TheChek News Flow

Robots Rise in the Old World

Siemens and Schneider lead the wave of automation sweeping Europe’s factories. Robotics is no longer a trend of the future.

Swiss watch exports have fallen for the second year in a row, erasing all export growth since 2011. While some established brands continue to post healthy results, others are cutting staff, buying back inventory, putting themselves up for sale, or going out of business.

This dour climate has influenced this year’s new introductions. Perhaps in a fit of nostalgia for happier times, 2017’s most noticeable trend was a focus on the past, with re-editions, reinterpretations, and even exact copies of vintage models introduced by many brands. Consumers, meanwhile, are still buying, but they’re getting smarter and savvier. They’re weeding out the mediocre and overpriced, and seeking meaningful, high-quality watches offering great value. Barron’s Penta is here to help the process with our selection of the Best Watches of 2017, in our usual eight categories.

Best Maverick and Best Overall:
Bulgari Octo Finissimo Automatic
Price: $12,800 on strap, $13,900 on bracelet

This year’s Best Maverick Watch also gets our vote for Best Overall timepiece. The Bulgari Octo Finissimo Automatic houses the world’s thinnest self-winding movement in production, at just 2.23 millimeters thick. It’s a mechanical marvel and a major achievement. While most view Bulgari as a jewelry brand, it has also become a serious watchmaker since acquiring the Gerald Genta and Daniel Roth brands in 2000 and unifying them under the Bulgari name in 2010.

Here’s why Bulgari has earned our top honor: Introducing any new mechanical movement requires years of development. Creating an ultrathin movement is an order of magnitude more difficult. Every component must be custom designed from the beginning. The movement, case, dial, and even the hands must be carefully engineered for extreme thinness, yet be robust enough for daily wear.

Bulgari’s caliber BVL 138 is exceptional in many ways. A solid platinum rotor for maximum inertia is used for the winding mechanism. The delicate escapement that releases the pulse of timekeeping is solidly held in place by a full balance bridge secured on two sides. High-quality hand-finishing is found on all parts, and in spite of its minuscule dimensions, it’s capable of an impressive 60 hours of power reserve when fully wound.

The Octo Finissimo’s styling is a winner, too. Its 40-mm case is architecturally sculpted with angular, stepped lugs that make it both sporty and elegant. Built entirely of lightweight, sandblasted titanium, the optional bracelet is wonderfully supple and conforms to the wrist with articulating links.

This is the third ultrathin record breaker in as many years for the brand. We commend Bulgari for its courage and relentless focus on the underrated art of ultrathin watchmaking.

Honorable Mentions:Audemars Piguet Royal Oak Perpetual Calendar Black Ceramic; Ulysse Nardin InnoVision 2

Best Ladies’ Watch:
Audemars Piguet Royal Oak Frosted Gold
Price: $56,900 white gold, $51,400 rose gold

Audemars Piguet has reinterpreted its iconic Royal Oak design, turning it into our standout ladies’ watch of 2017. Originally introduced in 1972 and designed in one night by legendary designer Gerald Genta, the Royal Oak was the most expensive steel watch when launched. The high cost was due to the elaborate, highest-grade finishing that AP lavished on every surface of the steel case and bracelet. Gold, platinum, and ladies’ Royal Oak models would soon follow—all featuring five elaborate finishing techniques that showcase the best of Swiss watchmaking.

Forty-five years later, AP took the already superb finishing of the Royal Oak to a new level by collaborating with jewelry designer Carolina Bucci, who specializes in the Florentine technique, an ancient gold-hammering method that makes the metal shine in a unique way. With a diamond-tipped tool, tiny indentations are made on the surface of the gold. No metal is lost or added, and AP, after months of experimentation, created a showstopper. The technique was successfully applied across the flat surfaces of the case and bracelet while preserving the crisp lines and brushed and polished edges that have defined the Royal Oak.

We were wowed when handling the watch—even the best photographs can’t adequately capture the effect. Every surface of the case and bracelet comes alive, reflecting light at different angles, and tricking one into believing that the watch is paved with diamonds. Available in two case sizes—33 mm and 37 mm, and in white or rose gold—we pick the 37-mm models with AP’s in-house, self-winding mechanical movement.

Honorable Mentions: Breguet Tradition Dame 7038; A. Lange & Söhne Little Lange 1 Moon Phase

Best Entry Level:
Breitling Superocean Héritage II
Price: $4,075 on strap

Breitling’s brand image is strongly tied to aviation; it employs the world’s largest civilian aerobatics jet team. But the recently sold brand also has a surprisingly rich history of diving watches, dating to 1957 with its Superocean—a cult favorite among collectors. To commemorate its 60th anniversary this year, Breitling launched its Superocean Héritage II collection with two versions: A time-only watch and a chronograph, offered in 42-mm and 46-mm case sizes. Our pick for this year’s Best Entry Level Watch is the simpler, more modestly sized Héritage II 42.

A totally modern, attractively designed reinterpretation of the original 1957 divers’ watch, the Héritage II 42 is packed with features you wouldn’t expect at a $4,000 price point.

Water resistant to 660 feet, it’s a robust divers’ watch equipped with a scratch-proof and shock-resistant ceramic bezel. Well styled for everyday wear, the highly legible dial is inspired by the vintage model, including a triangular hour hand, sword-shaped minute hand, and faceted, cone-shaped hour markers. The case’s broad, downward-curved lugs—the legs to which a strap attaches—are perfectly placed and just the right length for wrist comfort.

What we found especially interesting is its movement. Breitling chose a modified version of a state-of-the-art movement made by Tudor—a sister brand to Rolex. Featuring its own finishing and winding rotor, the caliber B20 provides 70 hours of power reserve, outstanding shock resistance, and chronometer-certified accuracy. Available with either a blue, black, or bronze-color dial and bezel, we recommend the optional mesh bracelet to enhance its vintage-inspired look.

Honorable Mentions: Tudor Heritage Black Bay 41; NOMOS Metro Chronometer

Best Sports Watch:
Jaeger-LeCoultre Master Control Chronograph
Price: $8,000

Jaeger-LeCoultre commemorated the 25th anniversary of its Master Control collection this year with three classically styled watches that had people reaching for their wallets as soon as they were announced. Penta’s Best Sports Watch of 2017 is the Master Control Chronograph, ref. Q1538530.

Its stunning “sector” style dial impressed us the most. Harmonious and well balanced, sector dials were found on highly collectible watches from the mid-20th century and are appreciated for their attractiveness and legibility. Exercising restraint, JLC opted to forgo a date window—an outstanding design decision. The dial has a wonderful two-tone finish, with circular satin-brushed finishing first found on its outer section, which contrasts with a grained, opaline finish at its center. The two-tone effect, rarely seen in modern watches, causes light to shimmer at different angles and makes the dial come alive. Two subsidiary dials at 3 o’clock and 9 o’clock measure the elapsed minutes and hours of the chronograph function—each sunken, and with fine, circular guilloché (a kind of engraving) that enhances the subdials’ legibility. Tasteful sky-blue dial accents are used for the chronograph’s counters and tachymeter, which match well with its elegant blued-steel hands.

JLC’s self-winding chronograph movement, the caliber 751G, powers the watch. A rock-solid, modern design, it uses a vertical clutch—an approach that permits the chronograph to run at all times with no negative effects on accuracy. Well-sized and beautifully proportioned with a 40-mm diameter and 11.7-mm thickness, the steel case, with its mix of mirror-polished and brushed-finish surfaces, makes it a versatile sports watch that can be worn for any occasion. And its $8,000 price, combined with great looks and a high-quality, in-house movement, make it a bargain to boot.

Honorable Mentions: Rolex Sea-Dweller, ref. 126600; Omega Speedmaster Racing Master Chronometer

Best Dress Watch:
Grand Seiko SBGW252 gold / SBGW253 steel
Price: $17,200 in gold, $5,700 in steel

Since 1960, Grand Seiko has been the high-end, precision-focused line of watches from Japanese brand Seiko, although it’s still largely unknown in the U.S. It was exclusively sold in Japan until the brand began international distribution in 2010. Grand Seiko is now an independent brand, distancing itself from the low-price, mass-produced quartz watches associated with Seiko.

Three superb limited-edition models in steel, gold, and platinum commemorate this spinoff. The gold and steel models are our choice for Best Dress Watch of 2017. In a year chock-full of vintage reintroductions, Seiko’s modern reinterpretation of the first Grand Seiko model from 1960—Japan’s first chronometer-grade wristwatch—is a beauty. A time-only watch with sweeping seconds, its simplicity gives it a timeless and elegant aesthetic that is ideal for business and formal wear. Details like the faceted, hand-polished case and curved dial and crystal explain why international collectors felt compelled to travel to Japan before 2010 to get their hands on Grand Seiko watches.

The 38-mm case diameter—up from the original’s 36 mm—is just right, considering its 11.2-mm thickness. It will fit wrists of all sizes while appealing to modern tastes. Inside ticks Grand Seiko’s own in-house caliber 9S64 manually wound movement, delivering 72 hours of timekeeping when fully wound. Lacking the fine hand-finishing details of high-end Swiss watches, it’s still manufactured with excellence, and each movement is hand-adjusted to provide minus-three to plus-five seconds per day accuracy. There are 1,960 examples in steel, 353 in gold, with subtle design differences between them. But each is a winner. At $5,700, the steel SBGW253 is also one of the year’s best bargains.

Honorable Mentions:Patek Philippe, ref. 5170P-001 Chronograph; Breguet Classique 7147

Best Value:
Rolex Datejust 41 in steel
Price: $7,350

Rolex made headlines this year with its own special-edition diving watch for the 50th anniversary of its Sea-Dweller. But Rolex’s lowest-priced new release for 2017—the stainless steel Datejust 41—is our pick for the Best Value watch of the year. The Datejust is Rolex’s best-selling and longest-running product line, in continuous production since 1945. In 2009, the Datejust’s size was increased for the first time, from 36 mm to 41 mm, to become the Datejust II.

That model was a bit too thick and unwieldy for some, and last year Rolex redesigned the case, making it slimmer and more appealing to many. We love the way the redesigned case fits even smaller wrists.

But it’s what’s inside that inspired our Best Value choice. The Datejust 41 is fitted with a simpler version of Rolex’s best and most accurate movement—previously used only in its most prestigious Day-Date product line. With 14 patents, the caliber 3235 provides 70 hours of power reserve and industry-leading accuracy of plus or minus two seconds per day. At its heart is Rolex’s Chronergy escapement, offering 15% greater efficiency thanks to lighter, geometrically optimized components.

Well-priced options in stainless steel are new, and available in a range of dial colors with a smooth bezel or fluted white-gold bezel. Retailing at $7,350, we love the clean lines—and lower price—of the smooth bezel model, ref. 126300, fitted on an Oyster bracelet.

Honorable Mentions: Omega Railmaster; TAG Heuer Autavia

Best High Jewelry:
Van Cleef & Arpels Lady Arpels Papillon Automate Watch
Price: $290,000

Van Cleef & Arpels once again takes the prize for Best High Jewelry Watch, this year with the delightful and mesmerizing Lady Arpels Papillon Automate. An exquisite diamond- and multicolored sapphire-set ladies’ watch, it’s a synthesis of VC&A’s unique skills as jeweler, enameler, and storyteller. Part of its “Poetic Complications” collection, the watch’s standout feature is the prominent golden butterfly that randomly—and realistically—flutters its enameled wings with the motion of its wearer’s wrist.

Resting at 9 o’clock on a flower sculpted from mother-of-pearl, the butterfly beats its wings from one to four times in a row—at random. Fitted with a high-end self-winding movement made especially for VC&A, the butterfly flutters four times when the movement is fully wound, but only once or twice when low on power. The more active the wearer, the more frequently the butterfly will flutter. A pusher at 8 o’clock triggers its motion, and as the watch’s crown is wound, it flutters until the movement is fully wound. Superb!

Set within a multilayered, moonlit pastoral scene, its dreamy dial is adorned with flowers made of round and pear-shape diamonds, and blue, mauve, and violet sapphires mimicking a pool of water. Curved blades of grass made of plique-à-jour enamel, here a unique 3-D enameling technique created by VC&A, give the scene a sense of depth and vibrancy. With four patents pending, the Papillon Automate is a wristwatch automaton done right.

It’s housed in a 40-mm case, surprisingly thin considering the space required for the butterfly’s wing motion. And, of course, its case dazzles with flawless diamonds; its bezel is set with 48 round brilliants, and the center caseband is paved with snow-set diamonds of random sizes.

HONORABLE MENTIONS: Cartier Panthère Joueuse; Piaget Altiplano Tourbillon High Jewellery

Best Complicated Watch:
Vacheron Constantin Les Cabinotieres Celestia Astronomical Grand Complication
Price: $1 million (estimated)

Vacheron Constantin’s supercomplicated Celestia Astronomical is a masterpiece, our top Complicated Watch of the year. An astronomical mechanical computer in miniature, we called it heavenly when Barron’s Penta was given the exclusive first look at it back in January (see Penta Daily, Jan. 16). With 23 complications displayed on two dials front and back, it ranks as one of the most complicated wristwatches ever made. Five years of development resulted in 514 components miraculously fitting inside an 8.7-mm movement.

At its heart is a “tropical” system of gears, brilliantly integrated with its perpetual-calendar mechanism. All time and solar indications are linked to the date, displaying an orchestrated, precision model of the heavens as it unfolds in real time. This includes the alignment of the Earth, sun, and moon; a mareoscope indicating tide level; and sunrise and sunset times.

Three modes of reading time—civil, solar, and sidereal—are each powered by its own dedicated gear trains. Flip the watch and be awed by the multilayered, semitransparent celestial chart showing the current position of the Milky Way galaxy.

Manually wound and enhanced by a tourbillon, the watch uses cutting-edge alloys and gear-tooth geometries to deliver a staggering three-week power reserve. That all of this fits within a wearable case is a testament to Vacheron Constantin’s industry-leading skills. The unique Celestia sold almost immediately for an estimated $1 million.

Multiple orders for custom versions have since rolled in—proof that buyers continue to line up for the world’s best watches.

Honorable Mentions: A. Lange & Söhne Zeitwerk Decimal Strike; Patek Philippe Perpetual Calendar, ref. 5320G-001

Amazon and Whole Foods: Is This a Grocery Apocalypse?

The surprise acquisition might not be so big, but the implications for grocers are staggering.

FLORENCE, Italy — “Basta blue!” That pronouncement fell from the lips of Andrea Benedini, brand manager at Luigi Bianchi Mantova and L.B.M. 1911, labels produced by a fourth-generation Italian men’s wear manufacturer whose unlined, garment-dyed blazers Esquire once called the only wardrobe essential for a well-dressed man.

Mr. Benedini’s exclamation, which means “enough blue!” and was uttered at his company’s stand at Pitti Uomo 92, the big men’s wear show here, showed he was thinking about color, or its general absence — a lack that, as it happens, has been on this critic’s mind.

It was roughly 100 collections ago that a novice Dries Van Noten produced a collection of brightly hued men’s clothes fashioned from garment-dyed cotton and shown inside one of Paris’s obscure covered passages, primarily occupied by restaurants and shops run by South Asian immigrants.

The show was memorably poetic, Nick Sullivan, the men’s style director at Esquire, said Tuesday evening before an elaborately theatrical Hugo Boss offering, with the magic of that Van Noten event amplified when shopkeepers rained rose petals on the models during the finale.

And it was one of the last times that designers would take color into their embrace. Men’s wear has been dominated for decades by blue, gray and black, so much so that one occasionally feels a twinge of sympathy for fashion writers condemned to ring changes on a vocabulary limited to variations on navy, charcoal or anthracite.

“Color is seen as frivolous,” the Italian journalist Angelo Flaccavento said Wednesday morning, as a crowd formed outside the Museo Bardini for a show of the designer Federico Curradi’s drifty dusters, stiff jeans jackets, open-weave woolens and sleeveless summer hoodies, many dyed in watercolor washes as cumulatively drab as a mouse’s behind.

“And it’s a bit of a dangerous time to be seen indulging in frivolity,” Mr. Flaccavento added, though the wonderfully blobby, garish sculptures that the contemporary artist Glenn Brown had inserted amid the museum’s faded antiquities appeared to do exactly that.

Mr. Benedini made his own argument in favor of frivol. “Yes, blue is most of our business, but as a man now you have to come up with another way to get compliments and attention,” he said.

Color is one surefire method of achieving that, he added. As if to prove his point, he showed off a series of jackets whose olive dullness was jump-started with jolts of acid yellow or pink in the form of pocket squares and scarves.

“Social media and the bloggers have affected the way we are consuming,” Mr. Benedini said. “Men are not just dressing for women anymore; they are dressing for men.”

Certainly they are at Pitti Uomo

So much has been written about the so-called Pitti peacocks that it is hardly worth expending more metaphorical ink discussing them here. Yet it may be worth mentioning that the aggressively natty individuals strutting about the grounds of the ancient Fortezza da Basso have begun to take on an aura of pathos. Their bright raiment may help them score big on Pinterest or Instagram, but in real life they come to seem as exquisitely ornamental and essentially purposeless as zoo birds.

Those preening types call to mind an observation made on Tuesday by Olivier Saillard, a distinguished French curator invited by the Pitti Uomo organizers to create a special fashion exhibition within the gilded salons of the colossal, Renaissance-era Palazzo Pitti.

“Fashion is not clothes,” Mr. Saillaird said flatly, after the opening of “the Ephemeral Museum of Fashion,” a show focusing on what might be called the metaphysics of fashion. Using both emblematic designs (Elsa Schiaparelli’s iconic shoe hat, say, or a famous sheath dress designed by the seminal 20th-century dressmaker Madeleine Vionnet) and ordinary suits from his own wardrobe, installed in ghostly tableaux, Mr. Saillard explores an element of costume ignored by most installations devoted to the subject: that is, the bodies that once inhabited the clothes.

“I would love to do a complete exhibition using no mannequins at all,” Mr. Saillard said, as guests sipping rosé Champagne crunched through the gravel courtyard of the Boboli Gardens.

The rigid conservation demands of most museum shows devoted to fashion tend to dictate that garments be regarded abstractly, as sculptural objects. One mostly faultless example of this is the exquisite show on view at the Metropolitan Museum of Art in New York: “Rei Kawakubo/Comme des Garçons: Art of the In-Between.”

“But fashion exhibitions can also consider the absence of the body,” its negative image, said Mr. Saillard, who for his show laid on a pallet a Vionnet too fragile to be displayed ever again after this exhibition; tossed jackets over chairs; and quoted Virginia Woolf’s description of a man who, while sleeping, “looked like a coat hanging at the end of a bed; there were all the wrinkles, and the sleeves and trousers kept their shape though no longer filled out by legs and arms.”

It is one of the surprising and admirable aspects of Pitti Uomo that its organizers use the pretext of selling clothes at a trade fair not much different from a car or boat show to investigate ideas, broaden cultural horizons and exploit the peerless history of their hometown. The opportunities they seize routinely are seemingly lost on fashion capitals like Milan, New York or Paris, where one fashion week monotonously blurs into the next.

Sure, duds and missteps occur in Florence. An absurdly pretentious Hood By Air show a few seasons back gave every indication that overreach was imperiling a promising design team and label; sure enough, the brand has since shut down.

And there is no question that even, say, the High Line could not compare for enchantment with Harold Acton’s villa, La Pietra, where Jonathan Anderson, one of this season’s guest designers, staged his show Wednesday evening.

The 15th-century villa (bequeathed on Acton’s death to New York University, which now uses it as a campus), is just outside Florence on a hillside terraced with ranks of dense green cypress, gray groves of olive and Baroque gardens bristling with mythological statuary. It made a gorgeous, if slightly anomalous, backdrop for Mr. Anderson’s designs.

Or maybe not: the cool wrap-front jeans, patchwork-denim Converse sneakers and outsize khakis were notable both for a restraint unusual by the standards of this designer and for ornamentation that leaned heavily on such elements of Americana as trading cards, jeans jackets, flip-flops, kiddie glitter hearts and Coca-Cola script.

Obtruding reality, on the other hand, can muddle even the best intentions. If one takes Virgil Abloh — the designer of Off-White and another special guest at this Pitti Uomo — at his word, there is some benefit in staging a fashion show ostensibly aimed at illuminating the international refugee crisis. Hundreds of thousands of Instagram users follow Mr. Abloh’s every move, or anyway track his latest product drops.

Presumably, some of those people would have been enlightened by words that Mr. Abloh, in collaboration with the artist Jenny Holzer, projected on the rusticated ocher walls of the Palazzo Pitti on a steamy summer night. Guests in bleachers read grim texts crawling up the palace’s facade, most of them fragments of poems by exiles caught up in a global immigration crisis that is “cruel and killing,” as Ms. Holzer said in an email exchange.

As the son of Ghanaian immigrants, Mr. Abloh said his aim was to supplant the usual fashion-show escapism with political urgency, to use his presentation in Florence as a Trojan horse for sneaking up on consumers with crucial messages.

As a designer, Mr. Abloh is less an innovator than an educator, and it is his ability to elevate the taste level of his social media legions that makes him a go-to collaborator for brands across the consumer spectrum.

Schooling the Supreme crowd — he calls them “the kids on Prince and Mercer” — in the finer points of fashion is one thing. Quite probably, the men’s wear he showed — voluminous and literally cool, playing with transparency and his usual peekaboo effects — will accomplish that.

The success of his polemics, on the other hand, can probably be best judged by their effect on guests Thursday night. Sitting in the bleachers, they read for a time as poems evoked the terrors of war and a cruel ocean yielding a harvest of dead children. Then, like Mr. Abloh’s social media fans — like most of us, really — their eyes flicked away from the bad-news projections and back to the reassuringly seductive light of their phones.

A balancing of the market is proving elusive amid a resurgent US shale industry

Opec’s efforts to raise oil prices by bringing a three-year-old glut to an end keep running into an uncomfortable fact — rival crude supplies are proving stronger than they ever feared.

In the past three weeks, since Opec, Russia and other producers agreed to extend oil supply cuts for another nine months, the price of Brent crude has fallen 13 per cent and is set to finish this week at the lowest level this year, near $47 a barrel.

While the countries involved in the deal — together representing more than 50 per cent of world oil output — have cut as much as 1.8m barrels a day of supplies from the market, their efforts just keep getting swamped.

The US shale industry has been resurgent in 2017 and is now expected to grow even faster next year. Oil stockpiles built up during the glut have been pulled from storage and demand, many traders believe, has not grown as quickly as many expected.

Other countries like Brazil are also seeing output rise after investments made before the price crash from above $100 a barrel in 2014.

“In Opec’s minds, they have made the cuts and the market should be patient while stocks come down,” said Gary Ross, head of oil at Pira Energy Group, a unit of S&P Global Platts.

“[But] even by the end of the year, it looks to us that there will still be 150m-200m barrels of surplus inventories.”

Opec and its allies are now essentially in a race against time to show they can mop up the excess.

After falling in 2015 and 2016, US shale oil production is tipped by the US Energy Information Administration to hit a record next month of 5.475m barrels a day — surpassing the peak hit two years ago before the full force of the price slump was felt.

The young industry has shown it can squeeze down costs and now compete when prices are near $50 a barrel.

The International Energy Agency this week said supplies from countries outside Opec, led by the US, would grow faster than demand next year, meaning the glut of oil stocks is unlikely to dissipate in 2018 without further intervention by Opec.

In the short term, Opec’s efforts as yet just do not seem to be working fast enough for many traders. Oil has started to be stored on supertankers sitting off key oil hubs — a sign of acute oversupply at a time when demand is normally strong.

At least 5m barrels of crude are being stored in the UK portion of the North Sea, according to satellite monitoring and data compiled by TankerTrackers.com, which measures shipments.

More tankers have also appeared off Singapore, a key hub for storing oil at sea during times of oversupply, as well as off producing countries in west Africa, which analysts at JBC Energy said was “a strong warning signal . . . during what should be peak refinery demand season”.

In an effort to curb the glut Saudi Arabia, Opec’s largest exporter and de facto leader, has indicated it will send less crude to the US, where timely government data mean stocks are more visible and therefore tend to have a larger impact on trader sentiment.

But analysts believe Opec also needs to curb supplies to Asia, the fastest growing region of global oil demand, to truly tighten the market — something many producers have been unwilling to do as they do not want to sacrifice customers in an expanding market.

In the meantime, traders will be watching to see if the growth in US shale starts to show signs of slowing. But even if drilling stops expanding, a quick drop in supplies is by no means guaranteed.

So-called drilled but uncompleted wells, known in the shale industry as DUCs, have also risen to a record level. These can be rapidly brought on if producers need a quick boost to cash flow, potentially keeping supply buoyant even if drilling slows.

“Pervasive doubts over the oil market rebalancing will linger without confirmation that the supply overhang is waning,” said analyst Stephen Brennock, at brokerage PVM in London.

“Until such conclusive proof emerges, all bets are off.”

US state has more than $14.5bn of past-due bills from suppliers, writes John Dizard

People are talking about a looming governance crisis in Washington, but that moment has already arrived for the state of Illinois. Thanks to the inability of the state legislature and the governor to agree a budget over the past two years, Illinois is on a straight path to becoming junk credit at the end of this month.

The consequences will be felt across the country. Apart from the higher costs for Illinois state borrowers, the budget crisis has opened a range of legal and even constitutional issues over the conflicting claims that pensions, debt service, social benefits and essential state services have on limited government resources.

That is not some general topic for think-tank seminars or newspaper leaders. It is now possible that many primary schools in Illinois will be unable to open on time for the autumn term come August or September. In February, in Marion County, Illinois, the mother of Kobe, a one year old boy with a breathing disability, opened her door to find sheriff’s deputies and a representative of her son’s oxygen bottle supplier demanding the return of their equipment. The state government, for which the mother works, had not paid her insurance benefits. The boy was allowed to keep his oxygen, for now.

In addition to the invoice for Kobe’s breathing apparatus, the state of Illinois has more than $14.5bn of past-due bills from suppliers, about double the level of a year ago. This is in addition to its total bonded debt of about $27bn, and estimated unfunded pension liabilities of $130bn. The state government is bringing in annual revenues of about $30bn.

The state has not issued a general obligation bond since November. Last week, Illinois GO bonds traded at a record 335 basis points over the MMD index of AAA municipal bonds. If, as muni bond people expect, the state is downgraded to junk next month by at least two rating agencies, the spread it pays on swaps contracts will rise from 345bp to 645bp.

Earlier this year proposals were drawn up for a large new taxable GO bond issue, perhaps for $7bn with a five-year maturity, which could pay down the state’s past due bills. The Republican governor, Bruce Rauner, and the Republican president of the state senate insisted that such a bond had to be part of a “grand bargain”. This would include, among other measures, a consolidation of state agencies, reform of the workers’ compensation system, a freeze on property taxes, term limits for elected officials and some state contributions to the city of Chicago’s pension funds.

The Democratic speaker of the state house of representatives, Michael Madigan, a public sector union ally who has held his position for 32 of the past 34 years, resisted Mr Rauner’s package deal. Earlier this year there was some hope of a compromise between the two sides. In recent months, though, as the state’s fiscal position has worsened, the governor and the state Democrats hardened their positions. This partly reflects an urban/rural divide between Chicago-area liberals and downstate conservatives.

As if this mutual loathing and intransigence were not enough, last week Judge Joan Lefkow of the Federal District Court in Chicago ordered the state government to make contractual payments for its Medicaid obligations to managed-care organisations. The language the judge used in her order sent a shockwave through the municipal bond market.

As she pointed out, the state comptroller “is funding the state payroll as well as debt service at 100 per cent . . . Although the court means no disrespect to the comptroller, who faces an unenviable situation, it finds that minimally funding the [Medicaid] obligations of the decree, while fully funding other obligations fails to comply not only with the consent decrees, but also with this court’s previous orders.”

Professional muni investors read and re-read the order. On its face, as one portfolio manager says, “she is starting the process of reprioritizing the primacy of debt service under state law and the state constitution. That would be game over.”

The judge asked the state and Medicaid advocates to try and work out a compromise by next week, but the point was made. Bondholders do not have priority over social welfare recipients. Whether that position is morally correct or not, it certainly will make it more difficult and expensive to sell Illinois bonds in the future, if the state wants to fund pension obligations or fix its highways.

One of the key questions to ask about distressed sovereign credits is whether the paper is owned by locals. Even during Nigeria’s time of troubles in the 1970s and 1980s, the central bank continued to pay its promissory notes, even as its bank loans went into default. Nigerian officials owned some of the notes.

And while interest income from Illinois GO bonds is exempt from federal income tax, it is not exempt from the state income tax on Illinois residents. So Illinois bond investors are spread around the entire country, lessening the local pain of downgrades or defaults.