Brazil to junk.
“Brazil’s numbers are astoundingly bad,” said Thin. “It is almost a perfect storm of domestic and external conditions.”
BBH’s latest quarterly review of its ratings model was published in late July. Thin updated Brazil’s numbers after its downgrade but has not yet re-run the model for Russia, Turkey and South Africa, his three top candidates for a sovereign downgrade. “But we can assume all three have got worse,” he said.
Without that revision, Russia is rated BB- in the BBH model: two notches below S&P and Moody’s and three below Fitch, the only one still to have it as investment grade.
South Africa is rated BB by BBH: two notches below S&P and three below Moody’s and Fitch. All three big agencies have South Africa as investment grade. BBH said it is junk.
Turkey is also rated BB by BBH, one notch deeper into junk than S&P and two notches below Moody’s and Fitch, which have it on the bottom rung of investment grade.
“We have all been talking about how great emerging markets are over the past 10 years because they have great fundamentals,” he said. “I’m as guilty as anyone. But we have all overplayed the fundamental story. Really it’s just been a big commodity boom.”
Turkey of course is different: it should benefit from cheap commodities.
“Turkey is politics,” said Thin. “Erdogan, former prime minister and now president, is following unorthodox policies. And they’ve been on a debt-fuelled bubble for the past five or six years.”
And what of India and Mexico and some other EMs with more reform-minded governments?
“The differentiation story is still very much alive,” he said. “It will really come alive as we see the Fed begin to raise rates. That’s when hot money will move quickly away from places like Turkey and South Africa that are so dependent on it.”