The Self-righting Ship – Debt, Inflation and the Credit Cycle

The Self-righting Ship – Debt, Inflation and the Credit Cycle

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Macro Letter – No 105 – 23-11-18

The Self-righting Ship – Debt, Inflation and the Credit Cycle

recovery_saltaire

Source: Stromness Lifeboat

  • Rising bond yields may already have tempered economic growth
  • Global stocks are in a corrective phase but not a bear-market
  • With oil prices under pressure inflation expectations have moderated

The first self-righting vessel was a life-boat, designed in 1789. It needed to be able to weather the most extreme conditions and its eventual introduction (in the 1840’s) transformed the business of recuse at sea forever. The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.

Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying this time it’s different, the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.

When in doubt, look to Japan

For central bankers, Japan is the petri dish in which all unconventional monetary policies are tested. Even today, QQE – Quantitative and Qualitative Easing – is only seriously being undertaken in Japan. The Qualitative element, involving the provision of permanent capital by the Bank of Japan (BoJ) through their purchases of common stocks (at present, still, indirectly via ETFs), remains avant garde even by the unorthodox standards of our times.

Recently the BoJ has hinted that it may abandon another of its unconventional monetary policies – yield curve control. This is the operation whereby the bank maintains rates for 10yr maturity JGBs in a range of between zero and 10 basis point – the range is implied rather than disclosed – by the purchase of a large percentage of all new Japanese Treasury issuance, they also intervene in the secondary market. During the past two decades, any attempt, on the part of the BoJ, to reverse monetary easing has prompted a rise in the value of the Yen and a downturn in economic growth, this time, however, might be different – did I use that most dangerous of terms again? It is a long time since Japanese banks were able to function in a normal manner, by which I mean borrowing short and lending long. The yield curve is almost flat and any JGBs with maturities shorter than 10 years tend to trade with negative yields in the secondary market.

Japanese banks were not heavily involved in the boom of the mid-2000’s and therefore weathered the 2008 crisis relatively well. Investing abroad has been challenging due to the continuous rise in the value of the Yen, but during the last few years the Japanese currency has begun to trade in a broad range rather than appreciating inexorably.

In the non-financial sector a number of heavily indebted companies continue to limp on, living beyond their useful life on a debt-fuelled last hurrah. Elsewhere, however, Japan has a number of world class companies trading at reasonable multiples to earnings. If the BoJ allows rates to rise the zombie corporations will finally exit the gene pool and new entrepreneurs will be able to fill the gap created in the marketplace more cheaply and to the benefit of the beleaguered Japanese consumer. My optimism about a sea-change at the BoJ may well prove misplaced. Forsaking an inflation target and offering Japanese savers positive real-interest rates is an heretically old-fashioned idea.

Whilst for Japan, total debt consists mainly of government obligations, for the rest of the developed world, the distribution is broader. Corporate and consumer borrowing forms a much larger share of the total sum. Giving the historically low level of interest rates in most developed economies today, even a moderate rise in interest rates has an immediate impact. Whereas, in the 1990’s, an increase from 5% to 10% mortgage rates represented a doubling payments by the mortgagee, today a move from 2% to 4% has the same impact.

The US stock market as bellwether for global growth

Last month US stocks suffered a sharp correction. The rise had been driven by technology and it was fears of a slowdown in the technology sector that precipitated the rout. Part of the concern also related to US T-Bonds as they breached 3% yields – a level German Bund investors can only dream of. Elsewhere stock markets have been in corrective (0 – 20%) or bear-market (20% or more) territory for some time. I wrote about this decoupling in Macro Letter – No 101 – 31-08-2018 – Divergent – the breakdown of stock market correlations, temp or perm? Now the divergence might be about to reverse. US stocks have yet to correct, whilst China and its vassals have already reacted to the change in global growth expectations. Globally, stocks have performed well for almost a decade: –

MSCI World

Source: MSCI and Yardeni

The next decade may see a prolonged period of range trading. After 10 years, during which momentum investing has paid handsomely, value investing may be the way to navigate the next.

Along with stocks, oil prices have fallen, despite geopolitical tensions. The Baker Hughes rig count reached 888 this week, the highest since early 2015. With WTI still above $60/bbl, the number of active rigs is likely to continue growing.

US 10yr bond yields have already moderated (down to 3.06% versus their high of 3.26%) and stocks have regained some composure after the sudden repricing of last month. The ship has self-righted for the present but the forecast remains turbulent.     

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The risk of a correction in the equity bull market

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Macro Letter – No 89 – 19-01-2018

The risk of a correction in the equity bull market

  • Rising commodity prices, including oil, are feeding through to PPI
  • Unemployment data suggests wages may begin to rise faster
  • Federal Reserve tightening will continue, other Central Banks may follow
  • The bull market will be nine years old in March, the second longest in history

Since March 2009, the US stock market has been trending broadly higher. If we can continue to make new highs, or at least, not correct to the downside by more than 20%, until August of this year it will be the longest equity bull-market in US history.

The optimists continue to extrapolate from the unexpected strength of 2017 and predict another year of asset increases, but by many metrics the market is expensive and the risks of a significant correction are become more pronounced.

Equity volatility has been consistently low for the longest period in 60 years. Technical traders are, of course, long the market, but, due to the low level of the VIX, their stop-loss orders are unusually close the current market price. A small correction may trigger a violent flight to the safety of cash.

Meanwhile in Japan, after more than two decades of under-performance, the stock market has begun to play catch-up with its developed nation counterparts. Japanese stock valuation is not cheap, however, as the table below, which is sorted by the CAPE ratio, reveals:-

Star_Capital_-_Equity_Valuations_31-12-2017

Source: Star Capital

Global economic growth surprised on the upside last year. For the first time since the great financial crisis, it appears that the Central Bankers experiment in balance sheet expansion has spilt over into the real-economy.

An alternative explanation is provided in this article – Is Stimulus Responsible for the Recent Improved Trends in the U.S. and Japan? – by Dent Researchhere are some selected highlights:-

Since central banks began their B.S. back in 2001, when the Bank of Japan first began Quantitative Easing efforts, I’ve warned that it wouldn’t be enough… that none of them would be able to commit to the vast sums of money they’d ultimately need to prevent the Economic Winter Season – and its accompanying deflation – from rolling over us.

Demographics and numerous other cycles, in my studied opinion, would ultimately overwhelm central bank efforts…

Are such high levels of artificial stimulus more important than demographic trends in spending, workforce growth, and productivity, which clearly dominated in the real economy before QE? Is global stimulus finally taking hold and are we on the verge of 3% to 4% growth again?…Fundamentals should still mean something in our economy…

And my Generational Spending Wave (immigration-adjusted births on a 46-year lag), which predicted the unprecedented boom from 1983 to 2007, as well as Japan’s longer-term crash of the 1990s forward, does point to improving trends in 2016 and 2017 assuming the peak spending has edged to 47 up for the Gen-Xers.

The declining births of the Gen-X generation (1962 – 1975) caused the slowdown in growth from 2008 forward after the Baby Boom peaked in late 2007, right on cue. But there was a brief, sharp surge in Gen-X births in 1969 and 1970. Forty-seven years later, there was a bump… right in 2016/17…

US Gets Short-lived - Dent Research

Source: Dent Research

The next wave down bottoms between 2020 and 2022 and doesn’t turn up strongly until 2025. The worst year of demographic decline should be 2019.

Japan has had a similar, albeit larger, surge in demographics against a longer-term downtrend.

Its Millennial generation brought an end to its demographic decline in spending in 2003. But the trends didn’t turn up more strongly until 2014, and now that they have, it’ll only last through 2020 before turning down dramatically again for decades…

Japan Gets Millennial Surge - Dent Research

Source: Dent Research

Prime Minister Abe is being credited with turning around Japan with his extreme acceleration in QE and his “three arrows” back in 2013. All that certainly would have an impact, but I don’t believe that’s what is most responsible for the improving trends. Rather, demographics is the key here as well, and this blip Japan is enjoying won’t last for more than three years!..

If demographics does still matter more, we should start to feel the power of demographics in the U.S. as we move into 2018.

If our economy starts to weaken for no obvious reason, and despite the new tax reform free lunch, then we will know that demographics still matter…

A different view of the risks facing equity investors in 2018 is provided by Louis-Vincent Gave of Gavekal, care of Mauldin Economics – Questions for the Coming Yearhe begins with Bitcoin:

…a recent Bloomberg article noted that 40% of bitcoins are owned by around 1,000 or so individuals who mostly reside in the greater San Francisco Bay area (the early adopters). Sitting in Asia, it feels as if at least another 40% must be Chinese investors (looking to skirt capital controls), and Korean and Japanese momentum traders. After all, the general rule of thumb in Asia is that when things go up, investors should buy more.

Asia’s fondness for chasing rising asset prices means that it tends to have the best bubbles. To this day, nothing has topped the late 1980s Taiwanese bubble, although perhaps, left to its own devices, the bitcoin bubble may take on a truly Asian flavor and outstrip them all? Already in Japan, some 1mn individuals are thought to day-trade bitcoins, while 300,000 shops reportedly have the capacity to accept them for payment. In South Korea, which accounts for about 20% of daily volume in bitcoin and has three of the largest exchanges, bitcoin futures have now been banned. For its part, Korea’s justice ministry is considering legislation that would ban payments in bitcoin all together.

At the very least, it sounds like the Bank of Korea’s recent 25bp interest rate hike was not enough to tame Korean animal spirits. So will the unfolding bitcoin bubble trigger a change of policy from the BoK and, much more importantly, from the Bank of Japan in 2018?

 Mr Gave then goes on to highlight the risks he perceives as under-priced for 2018, starting with the Bank of Japan:-

In recent years, the BoJ has been the most aggressive central bank, causing government bond yields to stay anchored close to zero across the curve, while acting as a “buyer of last resort” for equities by scooping up roughly three quarters of Japanese ETF shares. Yet, while equities have loved this intervention, Japanese insurers and banks have had a tougher time. Indeed, a chorus of voices is now calling for the BoJ to let the long end of the yield curve rise, if only to stop regional banks hitting the wall.

Japanese_banks_in_the_wars_-_Gavekal

Source: Gavekal/Macrobond

So could the BoJ tighten monetary policy in 2018? This may be more of an open question than the market assumes. Indeed, the “short yen” trade is popular on the premise that the BoJ will be the last central bank to stop quantitative easing. But what if this isn’t the case?

The author then switches to highlight the pros and cons. It’s the cons which interest me:-

  • PPI is around 3%
  • The banks need a steeper yield curve to survive
  • The trade surplus is positive once again
  • The US administration has been pressuring Japan to encourage the Yen to rise

I doubt the risk of BoJ tightening is very great – they made the mistake of tightening too early on previous occasions to their cost. In any case, raising short-term rates will more likely lead to a yield curve inversion making the banks position even worse. The trade surplus remains small and the Yen remains remarkably strong by long-term comparisons.

This brings us to the author’s next key risk (which, given Gavekal’s deflationist credentials, is all the more remarkable) that inflation will surprise on the upside:-

Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanization growth was always bound to slow. Combine that with China’s aging population and the fact that a rising share of rural residents are over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.

 Reduced excess capacity in China is real: from restrictions on coal mines, to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10mn industrial workers have lost their jobs since Xi’s took office (note: there are roughly 12.5m manufacturing workers in the US today!).

Chinas_decelerating_urbanisation_-_Gavekal

Source: Gavekal/Macrobond

Total_labor_market_in_China_-_Gavekal

Source: Gavekal/Macrobond

To say that most “excess investment” China unleashed with its 2015-16 monetary and regulatory policy stimulus went into domestic real estate is only a mild exaggeration. Very little went into manufacturing capacity, which may explain why the price of goods exports from China has, after a five-year period, shown signs of breaking out on the upside. Another part of the puzzle is that Chinese producer prices are also rising, so it is perhaps not surprising that export prices have followed suit. The point is, if China’s export prices do rise in a concerted manner, it will happen when inflation data in the likes of Japan, the US and Germany are moving northward…

China_PPI_-_Gavekal

Source: Gavekal/Macrobond

Global_Inflation_-_Gavekal

Source: Gavekal/Macrobond

…The real reason I worry about inflation today is that inflation has the potential to seriously disrupt the happy policy status quo that has underpinned markets since the February 2016 Shanghai G20 meeting.

Mr Gave recalls the Plaza and Louvre accords of 1985 and ‘87, reminding us that the subsequent rise in bond yields in the summer of 1987 brought the 1980’s stock market bubble to an abrupt halt.

…for the past 18 months, I have espoused the idea that, after a big rise in foreign exchange uncertainty – triggered mostly by China with its summer 2015 devaluation, but also by Japan and its talk of helicopter money, and by the violent devaluation of the euro that followed the eurozone crisis – the big financial powers acted to calm foreign exchange markets after the February 2016 meeting of the G20 in Shanghai.

…as in the post-Louvre accord quarters, risk assets have broadly rallied hard. It’s all felt wonderful, if not quite as care-free as the mid-1980s. And as long as we live under this Shanghai accord, perhaps we should not look a gift horse in the mouth and continue to pile on risk?

This brings me to the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?”

Again the author is at pains to point out that, for the bubble to burst an inflation hawk is required. A Central Bank needs to assume the mantle of the Bundesbank of yesteryear. He anticipates it will be the PBoC:-

…(let’s face it: the last two upswings in global growth, namely 2009 and 2016, were triggered by China more than the US). Indeed, the People’s Bank of China may well be the new Bundesbank for the simple reason that most technocrats roaming the halls of power in Beijing were brought up in the Marxist church. And the first tenet of the Marxist faith is that historical events are shaped by economic forces, with inflation being the most powerful of these. From Marx’s perspective, Louis XVI would have kept his head, and his throne, had it not been for rapid food price inflation the years that preceded the French Revolution. And for a Chinese technocrat, the Tiananmen uprising of 1989 only happened because food price inflation was running at above 20%. For this reason, the one central bank that can be counted on to be decently hawkish against rising inflation, or at least more hawkish then others, is the PBoC.

Mr Gave foresees inflation delivering a potential a triple punch; lower valuations for asset markets, followed by tighter monetary and fiscal policy in China, which will then trigger an incendiary end to the unofficial ‘Shanghai Agreement’. In 1987 it was German Bunds which offered the safe haven, short-dated RMB bonds may be their counterpart in the ensuing crisis.

This brings our author to the vexed question of the way in which the Federal Reserve will respond. The consensus view is that it will be business as usual after the handover from Yellen to Powell, but what if it’s not?

…imagine a parallel universe, such that within a few months of being sworn in, Powell faces a US economy where:-

Unemployment is close to record lows and government debt stands at record highs, yet the federal government embarks on an oddly timed fiscal stimulus through across-the-board tax cuts.

Shortly afterwards, the government further compounds this stimulus with a large infrastructure spending bill.

As inflationary pressures intensify around the world (partly due to this US stimulus), the PBoC, BoJ and ECB adopt more hawkish positions than have been discounted by the market.

The unexpected tightening by non-US central banks leads other currencies higher, and the US dollar lower.

The combination of low interest rates, expansionary fiscal policy and a weaker dollar causes the US economy to properly overheat, forcing the Fed to tighten more aggressively than expected.

Gave proposes four scenarios:-

  1. More of the same – along the lines of the current forecasts and ‘dot-plot’
  2. A huge US fiscal stimulus forcing more aggressive tightening
  3. An unexpected ‘shock’ either economic or geopolitical, leading to renewed QE
  4. The Fed tightens but inflation accelerates and the rest of the world’s Central Banks tighten more than expected

…In the first two scenarios, the US dollar will likely rise, either a little, or a lot. In the latter two scenarios, the dollar would likely be very weak. So if this analysis is broadly correct, shorting the dollar should be a good “tail risk” policy. If the global economy rolls over and/or a shock appears, the dollar will weaken. And if global nominal GDP growth accelerates further from here, the dollar will also likely weaken. Being long the dollar is a bet that the current investment environment is sustained.

The final risk which the author assesses is the impact of rising oil prices. It has often been said that a rise in the price of oil is a tax on consumption. Louis-Vincent Gave gives us an excellent worked example:-

assume that the world consumes 100mn barrels of oil a day…Then further assume that about 100 days of inventory is kept “in the system”… if the price of oil is US$60/bbl, then oil inventories will immobilize around US$600bn in working capital. But if the price drops to US$40/bbl, then the working capital needs of the broader energy industry drops by US$200bn.

The chart below shows the decline in true money supply:-

Excess_liquidity_is_slowing_-_Gavekal

Source: Gavekal/Macrobond

The Baker Hughes US oil rig count jumped last week from 742 to 752 but it is still below the highs of last August and far below the 1609 count of October 2014. The break-even oil price for US producers is shown in the chart below:-

Oil_Breakevens_-_Geopolitical_Futures

Source: Geopolitical Futures

If the global price of oil were entirely dependent on the marginal US producer, there would be little need to worry but the World Rig Count has also been slow to respond and Non-US producers are unable to bring additional rigs on-line as quickly, in response to price rises, as their US counterparts:-

Baker_Hughes_World_Rig_Count_10_years

Source: Baker Hughes

An additional concern for the oil price is the lack of capital investment over recent years. Many of the recent fracking wells in the US are depleting more rapidly. This once dynamic sector may have become less capable of reacting to the recent price increase. I’m not convinced, but a structurally higher oil price is a risk to consider.

Conclusion and investment opportunities

As Keynes famously said, ‘The markets can remain irrational longer than I can remain solvent.’ Global equity markets have commenced the year with gusto, but, after the second longest bull-market in history, it makes sense to be cautious. Growth stocks and Index tracking funds were the poster children of 2017. This year a more defensive approach is warranted, if only on the basis that lightening seldom strikes twice in the same place. Inflation may not become broad-based but industrial metals prices and freight rates have been rising since 2016. Oil has now broken out on the upside, monetary tightening and balance sheet reduction as the watch words of the leading Central Banks – even if most have failed to act thus far – these actions compel one to tread carefully.

A traditional value-based approach to stocks should be adopted. Japan may continue to play catch up with its developed nation peers – the demographic up-tick, mentioned by Dent research, suggests that the recent breakout may be sustained. The Federal Reserve is leading the reversal of the QE experiment, so the US stock market is probably most vulnerable, but the high correlations between global stock markets means that, if the US stock market catches a cold, the rest of the world is unlikely to avoid infection.

High-yield bonds have been the alternative to stocks for investors seeking income for several years. Direct lending and Private Debt funds have raised a record amount of assets in the past couple of years. If the stock market declines, credit spreads will widen and liquidity will diminish. In the US, short dated government bond yields have been rising steadily and yield curves have been flattening, nonetheless, high grade floating rate notes and T-Bills may be the only place to hide, especially if inflation should rise even as stocks collapse.

There will be a major stock market correction at some point, there always is. When, is still in doubt, but we are nearer the end of the bull-market than the beginning. Technical analysis suggests that one must remain long, but in the current low volatility environment it makes sense to use a trailing stop-loss to manage the potential downside risk. Many traders are adopting a similar strategy and the exit will be crowded when you reach the door. Expect slippage on your stop-loss, it’s a price worth paying to capture the second longest bull-market in history.

 

The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

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Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.

Russia – Will the Bear come in from the cold?

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Macro Letter – No 67 – 9-12-2016

Russia – Will the Bear come in from the cold?

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

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

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

rtsi_2016_-_moscow_exchange

Source: Moscow Exchange

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

rtsi-1995-2016

Source: Tradingview

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

russia-mktcap-to-gdp-guru-focus

Source: Guru Focus

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

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

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

Source: EFTdb.com

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

Bonds, Inflation and the Ruble

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

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

Source: Trading Economics

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

Source: Trading Economics

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

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

Source: Trading Economics

Economics and Politics

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

russia-gdp-growth-annual

Source: Trading Economics, Federal Statistics Service

Oil and Gas

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

russian_gas_15_year-indexmundi

Source: Indexmundi

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

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

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

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

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

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

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

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

Source: Bloomberg, Russian Energy Ministry

Prospects for 2017

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

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

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

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

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

China (and India)

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

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

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

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

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

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

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

The Trump Card?

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

Conclusion and Investment Opportunities

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

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

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

rsxj-index-yahoo

Source: Yahoo Finance

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