The impact of household debt and saving on long run GDP growth

The impact of household debt and saving on long run GDP growth

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Macro Letter – No 70 – 10-02-2017

The impact of household debt and saving on long run GDP growth

Neither a borrower nor a lender be;

For loan oft loses both itself and friend,

And borrowing dulls the edge of husbandry.

Hamlet I, iii – Shakespeare

  • BIS research indicates that household debt to GDP ratios above 80% reduce growth
  • But higher household savings do not appear to lead to higher investment
  • Counter-cyclical fiscal stimulus and fractional reserve lending are much more powerful growth factors than household savings or even household debt

Last week saw the publication of a fascinating working paper by the BIS – The real effects of household debt in the short and long run –the conclusions of the authors were most illuminating, here is the abstract:-

Household debt levels relative to GDP have risen rapidly in many countries over the past decade. We investigate the macroeconomic impact of such increases by employing a novel estimation technique proposed by Chudik et al (2016), which tackles the problem of endogeneity present in traditional regressions. Using data on 54 economies over 1990‒2015, we show that household debt boosts consumption and GDP growth in the short run, mostly within one year. By contrast, a 1 percentage point increase in the household debt-to-GDP ratio tends to lower growth in the long run by 0.1 percentage point. Our results suggest that the negative long-run effects on consumption tend to intensify as the household debt-to-GDP ratio exceeds 60%. For GDP growth, that intensification seems to occur when the ratio exceeds 80%. Finally, we find that the degree of legal protection of creditors is able to account for the cross-country variation in the long-run impact.

The chart below shows the growing divergence between the household debt of developed and emerging market economies:-

household_debt_-_bis

Source: BIS

Of the emerging markets, South Korea has the highest household debt ratio, followed by Thailand, Malaysia and Hong Kong: all have ratios above 60%. Singapore is on the cusp of this watershed, whilst all the remaining emerging economies boast lower ratios.

Part of the reason for lower household debt in emerging economies is the collective market memory of the Asian financial crisis of 1997. Another factor is the higher savings rate among many emerging economies. The table below is incomplete, the data has been gathered from multiple sources and over differing time periods, but it is still quite instructive. It is ranked by highest household savings rate as a percentage of GDP. On this basis, I remain bullish on the prospects for growth in the Philippines and Indonesia, but also in India and Vietnam, notwithstanding the Indian Government debt to GDP ratio of 69% and Vietnam’s budget deficit of -5.4% of GDP:-

em_household_debt_table

There are other countries who household sector also looks robust: China and Russia, are of note.

Last month I wrote about The Risks and Rewards of Asian Real Estate. This BIS report offers an additional guide to valuation. It helps in the assessment of which emerging markets are more likely to weather the impact of de-globalising headwinds. Policy reversals, such as the scrapping of the TPP trade deal, and other developments connected to Trump’s “America First” initiative, spring to mind.

Savings and Investment

When attempting to forecast economic growth, household debt is one factor, but, according to the economics textbooks, household savings are another. Intuitively savings should support investment, however, in a recent article for Evonomics – Does Saving Cause Lending Cause Investment? (No.)Steve Roth shows clear empirical evidence that a higher savings rate does not lead to a higher rate of investment. Here is a chart from the St Louis Federal Reserve which supports Roth’s assertions:-

household_savings_fred

Source: St Louis Federal Reserve Bank

Personal savings represents a small fraction of GDP especially when compared to lending and investment. Roth goes on to analyse the correlations:-

correlations-saving-and-investment-steve-roth-evonomics

His assessment is as follows:-

Of course, correlation doesn’t demonstrate causation. But lack of correlation, and especially negative correlation, does much to disprove causation. What kind of disproofs do we see here?

Personal saving and commercial lending seem to be lightly correlated. The correlation declines over the course of a year, but then increases two or three years out. It’s an odd pattern, with a lot of possible causal stories that might explain it.

Personal saving and private investment (including both residential and business investment) are very weakly correlated, and what correlation there is is mostly negative. More saving correlates with less investment.

Commercial lending has medium-strong correlation with private investment in the short term, declining rapidly over time. This is not terribly surprising. But it has nothing to do with private saving.

Perhaps the most telling result here: Personal saving has a significant and quite consistent negative correlation with business investment. Again: more saving, less investment. This directly contradicts what you learned in Econ 101.

The last line — commercial lending versus business investment — is most interesting compared to line 3 (CommLending vs PrivInv). Changes in commercial lending seem to have their strongest short-term effects on residential investment, not business investment. But its effect on business investment seems more consistent and longer-term.

This is a fascinating insight, however, there are international factors at work here. This data looks at the US, but the US is a far from closed economy; the current account deficit tells you that. Setting aside cross border capital flows there are even larger forces to consider.

Firstly, in general, when an economy slows, its government increases fiscal spending and its central bank reduces interest rates. Secondly, when short term interest rates fall, banks are incentivised to borrow short and lend long. They achieve this using a fraction of their own capital, lending depositors’ money at longer maturity and profiting from the interest rate differential.

Once fiscal stimulus has run its course and banks have leveraged their reserves to the maximum, the importance of household savings should, in theory, become more pronounced, but if interest rates are low investors are likely to defer investment. If government fiscal pump-priming has failed to deliver an economic recovery, investors are likely to be dissuaded from investing. Despite Roth’s empirical evidence to the contrary, I do not believe that the household savings rate is an unimportant measure to consider when forecasting economic growth, merely that it is overshadowed by other factors.

Conclusion

Household savings may have little impact on GDP growth but Household debt does. In the UK the savings Ratio was 6.6%, whilst the Household debt to income ratio was 152% at the end of 2015. By comparison, at the end of 2014 the US the savings ratio was 5% and household debt to income a more modest 113%. The ratio of the ratios is broadly similar at around 23 times.

With interest rates still close to the lowest levels in centuries and real interest rates, even lower, debt, rather than savings, is likely to be the principal driver of investment. That investment is likely to be channelled towards assets which can be collateralised, real estate being an obvious candidate.

I began this letter with a quote from Hamlet. I wonder what advice Polonius would give his son today? The incentive to borrow has seldom been more pronounced.

The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

  • Shanghai house prices increased 26.5% in 2016
  • International investment in Asian Real Estate is forecast to grow 64% by 2020
  • Chinese and Indian Real Estate has underperformed US stocks since 2009
  • Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed AssetLocation is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country Weight
Japan 32.94%
Hong Kong 26.40%
Australia 19.81%
China 9.62%
Singapore 6.30%
Other 4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and  ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

 

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

  • There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
  • Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
  • Geographic constraints – lack of space drives prices higher.
  • Planning restrictions – limitations on development and redevelopment drive prices higher.
  • Economic growth – this can be at the country level or on a per-capita basis.
  • Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
  • Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
  • Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
  • Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region 2017 Change
ASEAN* 4.90% -0.20%
India 7.20% -0.40%
China 6.50% 0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index Performance – March 09 – December 16 Performance in US$ Current Yield
S&P500 207% 207% 2%
FHFA House Price Index (US) 9.70% 9.70% 2.20%
Shanghai Composite (China) 50% 49.20% 4.20%
Shanghai Second Hand House Price Index 74% 72.85% 3.20%
S&P BSE Sensex (India) 204% 135.25% 1.50%
National Housing Bank Index (India) 58%* 38.45% 3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

india_-_national_housing_bank_-_house_price_index

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country Price/Income Ratio Rental Yield City Price/Rent Ratio City Mortgage As % of Income GDP f/c 2017
Malaysia 9.53 4.07 24.6 72.87 4%
Taiwan 12.87 1.54 64.91 78.76 1.80%
South Korea 12.38 2.04 49.1 85.47 2.40%
India 10.28 3.08 32.44 123.44 7.40%
Singapore 21.63 2.75 36.41 134.33 1.60%
Pakistan 12.09 4.08 24.51 156.97 5.10%
Philippines 16.91 3.75 26.69 162.87 6.60%
Bangladesh 12.89 3.25 30.81 181.3 6.80%
China 23.29 2.23 44.83 189.71 6.40%
Mongolia 15.77 9.78 10.22 203.47 1.80%
Thailand 24.43 3.8 26.29 212.03 3.30%
Hong Kong 36.15 2.25 44.35 224.85 1.80%
Sri Lanka 17.49 4.91 20.38 238.64 4.80%
Indonesia 21.03 4.67 21.41 247.68 5.10%
Vietnam 26.76 4.52 22.1 285.55 6.60%
Cambodia 24.32 7.44 13.44 292.43 7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager Asian AUM $Blns Total AUM $Blns
UBS Global Asset Management 9.33 64.89
Global Logistic Properties 9.26 20.14
CBRE Global Investors 8.56 91.27
LaSalle Investment Management 8.05 55.75
Blackstone Group 7.58 121.88
Alpha Investment Partners 7.48 8.70
Blackrock 7.32 22.92
Pramerica Real Estate Investors 6.84 59.17
Gaw Capital Partners 6.64 9.16
Prologis 6.08 29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.

Equity valuation in a de-globalising world

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Macro Letter – No 68 – 13-01-2017

Equity valuation in a de-globalising world

  • The Federal Reserve will raise rates in the coming year
  • The positive Yield Gap will vanish but equity markets should still rise
  • After an eight year bull market equities are vulnerable to negative shocks
  • A value based investment approach is to be favoured even in the current environment

In this Macro Letter I review stock market valuation. I conclude with some general recommendations but the main purpose of my letter is to investigate different methods of valuation and consider the benefits and dangers of diversification. I begin by looking at the US market and the prospects for the US economy. Then I turn to global equity markets, where I consider the benefits and perils of diversification into Frontier stocks. I go on to review global industry sectors, before returning to examine the long term value to be found in developed markets. I finish by looking at the recent outperformance of Value versus Growth.

US Stocks and the Yield Gap

The Equity bull market is entering its eighth year and for US stocks this is the second longest bull-market since WWII – the longest being, between 1987 and 2000. The current bull-market has differed from the 1987-2000 period in that interest rates have fallen throughout the period. Bond yields have also declined to historically low levels. The Yield Gap – the premium of dividend yields over bond yields – which had been inverted since the mid-1950’s, turned positive once more. The chart below shows the yield of the S&P500 and 10yr T-Bonds since 1900:-

yield-gap-in-a-longer-term-context-jpeg

Source: Reuters

What this chart shows most clearly is that the return to a positive Yield Gap has been a function of falling bond yields rather than any substantial rise in dividend pay-out.

The chart below looks at the relationships between the Yield Gap and the real return on US 10yr Treasuries and S&P500 dividends since 1930 – I have used the Implicit Price Deflator as the measure of inflation:-

us_yield_gap_-_real_bond_yld_-_real_div_yld

Source: Multpl, St Louis Federal Reserve

The decline in the real dividend yield was a response to rising inflation from the late 1950’s onwards. The return to a positive Yield Gap has been a recent phenomenon. The average Yield Gap since 1900 is -0.51%, since 1930 it has been -1.17%. It has been below its long-run average at -0.37% since 2008. The executive officers of US corporations will continue to favour share buy-backs over increased dividends – I do not expect dividend yields to keep pace with any pick-up in inflation in the near-term, but, share buy-backs will continue to support stocks in general.

S&P 500 forecasts for 2017

What does this mean for the return on the S&P 500 in 2017? According to Bloomberg, the consensus forecast is for a rise of 4% but the range of forecasts is a rather narrow +1.3% to +8.3%. As at the close on 11th January we were already up 1.6% from the 30th December close.

Corporate earnings continue to rise although the pace of increase has moderated. Factset Earning Insight – January 6th – makes the following observations:-

Earnings Growth: For Q4 2016, the estimated earnings growth rate for the S&P 500 is 3.0%. If the index reports earnings growth for Q4, it will mark the first time the index has seen year-over-year growth in earnings for two consecutive quarters since Q4 2014 and Q1 2015.

Earnings Revisions: On September 30, the estimated earnings growth rate for Q4 2016 was 5.2%. Ten of the eleven sectors have lower growth rates today (compared to September 30) due to downward revisions to earnings estimates, led by the Materials sector.

Earnings Guidance: For Q4 2016, 77 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance.

Valuation: The forward 12-month P/E ratio for the S&P 500 is 17.1. This P/E ratio is above the 5-year average (15.1) and the 10-year average (14.4).

Earnings Scorecard: As of today (with 4% of the companies in the S&P 500 reporting actual results for Q4 2016), 73% of S&P 500 companies have beat the mean EPS estimate and 36% of S&P 500 companies have beat the mean sales estimate.

…For Q1 2017, analysts are projecting earnings growth of 11.0% and revenue growth of 7.9%.

For Q2 2017, analysts are projecting earnings growth of 10.5% and revenue growth of 6.0%.

For all of 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 5.9%.

…At the sector level, the Energy (33.2) sector has the highest forward 12-month P/E ratio, while the Telecom Services (14.2) and Financials (14.2) sectors have the lowest forward 12-month P/E ratios. Nine sectors have forward 12-month P/E ratios that are above their 10-year averages, led by the Energy (33.2 vs. 17.9) sector. One sector (Telecom Services) has a forward 12-month P/E ratio that is below the 10-year average (14.2 vs. 14.6).

Other indicators, which should be supportive for the US economy, include the ISM – PMI Index which is closely correlated to the business cycle. It came in at 54. 7 the highest since November 2014. Here is a 10 year chart:-

united-states-business-confidence-10yr

Source: Trading Economics, Institute for Supply Management

A shorter-term indicator for the US economy is the Citigroup Economic Surprise Index – CESI. The chart below suggests that the surprise caused by Trump’s presidential victory is still gathering momentum:-

citi_cesi_index_-_january_2017_-_yardeni

Source: Yardeni, Citigroup

With both the ISM and the CESI indices rising, even the most bearish of macro-economist is likely to be “sceptically positive” on the US economy and this should be supportive for the US stock market.

Global Stocks

I have focussed on the US stock market because of the close correlation between the US and other major stock markets around the world.

As the world becomes less globalised, or as one moves away from the major stock markets, the diversification benefits of a global portfolio, such as the one Andrew Craig describes in his book “How to Own the World”, becomes more enticing. Andrew recommends diversification by asset class, but even a diversified equity portfolio – without the addition of bonds, commodities, real-estate and infrastructure – can offer an enhanced Sharpe Ratio. The table below looks at the three year monthly correlations of emerging and frontier stock markets with a correlation of less than 0.40 to the US market:-

Country Correlations < 0.40 to US stocks – 36 months
Malawi -0.12
Iraq -0.12
Panama -0.01
Cambodia 0.00
Rwanda 0.01
Venezuela 0.01
Uganda 0.01
Trinidad and Tobago 0.02
Tunisia 0.02
Botswana 0.07
Mauritius 0.07
Tanzania 0.08
Palestine 0.09
Laos 0.09
Ghana 0.10
Zambia 0.10
Peru 0.11
Bahrain 0.13
Jordan 0.15
Cote D’Ivoire 0.15
Sri Lanka 0.16
Argentina 0.17
Nigeria 0.17
Qatar 0.21
Kenya 0.21
Pakistan 0.24
Jamaica 0.24
Oman 0.25
Colombia 0.27
Saudi Arabia 0.31
Kuwait 0.36
China 0.37
Bermuda 0.38
Egypt 0.38
Vietnam 0.39

Source: Investment Frontier

Many of these stock markets are illiquid or suffer from investment restrictions: but here you will find some of the fastest growing economies in the world. These correlations look beguilingly low but remember that during broad-based market declines short-term correlations tend to rise – the illusory nature of liquidity drives this process. The price of a financial asset is driven by investment flows, cognitive behavioural biases drive investment decisions. Herd instinct rises dramatically when fear replaces greed.

Industry Sectors

The major stock markets also offer opportunities. Looking globally by industry sector there are some attractive longer-term value propositions. The table below ranks the major markets by sector as at 30th December 2016. The sectors have been sorted by trailing P/E ratio (mining and alternative energy P/E data is absent but by other measures mining is relatively cheap):-

Industry Sector PE PC PB PS DY
Real Est Serv 11.2 14.9 1 2.2 2.70%
Auto 12.1 5.7 1.4 0.6 2.50%
Banks 13.8 9.6 1.1 3.30%
Life Insur 14.2 6.4 1.1 0.7 3.00%
Electricity 14.9 5.6 1.3 1.1 4.00%
Forest & Paper 15.1 7.1 1.6 0.9 2.90%
Nonlife Ins 16.2 10.4 1.3 1 2.40%
Financial Serv 16.7 13.8 1.8 2.3 2.20%
Telecom (fxd) 17.5 5.5 2.3 1.4 4.20%
Travel & Leisure 17.6 9.1 2.9 1.4 2.10%
Tech HW & Equ 18.3 10.7 3 1.8 2.30%
Chemicals 18.8 10.1 2.4 1.3 2.60%
Household Gds 18.8 15 2.8 1.7 2.40%
Gen Ind 19 11.3 1.9 1.1 2.40%
REITs 20.4 16.7 1.7 7.7 4.50%
Construction 20.9 11.4 1.9 0.9 2.10%
Telecom (mob) 21.4 5.6 1.9 1.5 3.30%
Tobacco 21.5 21.1 9.8 4.9 3.60%
Media 21.6 10.9 2.9 2 2.10%
Food Retail 21.6 10.2 2.8 0.4 2.00%
Eltro & Elect Equ 21.7 12.2 2.2 1 1.70%
Pharma & Bio 22.4 16.3 3.4 3.5 2.30%
Food Prod 23.2 14.3 2.6 1.2 2.20%
Healthcare 23.7 13.1 3.2 1.4 1.10%
Leisure Gds 23.9 8.4 2 1.1 1.20%
Inds Transport 23.9 10.4 2.5 1.3 2.50%
Aero & Def 23.9 14.9 5 1.3 2.10%
Inds Eng 24.6 12.4 2.5 1.1 2.00%
Personal Gds 24.7 16.8 4.3 2 2.00%
Gen Retail 25.8 14 4.2 1 1.70%
Support Serv 26.4 11.9 2.8 1.1 1.90%
Beverages 27 14.9 4.2 2.4 2.70%
SW & Comp Serv 27.3 15.9 4.5 3.8 1.10%
Oil Service 73.9 11.8 1.9 1.7 3.70%
Oil&Gas Prod 116.9 8.2 1.4 1 3.10%
Inds Metal 165.7 7.7 1.1 0.7 2.40%
Mining 8.9 1.6 1.5 1.90%
Alt Energy 10.5 1.7 0.9 1.20%

Source: Star Capital

A number of sectors have been out of favour since 2008 and may remain so in 2017 but it is useful to know where under-performance can be found.

Developed Market Opportunities

At a country level there is better long-term valuation to be found outside the US, even among the developed countries. Here is Star Capital’s 10 to 15 year total annual return forecast for the major markets and regions:-

Country CAPE Forecast PB Forecast ø Forecast
Italy 12.7 9.10% 1.2 10.40% 9.70%
Spain 11.7 9.70% 1.4 8.80% 9.30%
United Kingdom 14.8 8.00% 1.8 7.20% 7.60%
France 18.3 6.60% 1.6 8.10% 7.30%
Australia 16.8 7.10% 2 6.60% 6.90%
Germany 18.6 6.40% 1.8 7.40% 6.90%
Japan 24.9 4.40% 1.3 9.40% 6.90%
Netherlands 19.8 6.00% 1.8 7.20% 6.60%
Canada 20.5 5.70% 1.9 6.90% 6.30%
Sweden 20.6 5.70% 2.1 6.20% 5.90%
Switzerland 21.5 5.40% 2.4 5.30% 5.30%
United States 26.4 4.00% 2.9 4.10% 4.00%
Emerging Markets 14 8.40% 1.6 7.90% 8.20%
Developed Europe 16.6 7.20% 1.8 7.40% 7.30%
World AC 20.8 5.60% 2 6.70% 6.20%
Developed Markets 21.9 5.30% 2 6.50% 5.90%

Source: Star Capital, Bloomberg, Reuters

I have sorted this data based on Star Capital’s composite annual return forecast. The first three countries, Italy, Spain and the UK, all face uncertainty linked to the future of the EU. Interestingly Switzerland offers better long-term returns than the US – with considerably less currency risk for the international investor.

Value Investing

Since the financial crisis in 2008 through to 2015 Growth stocks outperformed Value stocks. I predict a sea-change. The fathers of Value Investing, Ben Graham and David Dodd first published Securities Analysis in 1934. Towards the end of his career Graham opined (emphasis is mine):-

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I’m on the side of the “efficient market” school of thought now generally accepted by the professors.

As we embrace the “Big Data” era, the cost of analysing vast amounts of data will collapse, whilst, at the same time, the amount of available data will grow exponentially. I believe we are at the dawn of a new age for Value Investing where the quantitative analysis of a vast array of qualitative factors will allow investors to defy the Efficient Market Hypothesis, even if we cannot satisfactorily refute Eugene Fama’s premise. In 2016, for the first time in seven years, Value beat Growth across all major categories:-

value_outperformance_of_growth_2016

Source: MSCI, Bloomberg

Value stocks tend to exhibit higher volatility than growth stocks, but volatility is only one aspect of risk: buying Value offers long-term protection, especially during an economic downturn. According to Bloomberg’s Nir Kaissar, Value has consistently underperformed Growth since the financial crisis except in US Small Cap’s – his article – Value Investing Hits Back – is insightful.

Conclusion and Investment Opportunities

When I first began investing in stocks the one of the general rules was to buy when the P/E ratio was below 10 and sell when it rose above 20. Today, of the world’s major stock markets, only Russia and China offer single digit P/Es – low ratios are a structural feature of these markets. I wrote about Russia last month in – Russia – Will the Bear come in from the cold? My conclusion was that one should be cautiously optimistic:-

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord.

Interest rates in the US will rise, though probably not by as much, nor as quickly as the market is currently betting. A value based approach to stock selection offers greater protection and greater return in the long run.

The US stock market continues to rise. The US economy looks set to grow more rapidly in 2017 due to tax cuts and fiscal stimulus, but, for international companies which export to the US, the threat of protectionism is likely to temper enthusiasm for their stocks.

US financial services firms were a big winner after the Trump election result, they should continue to benefit even as interest rates increase – yield curves will steepen, increasing return on capital. US telecommunications stocks have a performed well since the election along with biotechnology – I have no specific view on these industries. Energy stocks have also rallied, perhaps as much on the OPEC deal as the Trump triumph – many new technologies are starting to be implemented by the energy industry but enthusiasm for these stocks may be tempered by a decline in oil prices once the rig count rebounds. The Baker-Hughes Rig Count ended the year at 525 up from a low of 316 in May. The old high of 1,609 was set back in October 2014 – there is plenty of spare capacity which will exert downward pressure on oil prices.

Indian economic growth will outpace China for another year. Despite a weakening Chinese Yuan, Vietnam remains competitive – it is on the cusp of moving from Frontier to Emerging Market status. Indonesia also looks likely to perform well during 2017, GDP forecasts are around 5%; however, Indonesia’s strong reliance on commodity exports makes it more vulnerable than some of its South and East Asian neighbours.

Russia – Will the Bear come in from the cold?

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Macro Letter – No 67 – 9-12-2016

Russia – Will the Bear come in from the cold?

  • In 2015/16 the Russian economy suffered in the sharpest recession since 2008/09
  • The RTSI Stock Index, anticipating a recovery, is up 78% from its January lows
  • Russian government bonds traded at 8% in August down from 16% in December 2014
  • The Ruble has stabilised after the devaluation of 2014/2015 and inflation is still falling

Since January many emerging equity and bond markets have staged a spectacular recovery. Russia has been among the winners, buoyed by hopes of an end to international sanctions and a, relative, rapprochement with the new US administration. A near-virtuous circle is achieved when combined with the country’s strengthening trade relationship with China and the rising oil price, stemming from the first OPEC production agreement in eight years.

Looking at the RTSI Index, a lot of this favourable news is already in the price:-

rtsi_2016_-_moscow_exchange

Source: Moscow Exchange

Since January the RTSI has rallied by 78% and, at 1082 is close to the highs of May 2015 (1092) from whence it broke down to the lows of January (607). Is it too late to join the party? A longer-term chart lends perspective:-

rtsi-1995-2016

Source: Tradingview

By a number of other metrics Russian stocks still look inexpensive. The chart below compares stock market capitalisation to GDP:-

russia-mktcap-to-gdp-guru-focus

Source: Guru Focus

The current ratio is 20%, the average over the period since 2000 is 65% – return to mean would imply a 19.25% annual return for Russian stocks over the next eight years. That would equate to a compound return of 409%.

The table below shows the P/E Ratios of four Russian ETFs as of 8th December:-

Symbol Name P/E Ratio
RSXJ VanEck Vectors Russia Small-Cap ETF 6.07
ERUS iShares MSCI Russia Capped ETF 7.33
RBL SPDR S&P Russia ETF 7.72
RSX VanEck Vectors Russia ETF 8.73

Source: EFTdb.com

For comparison, the iShares MSCI BRIC ETF (BKF) currently trades on a PE of 10 times.

Bonds, Inflation and the Ruble

Russian inflation has been declining rapidly this year as the sharp devaluation of 2014/2015 feeds through. The two charts below shows the USDRUB (black – RHS) and Russian CPI (blue – LHS) and Russian 10 year Government bonds (blue – LHS) versus CPI (black – RHS):-

russia-inflation-cpi-and-usdrub-1-1-14-to-8-12-16

Source: Trading Economics

russia-government-bond-yield-and-cpi-1-1-14-to-8-12-16

Source: Trading Economics

Whilst the Ruble has stabilised at a structurally higher level than prior to the annexation of the Crimea, the inflation rate has been brought back under control by the hawkish endeavours of the Central Bank of Russia. The benchmark one-week repo rate remains at 10%, down from 17% in December 2014 but still well above the rate of inflation – which the Central Bank of Russia forecast to fall to 4% by the end of next year. The yield curve remains inverted but that has not always been a structural feature of the Russian market. The chart below compares the one week repo rate (black – RHS) versus 10yr Government bonds (blue – LHS):-

russia-government-bond-yield-vs-interest-rate-2003-2016

Source: Trading Economics

Economics and Politics

The IMF WEO – October 2016 revised its GDP forecast for Russia in 2017 to +1.1% (versus +0.1% in July) although they revised their 2016 estimate to -0.8% from +0.4%. Focus Economics poll of analysts, forecast 1.2%, whilst Fathom Consulting’s Global Economic Strategic asset Allocation Model (GESAM) is predicting +0.8. Between 1996 and 2016 the average rate of GDP growth was 3.08%. As the chart below shows, the growth rate has been volatile and, like many countries globally, the post 2008/2009 period has been more subdued:-

russia-gdp-growth-annual

Source: Trading Economics, Federal Statistics Service

Oil and Gas

Russia’s largest export markets are Netherlands 11.9%, China 8.3% and Germany 7.4%. Their main exports are oil and gas. The chart below shows the price of Russian gas at the German border over the last 15 years:-

russian_gas_15_year-indexmundi

Source: Indexmundi

Whilst this may be good news for European consumers it has led to considerable political tension. Russia is developing a new gas pipeline – Nord Stream 2 – which will double Russia’s gas export capacity and avoid the geographic obstacle of the Ukraine. It is scheduled to be operational in 2019.

However the EU is developing another gas pipeline – the Southern Gas Corridor, avoiding Russian territory, which is scheduled to be operational in 2020 – to diversify their sources of supply. The Carnegie Moscow Centre – Gazprom’s EU Strategy Is a Dead End – December 6th 2016 takes up the story:-

The EU points out that Ukraine has never violated its gas transit obligations, while Russia shut off the tap during some of the coldest days in 2006 and 2009, and then sharply cut the volume of exports to Europe in late 2014, each time for political reasons. Brussels believes that the real threat to European energy security is not Ukraine but rather the unpredictability of Russian authorities.

US LNG exports are slowly increasing but producers are expected to focus on meeting demand from Japan and other parts of Asia, where prices are higher, first. The Colombia SIPA Center on Global Energy Policy – American Gas to the Rescue – September 2014 – made the following observations which still hold true:-

Although US LNG exports increase Europe’s bargaining position, they will not free Europe from Russian gas. Russia will remain Europe’s dominant gas supplier for the foreseeable future, due both to its ability to remain cost-competitive in the region and the fact that US LNG will displace other high-cost sources of natural gas supply. In our modeling we find that 9 billion cubic feet per day (93 billion cubic meters per year) of gross US LNG exports results in only a 1.5 bcf/d (15 bcm) net addition in global natural gas production. 

By forcing state-run Gazprom to reduce prices to remain competitive in the European market, US LNG exports could have a meaningful impact on total Russian gas export revenue. While painful for Russian gas companies, the total economic impact on state coffers is unlikely to be significant enough to prompt a change in Moscow’s foreign policy, particularly in the next few years.

Oil is a more global market and the 29th November OPEC production agreement, the first that OPEC members have signed in eight years, should help to stabilise global prices – that is assuming that OPEC members do not cheat. Russia, although not a member of OPEC, agreed to reduce production by 300,000 bpd. Russia had just achieved record post-soviet production of 11.1mln bpd in September, they have room to moderate their output:-

rusian-oil-production-2005-2016-bloomberg-energy-ministry

Source: Bloomberg, Russian Energy Ministry

Prospects for 2017

In 2015 tax from oil and gas amounted to 52% of Russian receipts – a stabilisation of the oil price will be a significant fiscal boost next year. Russia has been far from profligate since 2008, it runs a trade and current account surplus and, although the government is in deficit to the tune of 2.6% of GDP this year, the government debt to GDP ratio is a very manageable 17.17%.

Looking ahead to 2017 Brookings – The Russian economy inches forward – highlights a number of features which support optimism for the future:-

…the country seems to have turned the corner and growth is expected to be positive in 2017-2018. One key reason is that over the last two years, the government’s policy response package of a flexible exchange rate policy, expenditure cuts in real terms, and bank recapitalization—along with tapping the Reserve Fund—has helped buffer the economy against multiple shocks.

…The banking sector has also now largely stabilized. The consolidated budget of regional governments even registered a surplus in the first eight months of 2016. Indeed, on the back of projected rising oil prices, we expect the economy to enter positive territory in 2017 and 2018, reaching 1.5-1.7 percent.

With a growing federal fiscal deficit (3.7 percent of GDP by end 2016), one proactive step the government has taken is to reintroduce a three-year, medium-term fiscal framework, which proposes to cut the deficit by about 1 percent each year ultimately leading to a balanced budget by 2020. The budget is conservatively costed at a $40 per barrel oil price, and cuts are driven mostly by a reduction in expenditures in mostly defense/military and social policy. If adhered to, this medium-term framework will be an important step toward reducing overall policy uncertainty. 

China (and India)

In the longer term a major focus of Russian economic policy has, and continues to be, the development of trade with China. The first Russo-Chinese partnership agreements were signed in 1994 and 1996, followed by the Treaty of Friendship and Cooperation in 2001 and the Strategic Partnership in 2012 which was superseded by a further agreement in 2014 – signed by President Xi. Ratified shortly after the annexation of the Crimea and imposition of sanctions by the US and EU, the latest agreement has substance. Here are some of the more prominent deals which have emerged from the closer cooperation:-

  • Gazprom and China National Petroleum Corporation (CNPC) announced a 40 year gas supply deal, including plans to build the “Power of Siberia” gas pipeline.
  • Rosneft agreed to supply CNPC with $500bln of oil, potentially making Russia, China’s largest supplier of oil, surpassing Saudi Arabia. The Eastern Siberia-Pacific Ocean oil pipeline will be connected to Northeast China next year and a pipeline linking Siberia’s Chayandinskoye oil and gas field to China comes online in 2018.
  • The Central Bank of Russia signed a RUB 815bln swap agreement with the PBoC to boost bilateral trade. They had previously contracted business in US$.

The Diplomat – Behind China and Russia’s ‘Special Relationship’ – investigates the impact this new cooperation is beginning to have:-

…Russia has become one of the five largest recipients of Chinese outbound direct investment in relation to the Chinese government’s Belt and Road Initiative (BRI) connecting Asia with Europe. Meanwhile, China was Russia’s largest bilateral trade partner, in 2015; in spite of declining overall bilateral trade in U.S. dollar terms (mainly due to sharp declines in the ruble as well as the yuan), relative to 2014, trade flows continued to expand in terms of volume.

In this context, it was significant that Russia’s exports of mechanical and technical products to China rose by about 45 percent over the course of 2015 possibly signifying an important trend in the diversification and competitiveness of Russia’s non-energy sector in terms of bilateral trade prospects with China.

The Diplomat goes on to highlight the improved and increasing importance of Russian trade with India:-

The Russia-India-China (RIC) trilateral grouping is considered by its participants as an important arrangement in securing political stability, both globally and in the region. India and Russia’s relations have remained strong for several decades, with Russia being India’s largest defense and nuclear energy partner. However, while China’s and Russia’s relations have clearly improved in the last few years, the China-India relationship has somewhat lagged the development of the other two legs of the triangle. Consequently, Russia has played a role in bringing both sides closer together through its interactions in the RIC grouping.

The Trump Card?

US pre-election rhetoric from the Trump campaign suggested a less combative approach to Russia. Trump said he would “look into” recognising Crimea and removing sanctions, however, Republican hawks in Congress will want to have their say. Syria may be the key to a real improvement in relations – don’t hold your breath.

Conclusion and Investment Opportunities

The Ruble has stabilised and whilst Russia has some external debt the amount is not excessive. The effect of the devaluation of 2014/2015 has run its course and inflation is forecast to decline further next year. It may weaken against the US$ in line with other countries but is likely to be range-bound, with a potential upward bias, against its major trading partners.

The Central Bank of Russia has maintained tight grip short term interest rates, leaving it room to reduce rates, perhaps, as soon as Q1 2017. Russian government bond yields halved since their highs of 16% in late 2014, but have risen by around 60bp since August following the trend in other global bond markets. With short term interest rates set to decline, the inversion of the yield curve is likely to unwind, but this favours shorter dated, lower duration bonds – there is also a risk of forced liquidation by international investors, if US and other bond markets should decline in tandem.

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord. The VanEck Vectors Russia Small-Cap ETF (RSXJ) has very little exposure to oil and gas and therefore reflects a less commodity-centric aspect of the Russian economy. The chart below covers the five years since 2011. It has risen further than the major indices since January yet still trades at a lower PE ratio:-

rsxj-index-yahoo

Source: Yahoo Finance

Like the RTSI Index the small-cap ETF looks over-bought, however, the economic recovery in Russia appears to be broad-based, Chinese growth, in response to further fiscal stimulus, has increased and the oil price has (at least for the present) stabilised around $50/bbl. If you do not have exposure to Russia, you should consider an allocation. There may be better opportunities to buy, but waiting for trends to retrace can leave you feeling like Tantalus. The last two bull-markets – January 2009 to March 2011, and July 2004 to May 2008 – saw the RTSI Index rally 315% and 382% respectively. In the aftermath of the Russian crisis of 1998 the index rose from 61 to 755 in less than six years (1,138%). Don’t be shy but also keep some power dry.

Protectionism: which countries have room for fiscal expansion?

Protectionism: which countries have room for fiscal expansion?

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Macro Letter – No 66 – 25-11-2016

Protectionism: which countries have room for fiscal expansion?

  • As globalisation goes into reverse, fiscal policy will take the strain
  • Countries with government debt to GDP ratios <70% represent >45% of global GDP
  • Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…But now I only hear

Its melancholy, long, withdrawing roar…

Matthew Arnold – Dover Beach

Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.

The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?

Anti-globalisation – the melancholy, long, withdrawing roar

The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-

world-bank-economist-real-income-growth-1988-2008

Source: The Economist, World Bank, Lakner and Milanovic

This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.

What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-

pricesnew

Source: American Enterprise Institute

At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.

Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.

Which countries will lose out from protectionism?

It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.

Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.

The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21st November:-

Country GDP Base Rate Inflation Debt to GDP 10yr yield Notes
Japan 4,123 -0.10% -0.50% 229% 0.03
Greece 195 0.00% -0.50% 177% 6.95
Italy 1,815 0.00% -0.20% 133% 2.06
Portugal 199 0.00% 0.90% 129% 3.70
Belgium 454 0.00% 1.81% 106% 0.65
Singapore 293 0.07% -0.20% 105% 2.36
United States 17,947 0.50% 1.60% 104% 2.32
Spain 1,199 0.00% 0.70% 99% 1.60
France 2,422 0.00% 0.40% 96% 0.74
Ireland 238 0.00% -0.30% 94% 0.98
Canada 1,551 0.50% 1.50% 92% 1.57
UK 2,849 0.25% 0.90% 89% 1.41
Austria 374 0.00% 1.30% 86% 0.54
Egypt 331 14.75% 13.60% 85% 16.95
Germany 3,356 0.00% 0.80% 71% 0.27
India 2,074 6.25% 4.20% 67% 6.30
Brazil 1,775 14.00% 7.87% 66% 11.98
Netherlands 753 0.00% 0.40% 65% 0.43
Israel 296 0.10% -0.30% 65% 2.14
Pakistan 270 5.75% 4.21% 65% 8.03
Finland 230 0.00% 0.50% 63% 0.46
Malaysia 296 3.00% 1.50% 54% 4.39
Poland 475 1.50% -0.20% 51% 3.58
Vietnam 194 6.50% 4.09% 51% 6.10
South Africa 313 7.00% 6.10% 50% 8.98
Venezuela 510 21.73% 180.90% 50% 10.57
Argentina 548 25.75% 40.50% 48% 2.99
Philippines 292 3.00% 2.30% 45% 4.40
Thailand 395 1.50% 0.34% 44% 2.68
China 10,866 4.35% 2.10% 44% 2.91
Sweden 493 -0.50% 1.20% 43% 0.52
Mexico 1,144 5.25% 3.06% 43% 7.39
Czech Republic 182 0.05% 0.80% 41% 0.59
Denmark 295 -0.65% 0.30% 40% 0.40
Romania 178 1.75% -0.40% 38% 3.55
Colombia 292 7.75% 6.48% 38% 7.75
Australia 1,340 1.50% 1.30% 37% 2.67
South Korea 1,378 1.25% 1.30% 35% 2.12
Switzerland 665 -0.75% -0.20% 34% -0.15
Turkey 718 7.50% 7.16% 33% 10.77
Hong Kong 310 0.75% 2.70% 32% 1.37
Taiwan 524 1.38% 1.70% 32% 1.41
Norway 388 0.50% 3.70% 32% 1.65
Bangladesh 195 6.75% 5.57% 27% 6.89
Indonesia 862 4.75% 3.31% 27% 7.85
New Zealand 174 1.75% 0.40% 25% 3.11
Kazakhstan 184 12.00% 11.50% 23% 3.82 ***
Peru 192 4.25% 3.41% 23% 6.43
Russia 1,326 10.00% 6.10% 18% 8.71
Chile 240 3.50% 2.80% 18% 4.60
Iran 425 20.00% 9.50% 16% 20.00 **
UAE 370 1.25% 0.60% 16% 3.57 *
Nigeria 481 14.00% 18.30% 12% 15.97
Saudi Arabia 646 2.00% 2.60% 6% 3.97 *

 Notes

*Estimate from recent sovereign issues

**Estimated 1yr bond yield

***Estimated from recent US$ issue

Source: Trading economics, Investing.com, Bangledesh Treasury

Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.

If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).

Most Favoured Borrowers

Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.

The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-

Country GDP Debt to GDP 10yr yield Gov. Debt 70% Ratio 90% Ratio 12m fwd PE CAPE Div Yld.
Saudi Arabia 646 6% 3.97 38 452 581 ? ? ?
Chile 240 18% 4.60 42 168 216 15.6 ? ?
New Zealand 174 25% 3.11 43 122 157 19.3 22 4.1%
Peru 192 23% 6.43 44 134 173 12.1 ? ?
Bangladesh 195 27% 6.89 53 137 176 ? ? ?
UAE 370 16% 3.57 58 259 333 ? ? ?
Colombia 292 38% 7.75 111 204 263 ? ? ?
Norway 388 32% 1.65 123 272 349 14.2 11.5 4.3%
Philippines 292 45% 4.40 132 204 263 16.4 22.6 1.6%
Malaysia 296 54% 4.39 160 207 266 15.6 16 3.1%
Taiwan 524 32% 1.41 166 367 472 12.8 19 3.9%
Thailand 395 44% 2.68 175 277 356 13.8 17.7 3.1%
Israel 296 65% 2.14 192 207 266 9.4 14.6 2.8%
Sweden 493 43% 0.52 214 345 444 16.1 19.8 3.6%
Indonesia 862 27% 7.85 233 603 776 14.7 19.6 1.9%
South Korea 1,378 35% 2.12 484 965 1,240 9.6 13.1 1.7%
Australia 1,340 37% 2.67 493 938 1,206 15.6 16.1 4.3%
Mexico 1,144 43% 7.39 494 801 1,030 16.6 22.4 1.9%
India 2,074 67% 6.30 1,394 1,452 1,867 15.9 18.6 1.5%
4,649 8,114 10,432

 Source: Trading economics, Investing.com, Bangledesh Treasury, Star Capital, Yardeni Research

The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to  Reinhart and Rogoff in their paper Growth in a Time of Debt.

Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.

Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.

Despite US debt to GDP being above 100%, the new US President-elect has promised $5.3trln of fiscal spending during his first term. Whether this is a good idea or not is debated this week by the Peterson Institute – What Size Fiscal Deficits for the United States?

Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.

Conclusions and investment opportunities

Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.

Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.

Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.

According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.

Indian bond yields actually fell in the wake of the US election – from 6.83% on 8th to 6.30% by 21st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.

Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.

A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.

Yield Curve Control – the road to infinite QE

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Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

  • The BoJ unveiled their latest unconventional monetary policy on 21st September
  • In order to target 10 year yields QE must be capable of being infinite
  • Infinite Japanese government borrowing at zero cost will eventually prove inflationary
  • The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”.  New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited.  This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds.  Zero-coupon bonds are not a joke – 28th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.  

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

  • Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
  • Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

nikkei-share-buybacks-may-2016-goldman-sachs

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

Saudi Arabian bonds and stocks – is it time to buy?

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Macro Letter – No 64 – 28-10-2016

Saudi Arabian bonds and stocks – is it time to buy?

  • Saudi Arabia issued $17.5bln of US$ denominated sovereign bonds – the largest issue ever
  • Saudi Aramco may float 5% of their business in the largest IPO ever
  • The TASI stock index is down more than 50% from its 2014 high
  • OPEC agreed to cut output by 640,000 to 1,140,000 bpd

The sovereign bond issue

The Saudi Arabia’s first international bond deal raised $17.5bln. They tapped the market across the yield curve issuing 5yr, 10yr and 30yr bonds. The auction was a success – international investors, mostly from the US, placed $67bln of bids. The issues were priced slightly higher than Qatar, which raised $9bln in May, and Abu Dhabi, which issued $2.5bln each of 5yr and 10yr paper in April.

The Saudi issue appears to have been priced to go, as the table below, showing the basis point spread over US Treasuries, indicates. According to the prospectus the Kingdom of Saudi Arabia (KSA) want to tap the US$ sovereign bond market extensively in the future, raising as much as $120bln; attracting investors has therefore been a critical aspect of their recent charm offensive:-

Issuer 5yr Spread 10yr Spread 30yr Spread Bid to Cover
Saudi Arabia 135 165 210 3.82
Qatar 120 150 210 2.56
Abu Dhabi 85 125 N/A 3.4

Source: Bloomberg

The high bid to cover ratio (3.8 times) enabled the Kingdom to issue $2.5bln more paper than had been originally indicated: and on better terms – 40bp over, higher rated, Qatar rather than 50bp which had been expected prior to the auction.

The bonds immediately rose in secondary market trading and other Gulf Cooperation Council (GCC) issues also caught a bid. The Saudi issue was also unusual in that the largest tranche ($6.5bln) was also the longest maturity (30yr). The high demand is indicative of the global quest for yield among investors. This is the largest ever Emerging Market bond issue, eclipsing Argentina’s $16.5bln offering in April.

The Aramco IPO

Another means by which the Kingdom plans to balance the books is through the Saudi Aramco IPO – part of the Vision 2030 plan – which may float as much as 5% of the company, worth around $100bln, in early 2018. This would be four times larger than the previous record for an IPO set by Alibaba in September 2014.

An interesting, if Machiavellian, view about the motivation behind the Aramco deal is provided by – Robert Boslego – Why Saudi Arabia Will Cut Production To Achieve Vision 2030:-

As part of the implementation of this plan, Saudi Aramco and Shell (NYSE:RDS.A) (NYSE:RDS.B) are dividing up their U.S. joint venture, Motiva, which will result in Saudi’s full ownership of the Port Author refinery. Aramco will fully own Motiva on April 1, 2017, and has been in talks of buying Lyondell’s Houston refinery.

I suspect Motiva may also purchase U.S. oil shale properties (or companies) that are in financial trouble as a result of the drop in prices since 2014. According to restructuring specialists, about 100 North American oil and gas companies have filed for bankruptcy, and there may be another 100 to go. This would enable Aramco to expand market share as well as control how fast production is brought back online if prices rise.

By using its ability to cut production to create additional spare capacity, Aramco can use that spare capacity to control prices as it wishes. It probably does not want prices much above $50/b to keep U.S. shale production to about where it is now, 8.5 mmbd. And it doesn’t want prices below $45/b because of the adverse impact of such low prices on its budget. And so it will likely adjust its production accordingly to keep prices in a $45-$55/b range.

Conclusions

Although I authored a series of articles stating that OPEC was bluffing (and it was), I now think that Saudi Arabia has formulated a plan and will assume the role of swing producer to satisfy its goals. It can and will cut unilaterally to create excess spare capacity, which it needs to control oil prices.

This will make the company attractive for its IPO. And by selling shares, Aramco can use some of the proceeds to buy U.S. shale reserves “on the cheap,” not unlike John D. Rockefeller, who bankrupted competitors to acquire them.

The Saudi’s long-term plan is to convert Aramco’s assets into a $2 trillion fund, which can safely reside in Swiss banks. And that is a much safer investment than oil reserves in the ground subject to external and internal political threats.

Whatever the motives behind Vision 2030, it is clear that radical action is needed. The Tadawul TASI Stock Index hit its lowest level since 2011 on 3rd October at 5418, down more than 50% from its high of 11,150 in September 2014 – back when oil was around $90/bbl.

As a starting point here is a brief review of the Saudi economy.

The Saudi Economy

The table below compares KSA with its GCC neighbours; Iran and Iraq have been added to broaden the picture of the oil producing states of the Middle East:-

Country GDP YoY Interest rate Inflation rate Jobless rate Gov. Budget Debt/GDP C/A Pop.
Saudi Arabia 1.40% 2.00% 3.30% 5.60% -15.00% 5.90% -8.2 31.52
Iran 0.60% 20.00% 9.40% 11.80% -2.58% 16.36% 0.41 78.8
UAE 3.40% 1.25% 0.60% 4.20% 5.00% 15.68% 5.8 9.16
Iraq 2.40% 4.00% 0.20% 16.40% -2.69% 37.02% -0.8 35.87
Qatar 1.10% 4.50% 2.60% 0.20% 16.10% 35.80% 8.3 2.34
Kuwait 1.80% 2.25% 2.90% 2.20% 26.59% 7.10% 11.5 3.89
Oman -14.10% 1.00% 1.30% 7.20% -17.10% 9.20% -15.4 4.15
Bahrain 2.50% 0.75% 2.60% 3.70% -5.00% 42.00% 3.3 1.37

Source: Trading Economics

In terms of inflation the KSA is in a better position than Iran and its unemployment rate is well below that of Iran or Iraq, but on several measures it looks weaker than its neighbours.

Moody’s downgraded KSA in May – click here for details – citing concern about their reliance on oil. They pointed to a 13.5% decline in nominal GDP during 2015 and forecast a further fall this year. This concurs with the IMF forecast of 1.2% in 2016 versus 3.5% GDP growth in 2015. It looks likely to be the weakest economic growth since 2009.

The government’s fiscal position has deteriorated in line with the oil price. In 2014 the deficit was 2.3%, by 2015 it was 15%:-

saudi-arabia-government-budget-1970-2016

Source: Trading Economics, SAMA

Despite austerity measures, including proposals to introduce a value added tax, the deficit is unlikely to improve beyond -13.5% in 2016. It is estimated that to balance the Saudi budget the oil price would need to be above $79/bbl.

At $98bln, the 2015 government deficit was the largest of the G20, of which Saudi Arabia is a member. According to the prospectus of the new bond issue Saudi debt increased from $37.9bln in December 2015 to $72.9bln in August 2016. Between now and 2020 Moody’s estimate the Kingdom will have a cumulative financing requirement of US$324bln. More than half the needs of the GCC states combined.  Despite the recent deterioration, Government debt to GDP was only 5.8% in 2015:-

saudi-arabia-government-debt-to-gdp-1999-2016

Source: Trading Economics, SAMA

They have temporary room for manoeuvre, but Moody’s forecast this ratio rising beyond 35% by 2018 – which is inconsistent with an Aa3 rating. Even the Saudi government see it rising to 30% by 2030.

The fiscal drag has also impacted foreign exchange reserves. From a peak of US$731bln in August 2014 they have fallen by 23% to US$562bln in August 2016:-

saudi-arabia-foreign-exchange-reserves-2010-2016

Source: Trading Economics, SAMA

Reserves will continue to decline, but it will be some time before the Kingdom loses its fourth ranked position by FX reserves globally. Total private and public sector external debt to GDP was only 15% in 2015 up from 12.3% in 2014 and 11.6% in 2013. There is room for this to grow without undermining the Riyal peg to the US$, which has been at 3.75 since January 2003. A rise in the ratio to above 50% could undermine confidence but otherwise the external debt outlook appears stable.

The fall in the oil price has also led to a dramatic reversal in the current account, from a surplus of 9.8% in 2014 to a deficit of 8.2% last year. In 2016 the deficit may reach 12% or more. It has been worse, as the chart below shows, but not since the 1980’s and the speed of deterioration, when there is no global recession to blame for the fall from grace, is alarming:-

saudi-arabia-current-account-to-gdp

Source: Trading Economics, SAMA

The National Vision 2030 reform plan has been launched, ostensibly, to wean the Kingdom away from its reliance on oil – which represents 85% of exports and 90% of fiscal revenues. In many ways this is an austerity plan but, if fully implemented, it could substantially improve the economic position of Saudi Arabia. There are, however, significant social challenges which may hamper its delivery.

Perhaps the greatest challenge domestically is youth unemployment. More than two thirds of Saudi Arabia’s population (31mln) is under 30 years of age. A demographic blessing and a curse. Official unemployment is 5.8% but for Saudis aged 15 to 24 it is nearer to 30%. A paper, from 2011, by The Woodrow Wilson International Center – Saudi Arabia’s Youth and the Kingdom’s Future – estimated that 37% of all Saudis were 14 years or younger. That means the KSA needs to create 3mln jobs by 2020. The table below shows the rising number unemployed:-

saudi-arabia-unemployed-persons-2008-2016

Source: Trading Economics, Central Department of Statistics and Economics

If you compare the chart above with the unemployment percentage shown below you would be forgiven for describing the government’s work creation endeavours as Sisyphean:-

saudi-arabia-unemployment-rate-2000-2016

Source: Trading Economics, Central Department of Statistics and Economics

Another and more immediate issue is the cost of hostilities with Yemen – and elsewhere. Exiting these conflicts could improve the government’s fiscal position swiftly. More than 25% ($56.8bln) of the 2016 budget has been allocated to military and security expenditure. It has been rising by 19% per annum since the Arab spring of 2011 and, according to IHS estimates, will reach $62bln by 2020.

The OPEC deal and tightness in the supply of oil

After meeting in Algiers at the end of September, OPEC members agreed, in principle, to reduce production to between 32.5 and 33mln bpd. A further meeting next month, in Vienna, should see a more concrete commitment. This is, after all, the first OPEC production agreement in eight years, and, despite continuing animosity between the KSA and Iran, the Saudi Energy Minister, Khalid al-Falih, made a dramatic concession, stating that Iran, Nigeria and Libya would be allowed to produce:-

…at maximum levels that make sense as part of any output limits.

Iranian production reached 3.65mln bpd in August – the highest since 2013 and 10.85% of the OPEC total. Nigeria pumped 1.39mln bpd (4.1%) and although Libya produced only 363,000 bpd, in line with its negligible output since 2013, it is important to remember they used to produce around 1.4mln bpd. Nigeria likewise has seen production fall from 2.6mln bpd in 2012. Putting this in perspective, total OPEC production reached a new high of 33.64mln bpd in September.

The oil price responded to the “good news from Algiers” moving swiftly higher. Russia has also been in tentative discussions with OPEC since the early summer. President Putin followed the OPEC communique by announcing that Russia will also freeze production. Russian production of 11.11mln bpd in September, is the highest since its peak in 1988. Other non-OPEC nations are rumoured to be considering joining the concert party.

Saudi Arabia is currently the largest producer of oil globally, followed by the USA. In August Saudi production fell from 10.67mln bpd to 10.63mln bpd. It rebounded slightly to 10.65mln bpd in September – this represents 32% of OPEC output.

There are a range of possible outcomes, assuming the OPEC deal goes ahead. Under the proposed terms of the agreement, production is to be reduced by between 1.14mln and 640,000 bpd. Saudi Arabia, as the swing producer, is obliged to foot the bill for an Iranian production freeze and adjust for any change in Nigerian and Libyan output. The chart below, which is taken from the Federal Reserve Bank of Dallas – Signs of Recovery Emerge in the U.S. Oil Market – Third Quarter 2016 make no assumptions about Saudi Arabia taking up the slack but it provides a useful visual aid:-

opec-secenario-dallas-fed

Source: EIA, OPEC, Dallas Fed

They go on to state in relation to US production:-

While drilling activity has edged up, industry participants believe it will be awhile before activity significantly increases. When queried in the third quarter 2016 Dallas Fed Energy Survey, most respondents said prices need to exceed $55 per barrel for solid gains to occur, with a ramp-up unlikely until at least second quarter 2017.

Assuming the minimum reduction in output to 33mln bpd and Iran, Nigeria and Libya maintaining production at current levels, Saudi Arabian must reduce its output by 300,000 bpd. If the output cut is the maximum, Iran freezes at current levels but Nigeria and Libya return to the production levels of 2012, Saudi Arabia will need to reduce its output by 623,000 bpd. The indications are that Nigeria and Libya will only be able to raise output by, at most, 500,000 bpd each, so a 623,000 bpd cut by Saudi Arabia is unlikely to be needed, but even in the worst case scenario, if the oil price can be raised by $3.11/bbl the Saudi production cut would be self-financing. My “Median” forecast below assumes Nigeria and Libya increase output by 1mln bpd in total:-

OPEC Cut ‘000s bpd KSA Cut ‘000s bpd KSA % of total OPEC Cut Oil Price B/E for KSA/bbl
Max 1,140 623 54.68% +$3.11
Median 890 422 47.41% +$2.06
Minimum 640 300 47.07% +$1.45

Source: OPEC

Many commentators are predicting lower oil prices for longer; they believe OPEC no longer has the power to influence the global oil price. This article by David Yager for Oil Price – Why Oil Prices Will Rise More And Sooner Than Most Believe – takes a different view. His argument revolves around the amount of spare capacity globally. The author thinks OPEC is near to full production, but it is his analysis of non-OPEC capacity which is sobering:-

…RBC Capital Markets was of the view oil prices would indeed rise but not until 2019. RBC says 2.2 million b/d of new non-OPEC production will enter the markets this year, 1.3 million b/d next year and 1.6 million b/d in 2018. Somehow U.S. production will rise by 900,000 b/d from 2017 and 2019 despite falling by 1.1 million b/d in the past 15 months and with rigs count at historic lows. At the same time RBC reported the 124 E&P companies it follows will cut spending another 32 percent in 2016 from 2015, a $US106 billion reduction.

…The Telegraph ran it under the title, “When oil turns it will be with such lightning speed that it could upend the market again”. Citing the lowest levels of oil discoveries since 1952, annual investment in new supplies down 42 percent in the past two years and how the International Energy Agency (IEA) estimates 9 percent average annual global reservoir depletion, the article stated, “…the global economy is becoming dangerously reliant on crude supply from political hotspots”. “Drillers are not finding enough oil to replace these (depletion) barrels, preparing the ground for an oil price spike and raising serious questions about energy security”.

Depletion of 9 percent per year is about 8.6 million b/d. Add demand growth and you’re approaching 10 million b/d. How do the crystal ball polishers of the world who see flat oil prices for the foreseeable future figure producers can replace this output when others report $US1 trillion in capital projects have been cancelled or delayed over the rest of the decade?

The last ingredient in the oil price confusion in inventory levels. OECD countries currently hold 3.1 billion barrels of oil inventory. That sounds like lot. But what nobody reports is the five-year average is about 2.7 billion barrels. Refinery storage tanks. Pipelines. Field locations. Tankers in transit. It’s huge. The current overhang is about 6 days of production higher than it has been for years, about 60 days. So inventories are up roughly 10 percent from where they have been.

Obviously this is going to take a change in the global supply/demand balance to return to historic levels and will dampen prices until it does. But don’t believe OECD inventories must go to zero.

…The current production overhang suppressing markets is only about 1 million b/d or less depending upon which forecast you’re looking at. Both the IEA (Paris) and the EIA (Washington) see the curves very close if they haven’t crossed already. Neither agency sees any overhang by the end of the next year.

…OPEC has no meaningful excess capacity. Non-OPEC production is flat out and, in the face of massive spending cuts, is more likely to fall than rise because production increases will be more than offset by natural reservoir depletion.

Since this article was published OECD inventories have declined a fraction. Here is the latest EIA data:-

  2014 2015 2016 2017
Non-OPEC Production 55.9 57.49 56.84 56.94
OPEC Production 37.45 38.32 39.2 40.07
OPEC Crude Oil Portion 30.99 31.76 32.45 33.03
Total World Production 93.35 95.81 96.04 97.01
OECD Commercial Inventory (end-of-year) 2688 2967 3049 3073
Total OPEC surplus crude oil production capacity 2.08 1.6 1.34 1.21
OECD Consumption 45.86 46.41 46.53 46.6
Non-OECD Consumption 46.69 47.63 48.8 50.07
Total World Consumption 92.55 94.04 95.33 96.67

Source: EIA

Whether or not David Yager is correct about supply, the direct cost to Saudi Arabia, of a 623,000 bpd reduction in output, pales into insignificance beside the cost of domestic oil and gas subsidies – around $61bln last year. Subsidies on electricity and water add another $10bln to the annual bill. These subsidies are being reduced as part of the Vison 2030 austerity plan. The government claim they can save $100bln by 2020, but given the impact of removing subsidies on domestic growth, I remain sceptical.

The Kingdom’s domestic demand for crude oil continues to grow. Brookings – Saudi Arabia’s economic time bomb forecast that it will reach 8.2mln bpd by 2030. By some estimates they may become a net importer of oil by their centenary in 2032. Saudi oil reserves are estimated at 268bln bbl. Her gas reserves are estimated to be 8.6trln M3 (2014) but exploration may yield considerable increases in these figures.

The Kingdom is also planning to build 16 nuclear power stations over the next 20 years, along with extensive expansion of solar power generating capacity. Improvements in technology mean that solar power stations will, given the right weather conditions, produce cheaper electricity than gas powered generation by the end of this year. This article from the Guardian – Solar and wind ‘cheaper than new nuclear’ by the time Hinkley is built – looks longer term.

According to EIA data US production in July totalled 8.69mln bpd down from 9.62mln bpd in March 2015. A further 200,000 bpd reduction is forecast for next year.

The table below, which is taken from the IEA – Medium Term Oil Market Report – 2016suggests this tightness in supply may last well beyond 2018:-

iea_mtomr_-_global_balance_2016

Source: IEA – MTOMR 2016

According to Baker Hughes data, US rig count has rebounded to 443 since the low of 316 at the end of May, but this is still 72% below its October 2014 peak of 1609. This March 2016 article from Futures Magazine – How quickly will U.S. energy producers respond to rising prices? Explains the dynamics of the US oil industry:-

Crude oil produced by shale made up 48% of total U.S. crude oil production in 2015, up from 22% in 2007 according to the Energy Information Administration (EIA), which warns that the horizontal wells drilled into tight formations tend to have very high initial production rates–but they also have steep initial decline rates. Some wells lose as much as 70% of their initial production the first year. With steep decline rates, constant drilling and development of new wells is necessary to maintain or increase production levels. The problem is that many of these smaller shale companies do not have the capital nor the manpower to keep drilling and keep production going.

This is one of the reasons that the EIA is predicting that U.S. oil production will fall by 7.4%, or roughly 700,000 barrels a day. That may be a modest assessment as we are hearing of more stress and bankruptcies in the space. The EIA warns that with the U.S. oil rig count down 76% since the fall of 2014, that unless capital spending picks up, the EIA says that U.S. oil production will keep falling in 2017, ending up 1.2 million barrels a day lower than the 2015 average at 8.2 million barrels a day.

The bearish argument that shale will save the day and keep prices under control does not fit with the longer term reality. When more traditional energy projects with much slower decline rates get shelved, there is the thought that the cash strapped shale producers can just drill, drill. Drill to make up that difference is a fantasy. The problem is that while shale may replace that oil for a while, in the long run it can never make up for the loss of projects that are more sustainable.

OPEC might just have the whip hand for the first time in several years.

The chart below, taken from the New York Federal Reserve – Oil Price Dynamics Report – 24th October 2016 – shows how increased supply since 2012 has pushed oil prices lower. Now oversupply appears to be abating once more; combine this with the inability of the fracking industry to “just drill” and the reduction in inventories and conditions may be ripe for an aggressive short squeeze:-

ny-fed-oil-supply-demand-imbalance-oct-24th-2016

Source: NY Federal Reserve, Haver Analytics, Reuters, Bloomberg

But, how sustainable is any oil price increase?

Longer term prospects for oil demand

commodity-crude-oil-9-92014-to-18-10-2016

Source: Trading Economics

In the short term there are, as always, a plethora of conflicting opinions about the direction of the price of oil. Longer term, advances in drilling techniques and other technologies – especially those relating to fracking – will exert a downward pressure on prices, especially as these methods are adopted more widely across the globe. Recent evidence supports the view that tight-oil extraction is economic at between $40 and $60 per bbl, although the Manhattan Institute – Shale 2:0 – May 2015 – suggests:-

In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

These reductions in extraction costs, combined with improvements in fuel efficiency and the falling cost of alternative energy, such as solar power, will constrain prices from rising for any length of time.

Published earlier this month, the World Energy Council – World Energy Scenarios 2016 – The Grand Transitionpropose three, very different, global outlooks, with rather memorable names:-

  1. Modern Jazz – digital disruption, innovation and market based reform
  2. Unfinished Symphony – intelligent and sustainable economic growth with low carbon
  3. Hard Rock – fragmented, weaker, inward-looking and unsustainable growth

They go on to point out that, despite economic growth – especially in countries like China and India – global reliance on fossil fuels has fallen from 86% in 1970 to 81% in 2014 – although in transportation reliance remains a spectacular 92%. The table below shows rising energy consumption under all three scenarios, but an astonishing divergence in its rise and source of supply, under the different regimes:-

Scenario – 2060 % increase in energy consumption % reliance on oil Transport % reliance on oil
Modern Jazz 22 50 67
Unfinished Symphony 38 63 60
Hard Rock 46 70 78

Source: World Energy Council

The authors expect demand for electricity to double by 2060 requiring $35trln to $43trln of infrastructure investment. Solar and Wind power are expected to increase their share of supply from 4% in 2014 to between 20% and 39% dependent upon the scenario.

As to the outlook for fossil fuels, global demand for coal is expected to peak between 2020 and 2040 and for oil, between 2030 and 2040.

…peaks for coal and oil have the potential to take the world from stranded assets predominantly in the private sector to state-owned stranded resources and could cause significant stress to the current global economic equilibrium with unforeseen consequences on geopolitical agendas. Carefully weighed exit strategies spanning several decades need to come to the top of the political agenda, or the destruction of vast amounts of public and private shareholder value is unavoidable. Economic diversification and employment strategies for growing populations will be a critical element of navigating the challenges of peak demand.

The economic diversification, to which the World Energy Council refer, is a global phenomenon but the impact on nations which are dependent on oil exports, such as Saudi Arabia, will be even more pronounced.

Conclusion and investment opportunities

As part of Vision 2030 – which was launched in the spring by the King Salman’s second son, Prince Mohammed bin Salman – the Saudi government introduced some new measures last month. They cancelled bonus payments to state employees and cut ministers’ salaries by 20%. Ministers’ perks – including the provision of cars and mobile phones – will also be withdrawn. In addition, legislative advisors to the monarchy have been subjected to a 15% pay cut.

These measures are scheduled to take effect this month. They are largely cosmetic, but the longer term aim of the plan is to reduce the public-sector wage bill by 5% – bringing it down to 40% of spending by 2020. Government jobs pay much better than the private sector and the 90/90 rule applies –that is 90% of Saudi Arabians work for the government and the 10% of workers in the private sector are 90% non-Saudi in origin. The proposed pay cuts will be deeply unpopular. Finally, unofficial sources claim, the government has begun cancelling $20bln of the $69bln of investment projects it had previously approved. All this austerity will be a drag on economic growth – it begins to sound more like Division 2030, I anticipate social unrest.

The impact of last month’s announcement on the stock market was unsurprisingly negative – the TASI Index fell 4% – largely negating the SAR20bln ($5.3bln) capital injection by the Saudi Arabian Monetary Agency (SAMA) from the previous day.

Saudi Bonds

Considering the geo-political uncertainty surrounding the KSA, is the spread over US Treasuries sufficient? In the short term – two to five years – I think it is, but from a longer term perspective this should be regarded as a trading asset. If US bond yield return to a more normal level – they have averaged 6.5% since 1974 – the credit spread is likely to widen. Its current level is a function of the lack of alternative assets offering an acceptable yield, pushing investors towards markets with which many are unfamiliar. KSA bonds do have advantages over some other emerging markets, their currency is pegged to the US$ and their foreign exchange reserves remain substantial, nonetheless, they will also be sensitive to the price of oil.

Saudi stocks

For foreign investors ETFs are still the only way to access the Saudi stock market, unless you already have $5bln of AUM – then you are limited to 5% of any company and a number of the 170 listed stocks remain restricted. For those not deterred, the iShares MSCI Saudi Arabia Capped ETF (KSA) is an example of a way to gain access.

Given how much of the economy of KSA relies on oil revenues, it is not surprising that the TASI Index correlates with the price of oil. It makes the Saudi stock exchange a traders market with energy prices dominating direction. Several emerging stock markets have rallied dramatically this year, as the chart below illustrates, the TASI has not been among their number:-

saudi-arabia-stock-market-1994-2016

Source: Saudi Stock Exchange, Trading Economics

Oil

Tightness in supply makes it likely that oil will find a higher trading range, but previous OPEC deals have been wrecked by cheating on quotas. Longer term, improvements in technology will reduce the cost of extraction, increase the amount of recoverable reserves and diminish our dependence on fossil fuels by improving energy efficiency and developing, affordable, renewable, alternative sources of energy. By all means trade the range but remember commodities have always had a negative real expected return in the long run.