At last count, over 48 countries have recognized the role of Acting President Juan Guaido of Venezuela, adding further pressure to the flailing regime of President Nicolas Maduro. U.S. sanctions further amplify Venezuela’s loss of market access, for key energy inputs, energy exports and credit for other goods. This piece surveys some of the economic and financial challenges ahead and how they could be affected by ongoing negotiations and potential impacts for asset markets.
Since the U.S. recognition of Juan Guaido as the interim president of Venezuela and the subsequent imposition of tighter sanctions, there has been much speculation about the prospects of reversing the economic and social devastation of the last decade, Given the significant financing needs, deterioration of physical and social capital, there could be some over-optimism about the speed and extent of the revival of the country’s energy sector and outstanding debt, the two areas that constitute the country’s most meaningful links with global financial markets. These two areas are also those in which domestic choices led to “own goals” that have done much to insulate global markets from Venezuela – migration is the one area that is now a meaningful drain on its neighbors.
Market implications:The impact on global oil supply is likely to be modest for the next year – with Venezuelan output uncertainty amplifying some of the lack of clarity on OPEC+ supply (Iran, Russia and Saudi cuts). Oil output volumes will likely be slow to bounce back given underinvestment. The pathway of long-term investment will depend on the terms offered to foreign investors, and key macroeconomic choices including around the exchange rate. Similarly, addressing the debt issues will also be complicated. Sanctions have frozen recent activity in the few bonds that traded freely, and confirmed our view, that rallies would be short-lived. A lengthy restructuring process lies ahead, with competing claims and counterclaims between different creditors.
I’m aware of how difficult it can be to place a timeline on political change – after all, one of my co-written scenario analyses on Venezuela from 2014 would have been surprised that the regime could hang on for this long, liquidate so many assets and contribute to so much pain.
Many research houses have highlighted the many ‘complications’ that lay ahead, particularly relating to the ongoing political standoff, massive humanitarian/migration needs, the debt burden and the potential energy and economic production. All of these issues are interlinked as efforts to force out the Maduro regime contribute to even greater financial strains in the short-term, while excessively optimistic hopes on energy sector bounce back are likely to complicate eventual negotiations on emergency multilateral support and debt restructurings. Any financial support could be complicated by assumptions by creditors that Venezuela’s oil future earnings should allow it to fund itself. Doing so would require significant capital injections to improve infrastucture, attract back human capital and rebuild key institutions. The good news is that there is strong human capital scattered across the Americas and beyond, and the opposition has had time to come up with a key plan, the challenge is that meeting the interests of all the stakeholders locally and internationally will be complicated by the pain of the recent policy regime, even if the current government and military apparatus could be quick.
The upside scenario:The potential for political change seems to open up the possibility of a long-term positive outlook. The focus on need to stabilize the economy, including some moves on the fiscal side and to slowly get on the pathway to lowering inflation expectations. They suggest a possibility for long-term improvement, if sizeable funds are made available to help rebuild the physical and social infrastructure, if significant capital reductions on the debt are negotiated and if any successor government is able to lure back and deploy Venezuela’s human capital.
More likely it will be a long slog, with contentious legal battles. The remainder of the piece looks at some of these incipient challenges.
Humanitarian needs and economic stabilization programs
There are a few small pools of capital available for purely humanitarian needs, mostly from regional peers, though these would be relatively small compared with Venezuela’s needs. At present the Maduro government has been unwilling to accept these funds and they would likely only be turned over to an opposition government (see OFAC’s direct FAQs)
The IMF and multi-lateral development banks have been watching for the end to the political crisis for many years. The lack of direct links with these organizations makes it harder to assess needs, though the IMF and others have long had “shadow” Venezuela country teams doing their best to estimate financing needs and a stabilization program to be available when requested. IMF estimates have pointed to sizeable needs in the neighborhood of $60 billion plus, not to mention sectoral investment needs. Presumably any long-term deal would likely require debt restructuring or reprofiling to massively push down capital repayment terms and maturities (see below). A short-term deal is likely first, but only after political change, a request for financing and the partial or complete lifting of sanctions, would also be necessary for energy and debt restructuring to make much progress.
Catalysts to watch: Statements on Guaido proxies or PDVSA on JV projects, terms for foreign investments, assessments of quality of wells. OPEC+ quota. OFAC implementation (if Maduro clings to power)
Energy (especially production) likely to lead any economic rebound, but one needs need to distinguish between near-term revival potential (low given investment needs) and long-term potential (good, albeit with high production costs for much of Venezuela’s reserves). Guaido proxies have said a lot of the things that International oil companies (IOCs) want to hear including the plans to reduce restrictions on foreign joint ventures, pay back arrears and the like. However, it remains to be seen what the local political consensus will be on contract terms, tariffs and investment. Capital account restrictions, to allow reinvestment of measures and repatriation of profits into projects may also be necessary.
Unlike countries like Libya or Iran where oil either went offline briefly or there was time to plan for shut-ins, Venezuela’s output decline was long standing and reflected in part a lack of funds for maintenance. This plus the likely drop off in production already on course, questions how quickly it can be revived. The example of Iran’s limited oil output gains may also be instructive. While the sanctions sword of Damocles remained a concern for investors, the relatively unattractive terms offered to foreign companies by Iran’s parliament was a contributing factor. Expect them to look closely at terms offered by Venezuela especially for any new plays in the relatively costly Orinoco Valley.
Still, the most promising parts of the energy sector are likely the joint ventures that PDVSA sharred with certain foreign partners. These accounted for most of the production in the last few years, and temporarily staved off/dampened the decline in output, at least until the Venezuelan government stopped them from repatriating the profits or reinvesting them. Allowing access to these financing (only possible after some sanctions adjustment and assuming a government change. This could still take some time to get back on track.
Over the long-term, political and energy sector policy change suggests Venezuela could be one of the few countries that meaningfully increases oil output. This has led to some analysis that Venezuelan oil output might lead to significant increases in OPEC+ oversupply, putting pressure on its partners. This doesn’t seem to be a near-term risk, for the reasons above, but will likely put pressure on some OPEC+ countries who have benefited from Venezuela’s own goal. Venezuelan projects likely have a mid-range production costs.
Catalysts to watch: statements from Guaido proxies on debt, OFAC implementation, adjustment made to sanctions implementation, details re China and Russia debts. Divergence among creditors some of which will step up efforts to attach early assets.
It may seem premature to be talking about debt restructuring given that most of the traded bonds are frozen and subject to sanctions for U.S. persons as part of the U.S. efforts to cut off the cash flow for the Maduro regime. Sanctions were the last straw for a government that was near default for years, scraping together sufficient funds to repay creditors by liquidating or leveraging any state assets, thus prioritizing repayments over the needs of local business and population. This liquidation of assets (FX and gold reserves, PetroCaribe debts) and other creative financing structures has left the Venezuelan government with very limited savings to invest or repay its creditors. It also contributed to the massive contraction in imports that helped Venezuela partly close its external deficit for a time. This was painful and unsustainable, especially as planned investment and revival will likely need meaningful imports of material, and reviving consumption will require financing for other imports. As with most energy production increases, these import needs will likely outpace the export increases, thus limiting improvements in the external financing outlook (current account).
This suggests that Venezuelan debt is not sustainable, especially when the bilateral debt to China and Russia is added to the mix. Of course calculating debt sustainability is complicated by lack of clarity on the volume and terms of the loans from these bilateral lenders. Nonetheless all of these lenders will seek to be made whole, something that does not seem consistent with economic stability and revival.
In short, a tough restructuring is probably ahead given the likely cash flow and financing needs. needs. Venezuela sharply and painfully reduced its imports some years ago to limit the new debt financing requirements. Repeating this is not consistent with economic revival.
Recent Russian reports provide more color on Russian official sector’s move out of the the USD in Q2 of last year. The big focus of the CBR reserves composition report (see thread here) was the move into CNY assets, making Russia is now one of the largest holders of offshore CNY reserve assets. Despite the speeding up of the reserves diversification (most of which continues to be into EUR). the USD continues to dominate in cross-border trade and financial transactions. The move, already visible in the US data last summer, raised questions about the impact on broader USD assets at a time of fiscal and monetary pressure on USTs. The risks of Russia purchases look overstated, given the relatively small size of its holdings, continued purchases by other countries (including other oil producers) and ability of the Federal Reserve to provide liquidity if needed. Bigger long-term concerns around USTs should focus around the fiscal position, which is going to increase the amount of issuance in coming years – likely increasing the US cost of financings. Local and foreign investors are likely to bear this cost unless there are any signs the U.S. willingness to pay is shifting.
Russia’s move to sell USD was political, following the April 2018 sanctions on Russia and the local press estimated realized losses of $1.5b – admittedly small compared to Russia’s stock of assets and not necessarily something of concern to the government.
The move sped up the shift away from the USD in Russia’s FX holdings. The increase brings CNY holdings up to $62 billion of Russia’s $430b+ portfolio, meaning Russia now accounts for about 1/3 of the $192 billion in global reported CNY reserve holdings (IMF COFER) and just about all of the $40 billion increase in global reserve holdings of CNY in Q2. This is but one of the increasing links between Russia and China, which I’ve previously cited as a source of resilience for Russia. Of course, CNY-denominated bonds are not very liquid, and bilateral trade in CNY is still quite low between the countries suggesting limited benefit for reserve assets, particularly given the likely interest rate moves.
What does this mean for broader USD holdings?
Figure 1: Holdings of Long-Term US Treasurys (USD million)
Compared to turnover of the USTs even the 100b is not something that big… but would be more important if other countries followed suit.
That doesn’t seem to be happening. Chinese holdings are pretty stable with ups and downs due to currency management and GCC countries (KSA but also Kuwait and Qatar) seem to have been parking funds in USTs at the end of last year- at least for now. The increase in Saudi holdings of USTs (net $40 billion) in Q3 partly offsets the sharp decline in Russian holdings, likely reflecting the increase in energy revenues. The increase in KSA holdings far outpaces its reserves growth suggesting that the Saudis may have been parking the funds in UST after raising the funds in some of the bond issuance.
The increase in cash flow from Saudi Arabia energy sales inQ2 and Q3 last year (and maybe the bond issuance) seems to have gone into USTs and may have helped them finance the outflows that resulted when locals and foreigners continued to flee after the Kashoggi murder. Given the fiscal dynamics there and fall in oil prices this increase was likely temporary. Still, there is reason to expect that any shortage of buyers and associated interest in rates, would likely bring in more pensions, insurers and others looking to match their asset and liability portfolios.
Of foreign holders, China remains key – and the PBoC seems unlikely to cut holdings for political reasons. As I’ve written in the past, Chinese Treasury holdings reflect domestic economic choices rather than geo-political ones suggesting that local capital outflows and FX management will drive its foreign portfolio. Attempts to reduce treasury holdings would put appreciation pressure on the renminbi, undermine global and Chinese financial stability and likely reduce the value of their existing holdings.
That’s not to say that de-dollarization is not something to watch, but it looks to be a slow moving machine. Other critical policies to watch remain efforts by the European authorities to skirt U.S. sanctions, which are so far having only limited rhetorical impact. More important is the fiscal outlook of the U.S. which will likely put pressure on a range of assets.
As 2018 winds to an end, and 2019 lookaheads are completed, its time to share a few books that stuck with me this year from the 50 non-fiction books I read or listened to this year. Given my IPE teaching this fall, and ongoing macro risk work for clients, my non-fiction reading was dominated by corruption, country risk cases as well as a lot on AI, future of work and big data. Surprisingly, I read a lot of fiscal policy, perhaps fitting in the year when the biggest expansionary policy in peacetime came into effect and in which the costs of unwinding the big monetary stimulus experiment began.
What were your favorites, what did I miss and what’s on your reading list?
2019 set to be a tougher year…
Growth momentum has weakened in the second half of 2018, particularly in European and Asian exporters, who are responding to the end of above potential growth of the last few years, which has moderated final demand growth. Tariffs, restrictions and tighter financing costs have reinforced this trend, making final harder to forecast and encouraging caution on new investment decisions, Meanwhile Fed tightening, exit from quantitative tightening and boost in available US Treasurys, have begun to increase debt service costs across a range of sectors and geographies.
Slowing final demand growth globally is not a surprise, and has been a part of our themes for the last year, but the trade disputes and restrictions have reinforced some caution from buyers and supply chains. The drivers of this slowing of growth include a) the disconnect between policy stance in the U.S,. and other major economies across fiscal and monetary policy b) the lack of structural measures to boost final demand growth, c) removal of the “sugar rush” of monetary policy support as quantitative tightening takes hold. The U.S. and Chinese central banks have been particularly focused on continuing with business as usual, with overall policy stances only partly supportive. In both cases, a relative disconnect between fiscal and monetary policy complicates the messaging, and exacerbates some of the FX pressure.
I’m off to the annual meetings of the World Bank and IMF this week, a good chance to take the pulse on global market consensus and the worries of policy makers. Global trade risks and their impact on an already decelerating global economy are likely to top the worry list – with the impact of tariffs, policy uncertainty on value chains in focus along with questions of policy and macro divergence, all of which have left many less optimistic than in the spring. Given the recent escalation of U.S. – China trade tensions, and signs of slackening in global export growth, the focus is likely to be on the downside risks to global growth, the divergence between U.S. economic activity and that of most of rest of the world.
Last night’s just-before-deadline announcement that Canada and U.S. had reached a deal was met with a sigh of relief in many capitals but especially Ottawa. Reaching a deal on the two linked bilateral deals was definitely better than the alternative of no deal and related uncertainty for investors and certainty of a tough congressional approval process for a bilateral U.S. Mexico deal. It reduces the risk of a negative market outcome for one of the more integrated blocks, a fact that was largely priced in, but it is hard to see the deal as more than defensive.
In short, it seems to be a deal narrower in scope, one that was defensive (holding back on U.S. protectionism rather than creating space for new areas of growth), raising the question about the deployment of political capital on a relatively narrow set of policy changes. Next up – legislative approval in the three countries (tricky in all, mostly in the U.S.) and dealing with the bigger issue/challenge – China. The outcomes for both congressional passage and a deal with China may both be harder than markets expect.
Lately with trade disputes ratcheting up, I’ve had a lot of questions about the impact of trade uncertainty on market actors and businesses, including whether markets are overpricing risks given the strength of global growth. The jury’s still out, particularly as we’ve been in an as good as it gets moment, but the results don’t look great looking ahead. Trade policy uncertainty by making supply chain costs harder to predict may reinforce what was likely to be a cyclical slowdown in 2019/2020.
I’ve been concerned for some time that trade uncertainty would make it harder for businesses and indeed households who likely bear the brunt of cost volatility to plan. FX would likely be a major vector of transmission , but uncertainty about supply chain costs, might exacerbate the impact of the tightening of global liquidity implied by the exit of central banks from super-accommodative policies.
I’m not suggesting that trade barriers are the only or even primary driver of decisions, but uncertainty might cause some businesses to hold off on making investments that were already iffy. It might also increase a trend towards deepening of domestic supply chains, which would shift some of the winners and losers in the global economy. Finally it might add to the trend of more consumption rather than investment driven global growth. This seemed a particular risk for countries such as Canada, that are very exposed to U.S. markets, and where the central bank has been concerned that trade uncertainty might be adding to already sluggish business investment.
Perhaps its no surprise that one of the more interesting recent pieces on the role of trade uncertainty comes from a Canadian institution Meredith Crowley and Dan Ciuriak make an important addition in Weaponizing Uncertainty which does a nice job summarizing recent episodes of uncertainty, vectors of transmission and highlighting ways in which uncertainty on its own might pose a new non-tariff barrier.
One of the biggest questions of the last few years has been when/if trade policy uncertainty might impact global and U.S. growth (see my podcast with hidden forces for a detailed discussion). We may be reaching that time, more so outside the U.S. the U.S. than inside it due to regulatory choices, and fiscal trends, however, U.S. consumers and businesses will be on the receving end of blowback also. Remember, than sizeable earnings of the S&P 500 are from foreign profits.
US policy trends
Recent framing of the U.S. numbers suggest that fiscal stimulus is prompting more of an impact on growth and providing a cushion for administration officials, but doing so is supporting imports, making it even harder for the administration to meet its self-imposed trade deficit goals. Moreover the impact on the USD raises some real questions about dollar funding, especially as the US government has increased its issuance in the market, putting pressure on competitors, exactly as the central bank bid is easing or reversing. This suggests that assessing fundamentals will be important, with weaker fundamental countries and companies providing support.
Chinese response: Could it be easing?
As I’ve noted in past pieces, Chinese policy response is critical to the global outlook, the performance of assets and the transmission. the Chinese policy response shifted form a moderately supportive one (monetary, credit) to a more neutral and slightly tighter one over the last year, amplifying the impact of a relatively tighter fiscal stance. The PBoC balance sheet is now expanding at a slower pace (as local exposures offset for lower foreign currency holdings). The output data from Q2 so far show a cyclical slowdown on the investment side, though not on the retail side. the natural reaction of the Chinese authorities would likely to be to take a slightly easier, stance particularly if they were worried about tightening from the U.S. and supply chain disruptions. This would have the side “benefit” of allowing the CNY to reverse recent appreciation against the basket. The question will come if the CNY starts weakening beyond the basket.
Note that I think market and policy chatter about the possibility that the Chinese might sell their holdings as relatively ridiculous. While China has been looking for opportunities to diversify the portfolio and aims at shifting the currency risk to non-Chinese actors, a political decision to sell their treasurys would have several detrimental impacts
Are we headed for another crisis?
Several recent reports (UNCTAD, World Bank) put emphasis on policy uncertainty in reducing long-term investments. I’m not sure trade protectionism can take the full blame here, though it may complicate things.
Domestic Policy uncertainty around fiscal policy, domestic prices and utility tariffs or infrastructure caps investment in Brazil (though recent IIF analysis on FDI suggests that risk may be overstated) as does expropriation risk in Russia, Saudi Arabia etc. these can add up. in general we have seen much more portfolio debt flows than equity and more short term than greenfield or even brownfield investment. This reflects questions on the business environment at home as well as demand at home and abroad.
I was asked a few weeks ago about worries that trade protectionism would lead to a 2008 like recession. That’s always possible, but I find it hard to see the vector for such a sharp contraction in credit and inability to access global demand. Major tariffs would likely be absorbed through Fx swings and some short Fx positions in usd would be stopped out but I don’t see as much shadow banking risk or collapse in counterparty risk. That’s not to see Macro outlook would be great under a tit for tat trade environment between us and China but the outcome might be more gradual. Key to watch is the policy moves of the Chinese government, especially given the sizeable increase in debt and continued quality of growth issues.
I think there is likely to be a modest drag to business investment outside the United States particularly in the Americas and Europe and some higher cost Asian producers. This is because the tariffs reinforce some other concerns about final demand- and on the margins tax measures have made it somewhat cheaper to locate operations (finance, services) in the us.
Then what tariffs matter a lot. Steel and aluminum tariffs will add to inflation and have a modest growth drag, but pretty limited and even nafta withdrawal will only somewhat disruptive in the near term with greater impacts in the medium term. I would be more concerned about the impact of sizeable tariffs on Chinese trade which would have greater impact on global supply chains including a drag of up to a percentage point on us growth and more on some of its trading partners. This is a major reason why it may not get implemented in full. Along the way, it will be harder to plan and financial and other investors may remain more wary. Coupled with concerns about current valuations, justifiying current P/Es looks difficult.
More to come.
Last week, OPEC+ ministers managed to come to a consensus after days of contentious discussions in Vienna, achieving the goal of formally keeping the OPEC+ alliance together, but failing to solve some of the thorny issues between key members including Saudi Arabia and Iran. The final agreement, which commits the group to reversing recent overcompliance to boost production, remains formally agnostic on who will contribute to that production increase. This post looks at the factors that will shape upcoming fundamental outlook and assesses the macro impact for some key producers.
This suggests the alliance has moved into a transition phase of exit and shift to a different and more contested data dependent mode. The time-buying (or can-kicking) deal allows for more time to assess several key supply and demand variables described below including the impact of sanctions, the politically driven pressures and the resilience of global consumers.
In the near-term, the results support higher prices, especially as the net addition of fuel will be modest, and the result of individual decisions not the collective. Meanwhile the looming implementation of Iran sanctions poses a risk. Additions from the countries which can add will likely to offset by continued Iranian export declines as businesses trim their imports ahead of key November sanctions dates. The uncertainty around supply and risk of unilateral action to make up the gap. increases the likelihood of volatility and production.
Overall the result mapped with my expectations of gradualism, a moderate increase now, with ongoing reassessment and eventual gains through the year. As noted in our coverage of the Iran deal exit, OPEC members were likely to add supplies slower and more modestly than some market actors expected, while bargaining and price discounting from the Iranians would complicate assessment of production. The political pressures and uncertainty on production outlook in several key countries (including Venezuela, Iran, Libya, Nigeria), make it hard to imagine a different outcome, but divides will build over time, as further outages build in countries like Iran and Venezuela and only a few countries can produce more in compensation.
Focus on the big alliance, not only the smaller ones within OPEC: The result highlights the importance for Saudi Arabia (and GCC allies) as well as Russia of retaining the alliance struck in 2016 on managing oil output. Remaining vague on the details of how the production will be re-allocated from Venezuela to the countries with spare capacity, avoids a political decision that will eventually need to be addressed, since its hard to see any meaningful increases from that country. In fact, output is likely to fall further due to strikes, job cuts and equipment seizures.
Gradualism allows for more information gathering: By later in the fall, there should be more clarity on the following relevant fundamental issues that make it currently difficult to plan.
Exit from easing needs new forward guidance. 2018 was always going to be the year when the alliance shifted to a new phase. Like global central banks moving to quantitative tightening, the alliance (which was in a formal tightening phase), will employ new forward guidance for easing. The Joint monitoring committee (and a range of private monitoring bodies, are likely to take on a bigger role with focus moving beyond 5 year inventories as their main fundamental metric. It remains unclear what the new metrics, and forward guidance will look like. Saudi Arabian officials have already gone on the record to highlight the need for well over 1 million barrels a day in increase by the end of the year. Doing so, while absorbing Iranian output is likely to be difficult.
What might the impacts be on oil producers?
The decision brings increased breathing space to most oil producers, especially Saudi Arabia, most of the rest of the GCC and Russia, which account for the bulk of global spare capacity. While prices might soften from their recent levels, the increase in output, even if moderate should keep oil revenues elevated compared to 2017 levels and increase the energy contribution to growth. This should modestly reduce oil fiscal breakevens, though we assume that most countries will take the opportunity to spend a little more given that non-oil growth has been sluggish especially in MENA and SSA.
Our analysis suggests more GCC countries will use this space to become a little more expansive on the fiscal side, offsetting for what continues to be sluggish private sector growth, credit and sentiment. We have already seen stimulus rolled out in Abu Dhabi and Qatar, and spending outpace plans in Saudi Arabia, though some of these look temporary. We assume that fiscal breakeven price in Saudi Arabia may fall slightly to the low/mid 80s from the current $89/barrel, suggesting slightly less draw on debt. This implies that there will be more final demand rather than petrodollar savings. Countries in a position to save more include UAE (Abu Dhabi), Kuwait, Qatar, Russia, Kazakhstan, and possibly Nigeria. The chart below highlights likely shift in the current account surplus (flow of savings net of imports of goods and capital).
Other countries including Oman, Saudi Arabia, Iraq will likely tend to borrow less or draw down fewer reserves. Saudi Arabia likely will have more pump priming space to support the private sector.
We see a modest increase in Russian output, but limited impact on growth. In Russia, the flexibility of the exchange rate remains a key adjustment tool and increase in output is an offset to the financial cost of sanctions.
Those most vulnerable remain Venezuela, where local mismanagement, asset seizures and the exacerbating impact of sanctions suggest significant further outages. While politically OPEC could not formally reallocate its target, its hard to see any reversal of outages, especially as recent legal cases and strikes undermine its capacity further.
Iran, too will start to feel the pinch from the drop in oil prices, with the full impact dependent on sanctions implementation. For more on the scenarios, please see here. Decisions on adjusting to Iranian outages are more likely to be bilateral (between buyers and sellers) than within the alliance, but its hard to see if able to sell its current targets.
It is now the time of mid-year reviews, so I thought a little recap was warranted. Recent Market action provides a good time to reassess some of the drivers of global growth and returns going into the second half of the year and look ahead to 2019. Key questions remains about the macro damage from rising rates and selected capital outflows, rising oil prices and especially trade conflict. All of these trends but especially trade uncertainty are likely to reinforce a cyclical moderation of growth globally (returning closer to potential). This post highlights a few key assumptions and the catalysts I’m watching in the coming weeks to help identify opportunities and risks going forward.
Bottom line: global economic and trade growth are likely to slow in 2019, weighing on equity valuations, especially once the one-off payoffs to investors are completed. Stronger energy prices bring winners and losers, within and between countries, suggesting some outperformance of oil-linked FX and equities. Core interest rates should edge up in a non-linear way, as global central banks stick to their plans in the face of greater issuance. This should provide select opportunities for stronger countries. Among regions, Latin America should continue to lag, as the capital outflow pressure dampens the recovery, while Asian countries look more resilient to higher interest rates.
In this post, I look in more depth at
Trade rollercoaster to continue: Tariffs and threats complicate investment.
The U.S. trade policy trajectory remains a major risk to market sentiment, a trend that’s unlikely to end any time soon. That U.S. policy shifted from mere rhetorical threats to more specific ones is no surprise, but the ultimate goal of what would be deemed a success remains unclear, aside from the goal of reducing the trade surplus, something that other macro choices at home and abroad (fiscal and monetary) make more difficult. While the U.S. may strike some mercantilist deals, including with China, I would anticipate that the trade policy risks will linger well into 2019, undermining corporations ability to make decisions. So what are the key scenarios?
The tariff announcements have come fast and furious from the U.S. followed by lists of possible retaliation targets from trading partners. The tariff threats intersect with and are designed to crystallize attention on ongoing coercive trade negotiations, where the aim seems focused on reducing the U.S. trade deficit, rather than necessarily any measures on improving the quality of growth. In this way there is a risk that This trade and investment rollercoaster is likely to continue through the fall and possibly into next year, raising risks of price increases and just making it harder for businesses to plan.
At this point, there seem to be two key scenarios
European Risks: Peripheral risks to stay active, but not sway ECB
Italy’s deadlocked cabinet formation and some less problematic politics in spain led their yields to recent heights and reignited concerns about a euro-exit. This still remains unlikely any time soon, but the lack of growth in Italy and an unsustainable debt burden suggests that there are no easy political solutions. On net, the rising costs (partly a function of the ECB steps towards tapering which allow market actors to look more closely at fundamentals) are likely to increase savings rates in Europe, especially if more austerity is mandated. In the last half decade, debt profiles of peripheral countries have become more concentrated nationally, which makes addressing this issues harder.
Europe was headed towards a cyclical moderation of growth after over potential growth for parts of the core over the recent period. Overall macro trends are likely to keep ECB on course, which will in turn gradually bring more focus on the fundamentals of the credit profile.
The transatlantic divides don’t help of course with both the trade risks and the implementation of sanctions on Iran (and to a lesser extent Russia) complicating matters within the zone by increasing divides. For example, Italy, France and Greece are among the most exposed to Iranian crude, and include some of the more energy intensive countries. By contrast Germany and CEE are more exposed to U.S. tariffs directly (small) or via diversion from China. Expect more of these macro and security policies to remain linked.
Emerging Market pressure: Differentiation likely but borrowing costs edging up
The reversal of some of the extensive capital flows is likely to drive differentiation across the EM space, with oil producers outperforming, along with those with manageable inflation outlooks, and external surpluses. Growth is likely to slow sharply or fail to recover in a few most afflicted countries, forcing external deficits to narrow (Turkey, Argentina), but central bank responses are likely to selectively revive the carry trade. I don’t see a major drag on global growth, but rather a limited growth acceleration.
In aggregate, EM have experienced capital outflows from equity and bonds, and most FX have weakened. However the selloff this year has been highly concentrated in a few countries – Turkey, Argentina, Brazil and to a lesser extent sanctioned Russia. All three have meaningful policy vulnerabilities that investors only remembered when U.S. yields began rising – including external imbalances (Turkey, Argentina), wide or widening fiscal or quasi fiscal spending (all three), policy uncertainty post 2018 elections (Turkey, Brazil). CEE countries, which previously benefited from the ECB bid to reduce yields, have also suffered more than in the taper tantrum.
By contrast many Asian FX have been more resilient – notably India and Indonesia, partly because they reduced short-term FX liabilities, and central banks have been responsive. On the margins the end of most EM monetary easing will constitute a modest drag on growth, but not a major one. Chinese policy is key to assessing the broader response – the focus on selective small corporate defaults and limited deleveraging, and extensive overall credit is likely to keep underlying demand decent.
As mentioned in last month’s EM Q&A, I don’t see a lot of pegs to break, a difference from past crises. Most of the lingering pegs and quasi-pegs remain among oil producers, and the improvement in trade outlook is likely to reduce pressure compared to the last two years. In fact countries like Nigeria would arguably have an appreciating currency. GCC pegs even invulnerable Bahrain and Oman, look much more manageable than even six months ago.
Oil Rebalancing: OPEC+ actions Bring Volatility and New Price Band.
The OPEC+ group cuts and desire for profits among shale producers have brought the oil market closer to balance, helped by massive economic implosion in Venezuela which has led the broader group to overcomply with cuts, boosting prices, especially of Brent and products. The increase risks denting but not reversing demand growth including from key emerging markets.
Logistics issues are likely to limit the ability of North American producers to take full advantage of this demand and price dynamic, keeping the WTI-Brent and other discounts like Western Canada select weaker, even as production costs begin to increase. Production will continue to increase, but so will backlogs and some production costs.
This months OPEC meeting and seminar is a key catalyst to watch. Markets are expecting some increase in production, at least to take the group back to compliance not over compliance and possibly to net increase as demand has picked up more than expected. Key questions include whether the producers group will
Beyond OPEC, two Latam countries, Brazil and Mexico have elections that might be key to energy production going forward. Both Brazil and Mexico are net importers of hydrocarbons meaning they are buffeted on both sides by oil price volatility. While an AMLO government is unlikely to have the margin to be able to reverse reforms there are some policies that might slowdown new developments. Brazil’s strike of recent weeks, highlights some of the challenges in passing on higher costs to end users. I’m not optimistic about the ability of Brazil’s new government to maneuver both their fiscal adjustment and new infrastructure investment. The country has been a source of under performance on the supply side. Watching not only election results, which may be deadlocked, especially with congress, but also new leadership of Petrobras will be important.
Last week, I wrote about some of the key questions surrounding the U.S. withdrawal or rather violation of the JCPOA which focused on the responses of Iran (production, discounting, regional policy), Europe (blocking measures), and Asian buyers of Iranian goods. Since then the focus has been on the European counter response to the U.S. decision, and on assessing the energy market impact, and the potential risks to the use of sanctions as a policy tool. I provide a few follow up thoughts here.
Exit first, protection later: Many European companies seem to be preparing to freeze or reduce their investment, worried about the risks of future fines, despite pledges of blocking statutes. Developed markets in Asia are likely to be more cautious Meanwhile at the same time, European leaders are rushing to implement blocking legislation that would shield European companies from fines, and would forbid some companies (banks?) from implementing measures lest they face other fines. These measures have exposed divergent views between and within key European countries (notably France and Germany in recent days).
The blocking statute and other moves are in part one of principle in which the Europeans look to establish their concern about U.S. extraterritorial sanctions for the current and future cases, especially where U.S. and Europe have diverging views on the goals. Companies may choose to be cautious implementing cuts or freezing new deals given their concerns about the limited upside from trade in this environment, and fearing to loose access to U.S. markets. The net result is likely one of confusion, broader derisking as some companies scaling back activity won’t scale it back up without assurances from Iran. As others have noted, the imposition of sanctions may be the nail in the coffin for investments that were already on edge due to questions about the investment terms including some oil and natural gas contracts.
Oil: Oil volumes will be a major indicator for all to assess whether the process of undermining or stabilizing the deal is a success. The Trump administration is likely to look for reductions to show that sanctions are being implemented, while Iran would likely see volume drops as a sign of bad faith from trading partners, leaving European and Asian buyers in the middle. One key difference from 2012 is that EU member states quickly eliminated oil imports, leaving key Asian buyers and Turkey to take part in the “significant reductions” in imports. Europe is unlikely to do so this time given the political goals. Expect there to be greater uncertainty and debate around the metrics to use in tracking compliance. As noted, last week, OPEC+ may well act slower and less extensively than buyers hope, increasing price spikes and overall volatility.
The chart below highlights some of the countries that will be pressured to reduce imports. While it includes non-oil exports as well as fuel, it provides a useful breakdown. One thing that stands out is that Iranian exports to Europe and India experienced the greatest boost post-JCPOA, with volumes increasing more modestly to South Korea, Turkey and China, as these countries tried to balance their regional trade. Japan notably, barely increased trade from the pre-JCPOA levels (though the change in energy prices partly obscures the trend.
Iran exports have been increasing along with hydrocarbon prices (rolling 3 month sums, USD billion)
Source: IMF (via macrobond)
The OFAC guidelines suggest waivers would only be granted to those companies that show “significant” reductions in the coming months ahead of the November deadlines. Market analysts estimate export declines of 200-700 thousand barrels in the coming months, and more in 2019, quite a wide range in scope. complicating this, the definition of significant reductions is less than clear as the Trump administration hasn’t signaled whether they share the Obama administration definition of 10-20% declines over each six month period, or how they consider market price dynamics. Given the timing of decisions may continue to boost oil prices in the summer and fall as the mid-terms approach, these signals could be very important.
This suggests that companies looking to play it safe may reduce volumes, especially if the Iranians are unwilling to discount as Chinese and Indian buyers are likely asking for. Those countries that have already negotiated insurance or set up vehicles to do so in 2012-14 may be better positioned to maintain their market share or engage in barter agreements with Iran. Many Asian countries had to learn quickly to navigate the system to make sure their payments reached the Iranians in that period. European insurers or banks are likely to be much more worried than some of their EM Asian counterparts. This suggests that Chinese, Indian and Russian influence may increase.
Shares of Iranian Exports by Countries (% of total exports in USD terms)
Source: IMF (via Macrobond)
Impact on OPEC+ agreement: Many analysts see the sanctions decision as a risk to the OPEC+ (Vienna group) agreement which seeks to restrict output. Its definitely a test, and one likely to tighten the market further, particularly coming after massive declines from Venezuela and more moderate ones from Nigeria. The former’s almost 1mbd decline was partly absorbed by other countries cheating, but still resulted in quicker rebalancing of the market. In Iran’s case, other countries, most likely GCC countries like Saudi Arabia might respond by just directly selling more, rather than formally changing the deal. Recent statements from OPEC+ members don’t seem consistent with a group ready to start adding a lot more capacity – adding to uncertainty and the risk that new suppliers are slow and lower volumes than expected.
The ongoing trade threats and negotiations likely complicate oil decisions, amplifying the incentive for some actors to maintain their imports, and reducing it for others. Japanese and Korean companies, mostly government owned, may have high incentives to temper purchases to avoid fines, and perhaps to avoid retaliation in other ongoing trade negotiations and the planned DPRK discussions. Similarly, divergence in interests between European countries (Germany and France) may reflect ongoing negotiations on planned tariff implementation as well as the spillovers from Russia sanctions, not to mention different views on industrial policy (government support of companies) as well as the divergent sectors of interest in Iran. The net result is likely to be one in which China, already a dominant player in Iran (as a supplier, buyer and investor) increases its involvement. Meanwhile Russian interests could also increase, though its increased reliance on China and GCC as a source of long-term investment could muddy the waters there.
Impact on Iran’s economy: Many analysts believe that export declines might outpace that of production as Iran might seek to fill its relatively empty floating storage and might look to refine more products in the hopes of selling. While Iran might initially look to use a loophole and continue exporting products, such a loophole is unlikely to exist for long.
The overall impact on Iran’s economy is likely to be painful, especially coming in the midst of the ongoing currency crisis. A lag between production and export declines would shift the impact on Iran’s economy as oil sector contribution to GDP might slow more gradually (if at all) in the near term as output remains steady. However a reduction in sales would hit revenues and liquidity and likely constrain domestic demand via reduced government spending and lower domestic liquidity. FX shortages might reinforce these trends especially if the central bank continues its tight policy to temper inflation. Eventually, both exports and production might fall, hitting both oil and non-oil growth, as higher oil prices don’t offset for the volume losses. The concurrent reduction in (albeit limited) long-term investment would add to the drag, suggesting Iran’s growth could slow or even move towards recession.
Related imports (either for auto manufacture), energy projects or broader infrastructure are also likely to slow, especially if Iran struggles to make payments. This implies that Iran may become even more of a price taker on its imports, relying more on countries that buy its fuel. The full “escrow” account system that was much criticized in 2012-5 (it allowed for accrual of funds in local currency within oil consuming nations to purchase only approved goods), is unlikely to resume in the same degree, with financial transactions more leaky than at that point. Still, key consumers of fuel are likely to be direct or indirect suppliers, even as overall imports and the ability to pay for them declines.
Imports have been trending up, especially from Europe and UAE (rolling 3 month sums, USD billion)
Source: IMF (via macrobond)
Rachel's musings on macroeconomic issues, policy and more.