Can a multi-speed European Union evolve?

Can a multi-speed European Union evolve?

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Macro Letter – No 73 – 24-03-2017

Can a multi-speed European Union evolve?

  • An EC white paper on the future of Europe was released at the beginning of the month
  • A multi-speed approach to EU integration is now considered realistic
  • Will a “leaders and laggards” approach to further integration work?
  • Will progress on integration enable the ECB to finally taper its QE?

At the Malta Summit last month German Chancellor Angela Merkel told reporters:-

We certainly learned from the history of the last years, that there will be as well a European Union with different speeds that not all will participate every time in all steps of integration.

On March 1st the European Commission released a white paper entitled the Future of Europe. This is a discussion document for debate next week, when members of the EU gather in Rome to celebrate the 60th anniversary of the signing of the Treaty of Rome.

The White Paper sets out five scenarios for the potential state of the Union by 2025:-

Scenario 1: Carrying On – The EU27 focuses on delivering its positive reform agenda in the spirit of the Commission’s New Start for Europe from 2014 and of the Bratislava Declaration agreed by all 27 Member States in 2016. By 2025 this could mean: Europeans can drive automated and connected cars but can encounter problems when crossing borders as some legal and technical obstacles persist. Europeans mostly travel across borders without having to stop for checks. Reinforced security controls mean having to arrive at airports and train stations well in advance of departure.

Scenario 2: Nothing but the Single Market – The EU27 is gradually re-centred on the single market as the 27 Member States are not able to find common ground on an increasing number of policy areas. By 2025 this could mean: Crossing borders for business or tourism becomes difficult due to regular checks. Finding a job abroad is harder and the transfer of pension rights to another country not guaranteed. Those falling ill abroad face expensive medical bills. Europeans are reluctant to use connected cars due to the absence of EU-wide rules and technical standards.

Scenario 3: Those Who Want More Do More – The EU27 proceeds as today but allows willing Member States to do more together in specific areas such as defence, internal security or social matters. One or several “coalitions of the willing” emerge. By 2025 this could mean that: 15 Member States set up a police and magistrates corps to tackle cross-border criminal activities. Security information is immediately exchanged as national databases are fully interconnected. Connected cars are used widely in 12 Member States which have agreed to harmonise their liability rules and technical standards.

Scenario 4: Doing Less More Efficiently – The EU27 focuses on delivering more and faster in selected policy areas, while doing less where it is perceived not to have an added value. Attention and limited resources are focused on selected policy areas. By 2025 this could mean A European Telecoms Authority will have the power to free up frequencies for cross-border communication services, such as the ones used by connected cars. It will also protect the rights of mobile and Internet users wherever they are in the EU.A new European Counter-terrorism Agency helps to deter and prevent serious attacks through a systematic tracking and flagging of suspects.

Scenario 5: Doing Much More Together – Member States decide to share more power, resources and decision-making across the board. Decisions are agreed faster at European level and rapidly enforced. By 2025 this could mean: Europeans who want to complain about a proposed EU funded wind turbine project in their local area cannot reach the responsible authority as they are told to contact the competent European authorities. Connected cars drive seamlessly across Europe as clear EU-wide rules exist. Drivers can rely on an EU agency to enforce the rules.

There is not much sign of a multi-speed approach in the above and yet, on 6th March the leaders of Germany, France, Italy and Spain convened in Versailles where they jointly expressed the opinion that allowing the EU to integrate at different speeds would re-establish confidence among citizens in the value of collective European action.

There are a couple of “general instruments”, contained in existing treaties, which give states some flexibility; ECFR – How The EU Can Bend Without Breaking suggests “Enhanced Cooperation” and “Permanent Structured Cooperation”(PESCO) as examples, emphasis mine:-

Enhanced cooperation was devised with the Amsterdam Treaty…in 1997, and revised in successive treaty reforms in Nice and Lisbon. Enhanced cooperation is stipulated as a procedure whereby a minimum of nine EU countries are allowed to establish advanced cooperation within the EU structures. The framework for the application of enhanced cooperation is rigid: It is only allowed as a means of last resort, not to be applied within exclusive competencies of the union. It needs to: respect the institutional framework of the EU (with a strong role for the European Commission in particular); support the aim of an ever-closer union; be open to all EU countries in principle; and not harm the single market. In this straitjacket, enhanced cooperation has so far been used in the fairly technical areas of divorce law and patents, and property regimes for international couples. Enhanced cooperation on a financial transaction tax has been in development since 2011, but the ten countries cooperating on this have struggled to come to a final agreement.

PESCO allows a core group of member states to make binding commitments to each other on security and defence, with a more resilient military and security architecture as its aim. It was originally initiated at the European Convention in 2003 to be part of the envisaged European Defence Union. At the time, this group would have consisted of France, Germany, and the United Kingdom. After disagreements on defence spending in this group and the referendum defeat for the European Constitution which meant the end of the Defence Union, a revised version of PESCO was added into the Lisbon treaty. This revised version allows for more space for the member states to decide on the binding commitments, which of them form the group, and the level of investment. However, because of its history, some member states still regard it as a top-down process which lacks clarity about how the groups and criteria are established. So far, PESCO has not been used, but it has recently been put back on the agenda by a group of EU member states.

These do not get the EU very far, but the ECFR go on to mention an additional Schengen-style approach, where international treaties of EU members can be concluded outside of the EU framework. These treaties can later be adopted by other EU members.

As part of their research the ECFR carried out more than 100 interviews with government officials and experts at universities and think-tanks across the 28 member states to discover their motivation for adopting a more flexible approach. The chart below shows the outcomes:-

ECFR FutureEU_MotiviationFlexibility

Source: ECFR

Interestingly, in two countries, Denmark and Greece, officials and experts believe that more flexibility will result in greater fragmentation. Nonetheless, officials and experts in Croatia, Finland, Germany, Italy, Latvia, and Spain are in favour of embracing a more flexible approach. Benelux and France remain sceptical. Here is how the map of Europe looks to the ECFR:-

ECFR206_THE_FUTURE_SHAPE_OF_EUROPE_-_CountryMap

Source: ECFR

The timeline for action is likely to be gradual. President Juncker’s plans to develop the ideas contained in the white paper in his State of the Union speech in September. The first policy proposals may be drafted in time for the European Council meeting in December. It is envisaged that an agreed course of action will be rolled out in time for the European Parliament elections in June 2019.

Can Europe wait?

Two years is not that long a time in European politics but financial markets may lack such patience. Here is the Greek government debt repayment schedule prior to the European Parliament Elections:-

Greece_-_Repayment_Schedule_-_WSJ

Source: Wall Street Journal

This five year chart shows the steady rise in total Greek government debt:-

greece-government-debt

Source: Tradingeconomics, Bank of Greece

Greek debt totalled Eur 326bln in Q4 2016, the debt to GDP ratio for 2015 was 177%. Italy’s debt to GDP was a mere 133% over the same period.

ECB dilemma

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016. The chart below shows the evolution of Eurozone long-term interest rates between October 2009 and November 2016:-

Long-term_interest_rates_(eurozone) Oct 09 to Nov 16 - ECB

Source: ECB

In 2011 the Euro Area debt to GDP ratio was 86%, by 2015 it had reached 91%. The table below shows the highest 10yr yield since the great financial crisis for a selection of Eurozone government bonds together with their ratios of debt to GDP. It goes on to show the same ratio at the end of 2015. Only Germany is in a stronger position today than it was during the Eurozone crisis in terms of its debt as a percentage of its GDP:-

Bond_yields_and_debt_to_GDP (1)

Source: Trading Economics

Since these countries bond markets hit their yield highs during the Eurozone Crisis, Greece, Italy and Spain have seen an improvement in GDP growth, but only Spain is likely to achieve sufficient growth to reduce its debt burden. If the ECB is to cease killing the proverbial fatted calf, a less profligate fiscal approach is required.

Euro Area GDP averaged slightly less than 1.8% per annum over the last two years, yet the debt to GDP ratio only declined a little over 1% from its all-time high. Further European integration sounds excellent in theory but in practice any positive impact on economic growth is unlikely to be evident for several years.

EU integration has been moving at different speeds for years, if anything, the process has been held back by attempts to move in unison. There are risks of causing fragmentation with both approaches, either within countries or between them.

Conclusions and Investment Opportunities

Another Eurozone financial crisis cannot be ruled out this year. The political uncertainty of the Netherlands is past, but France may yet surprise. Once Germany has voted in September, it will be time to focus on the endeavours of the ECB. Their asset purchase programme is scheduled to end in December.

I would expect this programme to be extended once more, if not, the stresses which nearly tore the Eurozone asunder in 2011/2012 are likely to return. The fiscal position of the Euro Area is only slightly worse than it was five years ago, but, having flirted with the lowest yields ever recorded, bond markets have considerably further to fall in percentage terms than in during the previous crisis.

Spanish 10yr Bonos represents a better prospect than Italian 10yr BTPs, but one would have to endure negative carry to set up this spread trade: look for opportunities if the spread narrows towards zero. German Bunds are always likely to act as the safe haven in a crisis and their yields have risen substantially in the past year, yet at less than ½% they are 300bp below their “safe-haven” level of April 2011.

The Euro is unlikely to rally in this environment. The chart below shows the Euro Effective Exchange Rate since 2005:-

Euro_Effective_Exchange_Rate_-_ECB (1)

Source: ECB

The all-time low for the Euro is 82.34 which was the level is plumbed back in October 2000. This does sound an outlandish target during the next debacle.

Euro weakness would, however, be supportive for export oriented European stocks. The weakness that stocks would initially suffer, as a result of the return of the Euro crisis, would quickly be reversed, in much the same manner that UK stocks were pummelled on the initial Brexit result only to rebound.

Low cost manufacturing in Asia – The Mighty Five – MITI V

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Macro Letter – No 73 – 10-03-2017

Low cost manufacturing in Asia – The Mighty Five – MITI V

  • Low cost manufacturing is moving away from China
  • Malaysia, India, Thailand, Indonesia and Vietnam will continue to benefit
  • Currency risks remain substantial
  • Stock market valuations are not cheap but they offer long term value

The MITI V is the latest acronym to emerge from the wordsmiths at Deloitte’s. Malaysia, India, Thailand, Indonesia and Vietnam. All these countries have a competitive advantage over China in the manufacture of labour intensive commodity type products like apparel, toys, textiles and basic consumer electronics. According to Deloitte’s 2016 Global Manufacturing Competitiveness Index they are either among, or destined to join, the top 15 most competitive countries in the world for manufacturing, by the end of the decade. Here is the Deliotte 2016 ranking:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deliotte

The difficulty with grouping disparate countries together is that their differences are coalesced. Malaysia and Thailand are likely to excel in high to medium technology industries, their administrations are cognizant of the advantages of international trade. India, whilst it has enormous potential, both as an exporter and as a manufacturer for its vast domestic market, has, until recently, been less favourably disposed towards international trade and investment. Vietnam continues to benefit from its proximity to China. Indonesia, by contrast, has struggled with endemic corruption: its economy is decentralised and this vast country has major infrastructure challenges.

The table below is sorted by average earnings:-

MITI_V_-_Stats

Source: World Bank, Trading Economics

India and Vietnam look well placed to become the low-cost manufacturer of choice (though there are other contenders such as Bangladesh which should not be forgotten when considering comparative advantage).

Another factor to bear in mind is the inexorable march of technology. Bill Gates recently floated the idea of a Robot Tax, it met with condemnation in many quarters – Mises Institute – Bill Gates’s Robot Tax Is a Terrible Ideaexamines the issue. The mere fact that a Robot Tax is being contemplated, points to the greatest single challenge to low-cost producers of goods, namely automation. Deliotte’s does not see this aspect of innovation displacing the low-cost manufacturing countries over the next few years, but it is important not to forget this factor in one’s assessment.

Before looking at the relative merits of each market from an investment perspective, here is what Deliotte’s describe as the opportunities and challenges facing each of these Asian Tigers:-

 

Malaysia

…has a low cost base with workers earning a quarter of what their counterparts earn in neighboring Singapore. The country also remains strongly focused on assembly, testing, design, and development involved in component parts and systems production, making it well suited to support high-tech sectors.

…is challenged by a talent shortage, political unrest, and comparatively low productivity.

India

Sixty-two percent of global manufacturing executives’ surveyed rank India as highly competitive on cost, closely mirroring China’s performance on this metric.

…highly skilled workforce and a particularly rich pool of English speaking scientists, researchers, and engineers which makes it well-suited to support high-tech sectors. India’s government also offers support in the form of initiatives and funding that focus on attracting manufacturing investments.

…challenged by poor infrastructure and a governance model that is slow to react

…As 43 percent of its US$174 billion in manufacturing exports require high-skill and technological intensity, India may have a strong incentive to solve its regulatory and bureaucratic challenges if it is to strengthen its candidacy as an alternative to China.

Thailand

When it comes to manufacturing exports (US$167 billion in 2014), Thailand stands slightly below India, but exceeds Malaysia, Vietnam, and Indonesia. This output is driven largely by the nation’s skilled workforce and high labor productivity, supported by a 90 percent national literacy rate, and approximately 100,000 engineering, technology, and science graduates every year.

…highly skilled and productive workforce creates relatively high labor costs at US$2.78 per hour in 2013.

…remains attractive to manufacturing companies, offering a lower corporate tax rate (20 percent) than Vietnam, India, Malaysia or Indonesia. Already well established with a booming automotive industry, Thailand may provide an option for manufacturers willing to navigate the political uncertainty that persists in the region.

Indonesia

Manufacturing labor costs in Indonesia are less than one-fifth of those in China.

…The island nation’s overall 10-year growth in productivity (50 percent) exceeds that of Thailand, Malaysia, and Vietnam,

…manufacturing GDP represents a significant portion of its overall GDP and with such a strong manufacturing focus, particularly in electronics, coupled with the sheer size of its population, Indonesia remains high on the list of alternatives for manufacturers looking to shift production capacity away from China in the future.

Vietnam

…comparatively low overall labor costs.

…has raised its overall productivity over the last 10 years, growing 49 percent during the period, outpacing other nations like Thailand and Malaysia. Such productivity has prompted manufacturers to construct billion-dollar manufacturing complexes in the country.

Deliotte’s go on to describe the incentives offered to multinational corporations by these countries:-

(1) numerous tax incentives in the form of tax holidays ranging from three to 10 years, (2) tax exemptions or reduced import duties, and (3) reduced duties on capital goods and raw materials used in export-oriented production.

Forecasts for 2017

In the nearer term the MITI V have more varied prospects, here are Focus Economics latest consensus GDP growth expectations from last month:-

Malaysia Economic Outlook 2017 GDP forecast 4.3%

…GDP recorded the strongest performance in four quarters in Q4, expanding at a better-than-expected rate of 4.5%.

…acceleration in fixed investment and resilient private consumption. Exports also showed a significant improvement, growing at the fastest pace since Q4 2015, thanks to a weaker ringgit and rising oil prices. However, the external sector’s net contribution to growth remained stable as imports also gained steam. Government consumption, which contracted for the first time since Q2 2014, was the only drag on growth in Q4, reflecting the government’s commitment to its fiscal consolidation agenda for 2016.

India Economic Outlook 2017 GDP forecast – 7.4%

Economic activity is beginning to firm after demonetization shocked the economy in the October to December period. The manufacturing PMI crossed into expansionary territory in January and imports rebounded.

…Despite the backdrop of more moderate growth, the government stuck to a market friendly budget for FY 2017

…which was presented on 1 February, pursues growth-supportive policies while targeting a narrower deficit of 3.2% of GDP…

…five states will conduct elections in February, with results to be announced on 11 March. The elections will test the electorate’s mood regarding the government after the economy’s tumultuous past months and ahead of the 2019 general vote.

Thailand Economic Outlook 2017 GDP forecast 3.2%

Growth decelerated mildly in the final quarter of 2016 due to subdued private consumption and a smaller contribution from the external sector. The economy expanded 3.0% annually in Q4, down from 3.2% in Q3.

…January, consumer confidence hit a nearly one-year high, while business sentiment receded mildly. On 27 January, the government announced supplementary fiscal stimulus of USD 5.4 billion for this year’s budget, which ends in September. The sum will be disbursed specifically in rural areas in a bid to close the growing inequality between urban and rural infrastructure and income. This shows that the military government is set to continue providing fiscal stimulus to GDP this year, which should spill over in the private sector via higher employment and improved economic sentiment.

Indonesia Economic Outlook 2017 GDP forecast 5.2%

…economy lost steam in the fourth quarter of last year as diminished government revenues caused public spending to fall at a multi-year low.

…household consumption remained healthy and the recent uptick in commodities prices boosted export revenues.

…for the start of 2017…momentum firmed up: the manufacturing PMI crossed into expansionary territory in January and surging exports pushed the trade surplus to an over three-year high.

…poised for a credit ratings upgrade after Moody’s elevated its outlook from stable to positive on 8 February. All three major ratings agencies now have a positive outlook on Indonesia’s credit rating and an upgrade could be a catalyst for improving investor sentiment.

Vietnam Economic Outlook 2017 GDP forecast 6.4%

…particularly strong performance in the external sector in 2016. Despite slower demand from important trading partners, merchandise exports, which consist largely of manufactured goods, grew 9.0% annually. The manufacturing sector is quickly expanding thanks to the country’s competitive labor costs, fueling manufacturing exports and bolstering job creation in the sector.

…industrial production nearly stagnated in January, it mostly reflected a seasonal effect from the Lunar New Year, which disrupted supply chains across the region.

…manufacturing Purchasing Manager’s Index, though it inched down in January, continues to sit well above the 50-point line, reflecting that business conditions remain solid in the sector. Moreover, the New Year festivities boosted retail sales, which grew robustly in January.

Currency Risk

The table below shows the structural nature of the MITI V’s exchange rate depreciation against the US$. The 20 year column winds the clock back to the period just before the Asian Financial Crisis in 1997:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

Looking at the table another way, when investing in Indonesia it would make sense to factor in a 4% annual decline in the value of the Rupiah, a 2.2% to 2.4% decline in the Ringgit, Rupee and Dong and a 1.3% fall in the value of the Baht.

The continuous decline in these currencies has fuelled inflation and this is reflected to the yield and real yields available in their 10 year government bond markets. The table below shows the current bond yields together with inflation and their governments’ fiscal positions:-

MITI_V_-_Bonds_Inflation_Fiscal

Source: Trading Economics

Indonesian bonds offer insufficient real-yield to cover the average annual decline in the value of the Rupiah. Vietnam has an inverted yield curve which suggests shorter duration bonds would offer better value, its 10 year maturity offers the lowest real-yield of the group.

Whilst all these countries are running government budget deficits, Malaysia, Thailand and Indonesia have current account surpluses and Indonesia’s government debt to GDP is a more manageable 27% – this is probable due to its difficulty in attracting international investors on account of the 82% decline in its currency over the past two decades.

Stock Market Valuations

All five countries have seen their stock markets rise this year, although the SET 50 (Thailand) has backed off from its recent high. To compare with the currency table above here are the five stock markets, plus the S&P500, over one, two, five, ten and twenty years:-

MITI_V and US_Stocks_in_20yr

Source: Investing.com

For the US investor, India and Indonesia have been the star performers since 1997, each returning more than six-fold. Thailand, which was at the heart of the Asian crisis of 1997/98, has only delivered 114% over the same period whilst Malaysia, which imposed exchange controls to stave off the worst excesses of the Asian crisis, has failed to deliver equity returns capable of countering the fall in its currency. Finally, Vietnam, which only opened its first stock exchange in 2000, is still recovering from the boom and bust of 2007. The table below translates the performance into US$:-

MITI_V_-_Stock_performance_in_US_20yr

Source: Investing.com

Putting this data in perspective, over the last five years the S&P has beaten the MITI V not only in US$, but also in absolute terms. Looking forward, however, there are supportive valuation metrics which underpin some of the MITI V stock markets. The table below is calculated at 30-12-2016:-

MITI_V_PEs_etc

Source: Starcapital.de, *Author’s estimates

Conclusion and Investment Opportunities

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Thailand and Malaysia look less expensive from a price to earnings perspective, than India and Indonesia. Their dividend yields also look attractive relative to their bond yields, perhaps a hangover from the Asian Crisis of 1997.

Technically all five stock markets are at or near recent highs:-

MITI_V_-_stocks_-_distance_to_high

Source: Investing.com

The Vietnamese VN Index is a long way below its high and on a P/E, P/B and dividend yield basis it is the cheapest of the five stock markets, but it is worth remembering that it is still regarded at a Frontier Market, It was not included in the MSCI Emerging Markets indices last year. This remains a prospect at the next MSCI review in May/June.

Given how far global equity markets have travelled since the November US elections, it makes sense to be cautious about stock markets in general. Technically a break to new highs in any of these markets is likely to generate further upside momentum but Vietnam looks constructive both over the shorter term (as it makes new highs for the year) and over the longer term (being well below its all-time highs of 2007). In the Long Run, I expect these economies to the engines of world growth and their stock markets to reflect that growth.

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

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Macro Letter – No 71 – 24-02-2017

What impact could the NATO defence spending renegotiation have on EU budgets, bonds and stocks?

  • In 2006 NATO partners agreed to spend at least 2% of GDP on defence
  • Germany’s defence spending shortfall since 2006 equals $281bln
  • Retrospective adjustment is unlikely, but Europe needs to increase spending substantially
  • A minimum of $64bln/annum is required from Germany, France, Italy and Spain alone

Given the mutual relationship of the NATO treaty it could be argued that, for many years the US has been footing the lion’s share of the bill for defending Europe. Under the new US administration this situation is very likely to change.

The July 2016 Defence Expenditures of NATO Countries (2009-2016) presents the situation in clear terms. At the Riga summit back in 2006 NATO members agreed to raise defence expenditure to 2% of GDP. In that year only six countries met the threshold – Bulgaria, France, Greece, Turkey, the UK, and the US. Eight years later, at the NATO meeting in Wales, members renewed their commitment to this target. Last year only five members achieved the threshold – Estonia, Greece, Poland, the UK, and, of course, the US.

The original NATO treaty was signed on 4th April 1949 by 12 countries, it was expanded in 1952 to include Turkey and Greece and in 1955 to incorporate Germany. In 1982, after reverting to a democracy, Spain also joined. Further expansion occurred in 1999, again in 2004 and most recently 2009.

Back in 1949 Europe was still recovering from the disastrous social and economic impact of WWII. Today, in the post-Cold War era, things look very different and yet, whilst defence spending has waxed and waned over the intervening years, the US still spends substantially more on defence, both in absolute terms and as a percentage of GDP, than any of its treaty partners. The table below reveals the magnitude of the current situation:-

nato_expenditure_-_geopolitical_futures

Source: Geopolitical Futures, Mauldin Economics

US defence spending last year amounted to $664bln which equates to 3.61% of US GDP based on current estimates.

Setting aside the political debate about whether we should be spending more or less on defence, it would appear that the US continues to do more than its fair share, in economic terms, in defence of its NATO allies.

The next table looks at the budgetary implications of making the NATO budget equable. Firstly, all NATO countries committing 2% of GDP to defence (which would dramatically reduce the total NATO budget) or, secondly, maintaining the current level of spending, which would imply all countries contributing 2.58% of GDP. In both scenarios the US is a clear winner in economic terms:-

nato_expenditure_as_percentage_of_gdp_-_analysis-1

Source: NATO, UN, IMF

I have excluded the smaller, mainly Eastern European, countries from this analysis – their combined contribution is less than $13bln/annum. I do not wish to appear disparaging, on a percentage of GDP basis many of these countries contribute more than their larger European neighbours. My purpose in this analysis is to look at the relative increases or decreases under each scenario. Below are the Budget to GDP and Debt to GDP ratios before and after adjustment to the less demanding 2% defence expenditure target:-

nato_budget_and_debt_to_gdp_after_adjustment_to_2_

Source: NATO, UN, IMF, Trading Economics

The Maastricht Treaty incorporated certain criteria in order to satisfy Germany, along with other cautious countries, of the fiscal rectitude of all countries seeking to join the Eurozone. Although they were never really taken seriously by politicians, these fiscal restrictions included a maximum Government debt to GDP ratio of 60% and a Budget deficit to GDP ratio of less than 3%. Applying these arcane criteria, only three countries – Denmark, Norway and Turkey – are in the enviable position of being able to undertake the required defence spending increases with equanimity.

The burning question going forward is how the largest countries in Europe will react to the US compliant that they have failed to increase spending since 2006. As George Friedman of Geopolitical Futures – The Evolving NATO Alliance succinctly explains:-

…the US accounts for about 50% of NATO members’ total GDP and 32% of their total population—and yet the US makes up about 72% of defense spending.

… Western European countries (excluding the UK) account for 31% of NATO members’ GDP and 33%  of their population, and yet they contribute 16%  to NATO members’ total defense spending.

Eastern European countries, which account for 4.2% of NATO members’ GDP and 12.7% of their population, are much poorer and smaller than Western European countries. Eastern Europe contributes 2.7% to defense spending. In effect, Eastern Europe contributes closer to its share than its far wealthier and stronger neighbors to the west.

According to SIPRI Milex data for 2015, Russia spent 5.4% of GDP on defence. Other notable defenders of their realms include Pakistan (3.4%) and India (2.3%).

At the Munich Security Conference which took place last weekend, the prospect of Germany finding an extra Eur20bln per year for defence spending was raised, but, being an election year, little more was heard on the topic. The conference was fascinating however, here are some of the key quotes:-

A stable EU is as much in America’s interest as a united NATO – Ursula von der Leyen – Minister of Defence – Germany.

American security is permanently tied to European security – James Mattis – Secretary of Defence – USA.

The role of Germany in Europe is always to be a bridge – between North and South and East and West – Wolfgang Schauble – Minister of Finance – Germany.

Make no mistake, my friends. You should not count America out – John McCain – Chairman of Senate Committee on Armed Services – USA.

Let us not forget that NATO is the backbone of our value system – Jeanine Hennis-Plasschaert – Minister of Defence – Netherlands.

NATO is not an obsolete organisation. It is an organisation to which additional mandates should be added – Fikri Isik – Minister of National Defence – Turkey.

The United States of America strongly supports NATO and will be unwavering in our commitment to this Transatlantic alliance – Michael Pence – Vice President – USA.

Europe’s defence requires your support as much as ours – Michael Pence – Vice President – USA.

Things look very different if we add up our defence budgets, our development aid budgets and our humanitarian efforts all around the world – Jean-Claude Juncker – President – European Commission

The post-war generation rose to their challenge, we must rise to ours – Jens Stoltenberg – Secretary General – NATO.

The European Union is much stronger than we European’s realise – Federica Mogherini – Vice President – European Commission – High Representative for Foreign Affairs and Security Policy – EU.

No one has any clue what the foreign policy of this administration is – Christopher Murphy – Member of the Senate Committee on Foreign Relations.

From a negotiating perspective it would not be entirely unreasonable for the US to demand that the 2006 commitment of 2% spending be honoured retrospectively, in addition to the 2% commitment going forward. The table below shows how NATO members have performed in this respect since 2005, apart from the US, only Greece and the UK have been above target over the entire period. American frustration with its NATO partners is hardly surprising:-

nato_defense_expenditure_as_percentage_of_gdp_-_ge

Source: NATO, Geopolitical Futures

The tone of US comments at the Munich conference appear slightly more conciliatory than of late. Europe’s defence ministries have, nonetheless, been seriously shaken by the change in attitude which has accompanied the change of US administration.

According to commentators, who purport to have more of a clue than Christopher Murphy, US defence spending is likely to rise by between $500bln and $1trln under the new administration. This is no “Get Out of Jail Free” card for NATOs parsimonious majority, Europe will be pressured to defence spending at a time when budgets are already uncomfortably bloated. They have had more than a decade to comply with the Riga commitment.

Looking at the bigger picture for a moment, this sudden rise in spending is a small uptick in a downward trend. Defence budgets have been falling in all the major NATO countries, as the chart below indicates. In 1989 excluding the UK and US the average budget to GDP across NATO countries was 2.9% by 1998 it had fallen to 2% but since then it has steadily declined to an average of 1.4% today. This may be good from an economic perspective – as Frederic Bastiat argued most eloquently in relation to the cost of a standing army in his essay What Is Seen and What Is Not Seen:-

A hundred thousand men, costing the taxpayers a hundred million francs, live as well and provide as good a living for their suppliers as a hundred million francs will allow: that is what is seen.

But a hundred million francs, coming from the pockets of the taxpayers, ceases to provide a living for these taxpayers and their suppliers, to the extent of a hundred million francs: that is what is not seen. Calculate, figure, and tell me where there is any profit for the mass of the people.

Nonetheless, the economic burden of defence spending borne by the US is undoubtedly going to shift, or else, NATO will cease to be tenable going forward:-

defence_spending_as_a_pecentage_of_gdp_since_1949_

Source: SIPRI

Conclusion

I believe it is likely that Germany, France, Italy and Spain will find an additional $64bln/annum for Defence and Aid budgets. They may also have to pick up part of the bill for the smaller countries to their East.

Will this impact European bond markets? It seems like a drop in the ocean beside the Asset Purchase Program of the ECB. President Draghi announced in January that they will be reducing the monthly purchases from Eur 80bln per month to Eur 60bln starting in April. I suspect the impact will be limited but it might prolong the Asset Purchase Program somewhat.

The implications for defence contractors and their stock market valuations will be more direct. Here are some of the largest listed names in Europe. Not all of them have been darlings of the stock market of late:-

areospace_and_defence_companies-1

Source: Investing.com, LSE, NYSE Euronext

For those who, like myself, who prefer to analyse the sector rather than individual stocks, the STOXX Europe TMI Aerospace & Defense (SXPARO) may appeal; here is a three year chart:-

stoxx_-_europe_tmi_aerospace_defense

Source: STOXX

The combination of increased military spending by the US and the pressure being brought to bear on Europe, should see the defence sector outperform over the longer term. During the last 12 months the SXPARO has risen 15%. Its US equivalent, the iShares US Aerospace & Defense ETF (ITA) is up by 20% over the same period, whilst the Euro has declined by around 3% against the US$. As a general rule I prefer to buy Leaders rather than Laggards, but the logic of buying European if European governments are forced to honour their defence obligations remains compelling.

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.

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.

Uncharted British waters – the risk to growth, the opportunity to reform

400dpiLogo

Macro Letter – No 59 – 15-07-2016

Uncharted British waters – the risk to growth, the opportunity to reform

  • Uncertainty will delay investment and damage growth near term
  • A swift resolution of Britain’s trade relations with the EU is needed
  • Without an aggressive liberal reform agenda growth will be structurally lower
  • Sterling will remain subdued, Gilts, trade higher and large cap stocks well supported

Look, stranger, on this island now
The leaping light for your delight discovers,
Stand stable here
And silent be,
That through the channels of the ear
May wander like a river
The swaying sound of the sea.

W.H. Auden

thames-chart-collins-3057

Source: Captain Greenvile Collins – Great Britain’s Coasting Pilot – 1693

Captain Greenvile Collins was the Hydrographer in Ordinary – to William and Mary. His coastal pilot was the first, more or less, accurate guide to the coastline of England, Scotland and Wales, prior to this period mariners had relied mainly on Dutch charts. Collins’s charts do not comply with the convention of north being at the top and south at the bottom – the print above, of the Thames estuary, has north to the right. This, and the extract from W. H. Auden with which I began this letter, seem appropriate metaphors for the new way we need to navigate the financial markets of the UK post referendum.

Sterling has borne the brunt of the financial maelstrom, weakening against the currencies of all our major trading partners. Gilts have rallied on expectations of further largesse from the Bank of England (BoE) and a more generalised international flight to quality in “risk-free” government bonds. This saw Swiss Confederation bonds trade at negative yields to maturity out to 48 years.

With interest rates now at historic lows around the developed world and investors desperate for yield, almost regardless of risk, equity markets have remained well supported. Many individual UK companies with international earnings have made new all-time highs. Banks and construction companies have not fared so well.

Now the dust begins to settle, we have the more challenging task of anticipating the longer term implications of the British schism, both for the UK and its European neighbours. In this letter I will focus principally on the UK.

A Return to the Astrolabe?

Astrolabe

Source: University of Cambridge

The Greeks invented the astrolabe sometime around 200BCE. The one above of Islamic origin and dates from 1309. Before the invention of the sextant this was the only reliable means of navigation.

Our aids to navigation have been compromised by the maelstrom of Brexit – it’s not quite a return to the Astrolabe but we may have lost the use of GPS and AIS.

This week the OECD was forced to suspend the publication of its monthly Composite Leading Indicators (CLI). Commenting on the decision they said:-

The CLIs cannot…account for significant unforeseen or unexpected events, for example natural disasters, such as the earthquake, and subsequent events that affected Japan in March 2011, and that resulted in a suspension of CLI estimates for Japan in April and May 2011. The outcome of the recent Referendum in the United Kingdom is another such significant unexpected event, which is affecting the underlying expectation and outturn indicators used to construct the CLIs regularly published by the OECD, both for the UK and other OECD countries and emerging economies.

It will be difficult to draw any clear conclusions from the economic data produced by the OECD or other national and international agencies for some while.

Speaking to the BBC prior to the referendum, OECD Secretary General, Angel Gurria had already suggested that UK growth would be damaged:-

It is the equivalent to roughly missing out on about one month’s income within four years but then it carries on to 2030. That tax is going to be continued to be paid by Britons over time.

Back in March Open Europe – What if…? The consequences, challenges and opportunities facing Britain outside the EU put it thus:-

UK GDP could be 2.2% lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU or reverts into protectionism. In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world, whilst pursuing large-scale deregulation at home, Britain could be better off by 1.6% of GDP in 2030. However, a far more realistic range is between a 0.8% permanent loss to GDP in 2030 and a 0.6% permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.

…Based on economic modelling of the trade impacts of Brexit and analysis of the most significant pieces of EU regulation, if Britain left the EU on 1 January 2018, we estimate that in 2030:

In a worst case scenario, where the UK fails to strike a trade deal with the rest of the EU and does not pursue a free trade agenda, Gross Domestic Product (GDP) would be 2.2% lower than if the UK had remained inside the EU.

In a best case scenario, where the UK strikes a Free Trade Agreement (FTA) with the EU, pursues very ambitious deregulation of its economy and opens up almost fully to trade with the rest of the world, UK GDP would be 1.6% higher than if it had stayed within the EU.

Open_Europe_Brexit_Impact_Table

Source: Open Europe, Ciuriak Consulting

Given that UK annual GDP growth averaged 2.46% between 1956 and 2016, the range of outcomes is profoundly important. GDP forecasts are always prone to error but the range of outcomes indicated above is exceedingly broad – divination might prove as useful.

Also published prior to the referendum Global Counsel – BREXIT: the impact on the UK and the EU assessed the prospects both for the UK and EU in the event of a UK exit. The table below is an excellent summary, although I don’t entirely agree with all the points nor their impact assessment:-

Global_Counsel_-_Brexit

Source: Global Counsel

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

Curiouser and Curiouser – the myth of devaluation continues. The 1992 experience….

“The UK’s trade performance since the onset of the economic downturn in 2008 has been one of the more curious developments in the UK economy” according to a recent report from the Office for National Statistics. “Explanation beyond exchange rates: trends in UK trade since 2007. 

We would argue, it is only curious for those who choose to ignore history. 

Much reference is made to the period 1990 – 1995 when the last “great depreciation led to an improvement in the balance of payments” – allegedly. Analysing the trade in goods data [BOKI] from the ONS own report demonstrates the failure of depreciation to improve the net trade in goods performance in the period 1990 – 1995.

Despite the fall in sterling, the inexorable structural decline in net trade in goods continued throughout. As we have long argued would be the case, in the most recent episode. Demand co-efficients are powerful, the price co-efficients much weaker and almost inelastic with regard to imports. Check out the slide show below for more information. 

The conclusions from the ONS report do not add up. Curiouser and Curiouser, policy makers just like Alice, sometimes choose to believe in as many as six impossible things before breakfast.

A brief history of devaluation from 1925 onwards…. 

The great devaluation of 1931 – 24%

In 1925, the dollar sterling exchange rate was $4.87. Britain had readopted the gold standard. Unfortunately, the relative high value of the pound placed considerable pressure on the trade and capital account, the balance of payments problem developed into a “run on the pound”. The UK left the gold standard in 1931, the floating pound quickly dropped to $3.69, providing an effective devaluation of 24%. The gain, if such it was, could not be sustained. Over the next two years, confidence in the currency returned, the dollar weakened, sterling rallied in value to a level of $5.00 but…Fears of conflict in Europe placed pressure on the sterling. In 1939, with the outbreak of World War II the rate dropped to $3.99 from $4.61. In March, 1940, the British government pegged the value of the pound to the dollar, at $4.03.

The great devaluation of 1949 – 30%

Post war, Britain was heavily indebted to the USA. Despite a soft loan agreement with repayments over fifty years, the pound remained once again under intense pressure In 1949 Stafford Cripps devalued the pound by over 30%, giving a rate of $2.80. 

The great devaluation of 1967 – 14%

In 1967 another “balance of payments” crisis developed in the British economy with a subsequent “run on the pound. Harold Wilson announced, in November 1967, the pound had been devalued by just over 14%, the dollar sterling exchange rate fell to $2.40. This the famous “pound in your pocket” devaluation. Wilson tried to reassure the country by pointing out that the devaluation would not affect the value of money within Britain. 

In 1971, currencies began to float, depreciation not devaluation became the guideline

In 1977, sterling fell against the dollar with pound plummeting to a low of $1.63 in the autumn 1976. Another sterling crisis and a run on the pound. The British government was forced to borrow from the IMF to bridge the capital gap. The princely sum of £2.3 billion was required to restore confidence in the pound.  

By 1981, the pound was trading back at the $2.40 level but not for long. Parity was the pursuit by 1985 as the pound fell in value to a month low of $1.09 in February 1985.

In the late 1980s, Chancellor Lawson was pegging the pound to the Deutsche Mark to establish some form of stability for the currency. In October of 1990, Chancellor Major persuaded Cabinet to enter the ERM, the European Exchange Rate Mechanism. The DM rate was 2.95 to the pound and $1.9454 against the dollar. 

Less than two years later, Britain left the European experiment. 

The strains of holding the currency within the trading band had pushed interest rates to 12% in September, with some suggestions that rates would have to rise to 20% to maintain the peg. 

In September 1992, Chancellor Lamont announced the withdrawal from the ERM. The Pound fell in value against the dollar from $1.94 to $1.43, an effective depreciation of 26%. According to the wider Bank of England Exchange rate the weighted depreciation was 15%. 

The chart below shows GBPUSD since 1953, it doesn’t capture everything mentioned above but it highlights the volatility and terminal decline of the world’s ex-reserve currency:-

Cable since 1953

Source: FX Top

Reform, reform, reform

The UK needs to renegotiate terms with the EU as quickly as possible in order to minimise the damage to UK and global economic growth. I believe there are four options: –

EEA – the Norwegian Option

Pros

  • Maintain access to the Single Market in goods and services and movement of capital.
  • Ability to negotiate own trade deals.
  • Least disruptive alternative to EU membership.

Cons

  • Commitment to free movement of people and the provision of welfare benefits to EU citizens.
  • Accept EU regulation but have no influence over them.
  • Must comply with “rules of origin” – which impose controls on the use of products from outside the EU in goods which are subsequently exported within the EU. The cost of determining the origin of products is estimated to be at least 3.0% – the average tariff on goods from the US and Australia is 2.3% under World Trade Organisation (WTO) rules.
  • Comply with EU rules on employment, consumer protection, environmental protection and competition policy.
  • Pay an annual fee to access the Single Market, although less than for full EU membership.

EFTA – the Swiss Option

Pros

  • Maintain access to the Single Market in goods.
  • Ability to negotiate own trade deals.
  • Greater independence over the direction of social and employment law.

Cons

  • Commitment to free movement of people.
  • Must comply with “rules of origin”.
  • Restricted access to the EU market in services – particularly financial services.

WTO – the Default Option

Pros

  • Subject to Most Favoured Nation tariffs under WTO guidelines. In 2013, the EU’s trade-weighted average MFN tariff was 2.3% for non-agricultural products.
  • Ability to negotiate own trade deals.
  • Independence over legislation.

Cons

  • Tariffs on agricultural products range from 20% to 30%.
  • Tariffs for automobiles are 10%.
  • Services sector would face higher levels of non-tariff barriers such as domestic laws, regulations and supervision. Services made up 37% of total UK exports to the EU in 2014 – the WTO option will be costly.

Bilateral Free-Trade Agreement – the Canadian Option

Pros

  • Negotiate a bilateral trade agreement with the EU – sometimes called the Canada option after the, still unratified, Comprehensive Economic and Trade Agreement (CETA).

Cons

  • Must comply with “rules of origin” – if it mirrors the CETA deal.
  • Services are only partially covered.
  • Negotiations may take years.

The quickest solution would be the WTO default option, the least cathartic would be to join the EEA. I suspect we will end up somewhere between these two extremes; The Peterson Institute – Theresa May—More Merkel than Thatcher? Is of a different opinion:-

To survive politically at home, May must deliver Brexit at almost any cost, suggesting that she might well in the end be compelled to accept a “hard Brexit” that puts the UK entirely outside the internal market. Lacking a public mandate in a fractious party that retains only a slim parliamentary majority, May not surprisingly opposes new general elections, which would focus on Brexit and thus easily cost the Conservatives their majority, along with their new prime minister’s job. Unless the UK suffers substantially additional economic hardship in the coming years, the next UK elections may well occur as late as 2020.

For the financial markets there is a certain elegance in the “hard Brexit” WTO option. Uncertainty is removed, unilateral trade negotiations can be undertaken immediately and the other options remain available in the longer term.

Beyond renegotiation with the EU there is a broader reform agenda. Dust off your copy of Hayek’s The Road to Serfdom, this could see a return to the liberal policies, of smaller government and freer trade, which we last witnessed in the 1980’s. The IEA’s Ryan Bourne wrote an article this week for City AM – Forget populist executive pay curbs: Prime Minister May should embrace these six policies to revitalise growth in which he advocated:-

1) Overhaul property taxation: the government should abolish both council tax and stamp duty entirely and replace them with a single tax on the “consumption” of property – i.e. a tax on imputed rent. It is well known among economists that taxes on transactions like stamp duty are highly damaging, and we have already seen the high top rates significantly slow transactions since April.

2) Abolish corporation tax entirely: profit taxes discourage capital investment by lowering returns, which makes workers less productive and results in lower wage growth. In a globalised world, profits taxation also encourages capital to move elsewhere, both because it makes the UK less attractive as a location for “real” economic activity and because it creates incentives for avoidance through complex business structures. Rather than continuing this goose chase, let’s abolish it entirely and tax dividends at an individual level, as Estonia does.

Read more: Ignore Google’s corporation tax bill and scrap the tax altogether

3) Planning liberalisation: if you ask anyone to name the UK’s main economic problems, you’ll probably hear “poor productivity performance”, “a high cost of living” and “entrenched economic difficulties in some areas”. Constraining development through artificial boundaries and regulations is acknowledged to be a key driver of high house price inflation. Less acknowledged is that, for sectors like childcare, social care, restaurants and even many office-based industries, high rents and property prices raise other prices for consumers, with a dynamic strain on our growth prospects brought about by a reduction in competition and innovation. That’s not to mention the impact on labour mobility. Liberalisation of planning, including greenbelt reform – which May has sadly already seemingly ruled out – is probably the closest thing to a silver bullet as far as productivity improvements are concerned.

4) Sensible energy policy: the UK government has gone further than many EU countries on the “green agenda”. But the EU’s framework, with binding targets for renewables, has certainly helped shape policy in the direction of subsidies and subsidy-like obligations and interventions. Even if one accepts the need to reduce carbon emissions, an economist would suggest the implementation of either a straight carbon tax or, less optimally, a cap-and-trade scheme, rather than the current raft of interventions which make energy more expensive than it need be.

5) Agricultural liberalisation: exiting the EU Common Agricultural Policy gives us the opportunity to reassess agricultural policy. The UK should gradually phase out all subsidies, as New Zealand did, opening up the sector to global competition. This improved agricultural productivity in that country significantly. Combined with a policy of unilateral free trade, it would deliver substantially lower food prices for consumers too.

6) Deregulation: in the long term, Britain should extricate itself from the Single Market and May should set up a new Office for Deregulation, tasked with examining all existing EU laws and directives, with the clear aim of removing unnecessary burdens and lowering costs. In particular, this should focus on labour market regulation, financial services, banking and transport

In a departure from my normal focus on the nexus of macroeconomics and financial markets I wrote a reformist article last week for the Cobden Centre – A Plan to Engender Prosperity in Perfidious Albion – from Pariah to Paragon; in it, I made some additional reform proposals:-

Banking Reform: The financialisation of the UK economy has reached a point where productive, long term capital investment is in structural decline. Increasing bank capital requirements by 1% per annum and abolishing a zero weighting for government securities would go a long way to reversing this pernicious trend.

Monetary Reform: The key to long term prosperity is productivity growth. The key to productivity growth is investment in the processes of production. Interest rates (the price of money) in a free market, act as the investment signal. Free banking (a banking system without a lender of last resort) is a concept which all developed countries have rejected. Whilst the adoptions of Free banking is, perhaps, too extreme for credible consideration in the aftermath of Brexit, a move towards the free-market setting of interest rates is desirable to attempt to avert any further malinvestment of capital.

Labour Market Reform: A repeal of the Working Time Directive and the Agency Workers Directive would be a good start but we must resist the temptation to close our borders to immigration. Immigrants, both regional and international, have been essential to the economic prosperity of Britain for centuries. There will always be individual winners and losers from this process, therefore, the strain on public services should be addressed by introducing a contribution-based welfare system that ensures welfare for all – migrants and non-migrants – contingent upon a record of work.

Educational Reform: investment in technology to deliver education more efficiently would yield the greatest productivity gains but a reform of the incentives based on individual choice would also help to improve the quality of provision.

Free Trade Reform: David Ricardo defined the economic law of comparative advantage. In the aftermath of the UK exit from the EU it would be easy for the UK to slide towards introspection, especially if our European trading partners close ranks. We should resist this temptation if at all possible; it will undermine the long term productivity of the economy. We should promote global free trade, unilaterally, through our membership of the World Trade Organisation. In the last 43 years we have lost the art of negotiating trade deals for ourselves. It will take time to reacquire these skills but gradual withdrawal from the EU by way of the EEA/EFTA option would give the UK time to adjust. The EEA might even prove an acceptable longer term solution. I suspect the countries of EFTA will be keen to collaborate with us.

We should apply to rejoin the International Organization for Standardization , the International Electrotechnical Commission , and the International Telecommunication Union (all of which are based in Geneva) and, under the auspices of EFTA, we can rejoin the European Committee for Standardization (CEN), the European Committee for Electrotechnical Standardization (CENELEC), the European Telecommunications Standards Institute (ETSI), and the Institute for Reference Materials and Measurements (IRMM).

Conclusion

Financial markets will remain unsettled for an extended period; domestic capital investment will be delayed, whilst international investment may be cancelled altogether. If growth slows, and I believe it will, further easing of official interest rates and renewed quantitative easing are likely from the BoE. Gilts will trade higher, pension funds and insurance companies will continue to purchase these fixed income assets but the BoE will acquire an ever larger percentage of outstanding issuance. In 2007 Pensions and Insurers held nearly 50%, with Banks and Building Societies accounting for 17% of issuance. By Q3 2014 Pensions and Insurers share had fallen to 29%, Banks and Building Societies to 9%. Over seven years, the BoE had acquired 25% of the entire Gilt issuance.

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

 

What are the prospects for UK financial markets in 2016?

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Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU, there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.