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)
I’ve been spending a lot of time (maybe too much time) in the last few weeks thinking about the Iran deal and economic and political impact of the U.S. exit. I’m not alone, judging by the sheer number of quickly organized JCPOA exit panels in D.C. last week. If people seemed insufficiently worried about the risks a month ago, now the related topics are front and center, including concerns about the way the decision making process and U.S. isolation might undermine future sanctions, U.S. influence and regional security.
Having written at some length about the macro, energy and policy impacts, it seems a good time to highlight in this post some concerns about possible negative risks to the sanctions apparatus, a topic treated well by Elizabeth Rosenberg (with whom I’m lucky enough to do some work at the Center for a New American Security).
Interlocking sanctions confuse the targets and make it hard to imagine an eventual lifting: U.S. sanctions targeting Iran on different grounds are now becoming intertwined. The U.S. has long had sanctions against Iran for support of terrorism, the nuclear program and ballistic missiles among others. These are now becoming intertangled, blurring the lines for those looking to identify policies or behavior that might result in sanctions relief or an eventual deal. That is, its becoming harder to isolate the behavior that the target is being asked to change. While premature at this point, it increases risks the sanctions are merely punitive rather than being linked to a policy change Its worth noting that U.S. Russia sanctions too have converged towards to a focus on a wide-range of “bad actions” suggesting they too could be near-impossible to lift or to prove a policy change. Doing so may make it even harder to gain broader support for future sanctions decisions, which risks their effectiveness in their broader goal which is to prompt policy change, contain the target and avoid an escalation to direct conflict.
U.S. policy seems focused on driving regime change rather than specific policy changes.Many U.S. officials now seem focused on inflicting economic pain on Iran to stress the regime in the hopes it will be toppled. I remain concerned that inflicting pain may not lead to policies supportive of regional and global security and U.S. interests and may actually backfire, especially if they empower those focused on domestic resilience and resistance. While cutting off cash flow may result in a less free hand regionally, and less ability to support proxies, the focus on regime change is likely to disempower any pragmatists. Moreover it risks undermining the deal and making it more difficult for global cohesion.
Challenges to global financial plumbing and dollar funding system: The recent re-imposition revives key questions around the impact on the SWIFT system, which was key to cutting off dollar funding and broader funding in 2012. While a European system, the coordination was key to the depth of the sanctions, cutting off Iran from the global financial system. It also contributed to a further interlinkage between U.S. and European systems. The tug of war between the U.S. and Europe could add to the confusion for those processing payments and could lead to alternatives to SWIFT and existing payments systems, adding interest for creation of new tools in Russia and China, and even Europe. There may be a cautionary tale from the recent round of Russia sanctions which resulted in several exchanges freezing transactions for a period of time, lest any deals violate sanctions. While targeted to one designated entity, the moves by the LME and Euroclear, while individually rational could pose risks to the exchanges themselves. While not a real challenge to the system any time soon, they may reinforce other structural drivers of competition including new stores of value in non-dollar assets . They could also shift more transactions underground, making them harder to track, collect taxes and fees on and undermine a wide range of policies.
Transactional bargaining between enforcement decisions and trade/security policy: The recent tweet from President Trump that seemed to offer relief for ZTE (a sanctions violator) as part of a broader U.S.-China grand bargain raised concerns for many reasons, not least the willingness to undermine previous legal processes in exchange for possible trade/foreign policy gains at the executive level. Selected members of the Trump administration have rhetorically used sanctions relief as a bargaining chip in trade negotiations on several occasions in the last year including offers to China if they imposed tighter sanctions, negotiations with the EU on trade and Russia links to name a few. The willingness of the Trump administration to (at least rhetorically) use sanctions and sanctions relief for particular corporate entities as a bargaining chip for security and trade policy negotiations raises several issues around consistency of policy, industrial policy (of picking winners and losers at home or abroad).
There are no doubt many more..
To read the whole post with graphics, please download here. Last week many Emerging market assets came under pressure following the rise in the US 10 year yield. The sell-off was concentrated in Turkish and Argentine markets, whose FX and thus other assets fell sharply, and in USD sovereign debt more generally, but some other assets came under pressure, admittedly falling just outside recent trading ranges. The sell-off prompted a lot of questions about whether this is a broad-based crisis. I don't think it is? Rather it should be a reminder to look closely at national balance sheets, the quality of growth, fiscal space and resilience.
I’ll try to answer (briefly!) a few key questions in this post: What happened? How have affected central banks responded? How strong are EM fundamentals? Is this another EM-financial crisis (hint: probably not), What would it take for a broader sell-off? what might be the vectors of contagion if it escalated? should we be worried about pegs?
As one would expect given the portfolio effects, which are higher for hard currency debt and equity than local, some other liquid EM saw outflows including Mexico (NAFTA risk), Brazil (election), India and Indonesia (oil and some modest financial contagion) but these seemed modest and are likely to remain so unless there is a meaningful macro risks emanating from China or the U.S. These risks are likely to stay isolated, but add to some growth challenges across relevant regions. Other stronger assets caught in the cross-fire (and even some of the affected assets) may present buying opportunities.
This is unlikely to be the last such bout as investors test the resolve of the Fed to continue normalizing, the significant wave of US bond issuance is absorbed and growth rates stagnate or weaken due to the waning of stimulus and trade policy risks. Higher and rising oil prices – driven by the uncertainties about the Iran deal, continued implosion in Venezuela and profit seeking in Saudi Arabia, only complicate the outlook, causing concerns for oil importing regions and countries, and their consumption and external balance.
Early last week I wrote about my concern that the risks Iran deal were not on the radar of many global investors and policy makers, one of the surprises from my last DC trip. I needn’t have worried – its now top of the agenda, or at least sharing it with China trade, Nafta and DPRK - a very busy agenda. If the U.S. were a Muslim country, I would be accusing policymakers of trying to get things done before Ramadan begins, but election timelines and a desire for continual pressure on negotiating partners seem to be a more realistic explanation.
With the Iran deal front of mind seems a good time to expand on a few points from my ongoing analysis of Iran’s economy, including what’s happened since the passage of the JCPOA. While the economy has had some breathing space, focused around the revival of the energy sector, local policy choices and limited foreign investment kept domestic demand weak and challenged any private sector credit revival, all trends that are likely to be even more complicated in the coming months.
The mood at last week’s Spring meetings of the IMF and World Bank was quite upbeat, as anticipated (see my preview here) though there were considerable concerns that near-term strength, exacerbated by U.S. fiscal stimulus and still supportive global monetary stimulus might be masking medium-term vulnerabilities. Many major economies are growing above potential, and are likely to experience some slowdown in growth, the question is how far, and whether the issues remain chronic or turn acute.
U.S. policy – fiscal, monetary, trade and sanctions dominated many. mostly unofficial discussions – and constituted the most common potential future negative catalysts, though most believed that trade wars were unlikely. My baseline includes a drag on private investment from trade and investment uncertainty, offsetting some of the other positive trends and exacerbating some of the impact of FX and commodity trends. Many global consumers may begin to face some challenges from the rising energy costs, admittedly offset by the recycling of strong import demand from oil exporting regions at a national and subnational level. Moreover, the fading sugar rush of the U.S. fiscal stimulus is likely to wear off while Chinese and several other countries continue their slowdown from the recent trend of above potential growth.
Across many issue areas (notably trade, Russia, Iran), it remains hard to discern what the Trump administration or rather the president might see as a success, a state of play that leaves things more uncertain for business, risks accidents and may amplify related market volatility.
Overall views from investors were mixed on the pathway for the dollar, cautiously optimistic about EM bonds, local and hard currency, and more constructive on non-US equity. Investors continue to be worried about the valuation of US assets particularly equities and higher yielding corporate bonds. Turkey stood out as a weak link – perennially exposed to negative shocks,
Looking ahead, the next few weeks are peppered with a variety of policy catalysts including the Iran deal deadline (May 12), public hearings on several proposed US tariffs (mid May), self-imposed if moving NAFTA deadlines, just to name a few.
The rest of the post highlights what I learned about the following:
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Like many economic, development and financial types, I’m planning to be in Washington D.C. this week for the Spring meetings of the International Monetary Fund and World Bank, which provide a good opportunity to take the pulse on current views on the global economy. It also provides a good chance to connect the threads of U.S. foreign and domestic economic policy, or at least try to. And I haven’t even gotten into the opportunity to better understand potential policy shifts in places like Mexico, Brazil, South Africa, Nigeria or concerns about concerning debt burdens in Ukraine, Egypt, Mozambique etc etc.
I’m expecting to find the mood cautious in the wake of divergent macro performance expectations, uncertainty around tariff, trade and investment policy, their links with sanctions and geopolitical risk that is adding to valuations and volatility of commodity markets. This will likely amplify concerns that have been present for some time about pricey equity valuations particularly in the U.S, prompting greater concerns about what to buy. I expect a lot of discussion of the recent market volatility, new entrants including cryptocurrencies, and focus on countries more exposed to the financing costs.
A few of the long list of questions follow, and I’m sure I’ll be surprised along the way. Let me know what I missed and check back here next week for my takeaways.
My preoccupations can be broadly grouped into global growth and trade risks, investment climate interest rate and credit in the face of tightening, commodity reflation impact on balance sheets, and the upcoming sanctions timeline.
With Saudi Arabia’s Crown Prince Mohammed bin Salman in Washington at the start of his long U.S. tour, there have been no shortage of good analyses written about what’s at stake and the motivations for the trip and Saudi social and economic reform – my favorites include those by Karen Young and Alastair Newton, as well as broader assessments of macro and regional policy by Steffen Hertog and Gregory Gause. Despite adding to the deluge, I’m going to weigh in also, to focus on some tradeoffs that may not get much public air time on the trip but will be important for assessing developments in coming months and years. These include the balance between local and foreign investment asset allocation, role of the private sector and local market development. Foreign investors salivating over some of the new opportunities should pay attention to the tradeoffs to better align their interests.
With policies changing fast in Saudi Arabia (much much faster than long-time watchers ever expected and something for which authorities have to be lauded), authorities may have to choose between their overlapping goals including attracting capital, getting the highest valuations for their assets, adding local jobs, involving the private sector, gaining the higher financial and political returns, as well as meet their regional political goals which include countering Iran. In fact, achieving many of the other developments suggest that the involvement of the private sector, at least the local one is the goal that is likely to take a backseat as more and more spending and development is done by government or quasi-governmental bodies. This isn’t in itself necessarily a bad thing or a new thing, as government spending has long been a catalyst for local growth, but it does suggest tradeoffs that will need to be resolved.
The trip may bring to the fore tradeoffs about foreign asset management, local economic goals in both countries and the distribution of returns, but is unlikely to resolve them, and instead is likely an opportunity for MBS to roll out some of the bilateral mercantilist policies that the Trump administration favors (though has struggled to implement with countries like China).
Figure 1: FX reserves (USD billion)
Saudi U.S. Asset portfolio. The Saudi Public Investment fund is the new fund in town and is the key vehicle for diversifying within Saudi Arabia’s USD assets. After a significant drawdown of savings in 2014-6, including some of the US bonds and public equity held by Saudi Arabia, the country’s external accounts are close to balance as the trade surplus is offset by more modest capital outflows. With oil prices now at a level that pays for Saudi Arabia’s imports but doesn’t allow much space for new foreign asset accumulation, Saudi Arabia will be more likely to redeploy existing U.S. funds into perceived higher yielding assets and those that meet its economic agenda. In other words, its holdings of US Treasurys (and publicly traded US corporate bonds and equities) are likely to drop in favor of adding other USD-denominated assets including strategic stakes, a transition that many of its peers in the GCC underwent or at least tested some years ago. This will also include some board stakes and investments that raise additional regulatory scrutiny, not only in the U.S. but elsewhere. In doing so, Saudi Arabia would be following a well trodden path towards more direct investment rather than just investing widely in traded assets.
This tradeoff fuels another one – the split between foreign and domestic investment in the portfolio of the PIF and its role in the broader Saudi investment plan. A sizeable portion of the estimated $200 billion in AUM of the PIF represents domestic pools of capital including those designated for social infrastructure such as education. The PIF is not only quickly scaling up its portfolio of foreign strategic stakes but also is being designated as a primary vehicle for key domestic projects and may be tasked with co-investing with inward investment to Saudi Arabia (like other funds like Russia's RDIF). This means the organization has to juggle a range of different mandates at the same time. It is thus part of the broad centralized nature of the decision making process in the office of the crown prince and thus may face challenges in interacting with other entities including other parts of the economy ministry, central bank among others.
Fast-moving central implementation vs predictable (decentralized) institutions: A key driver of the fast pace of implementation has been the centralization of policy in the office of the crown prince and his designates, with only a few lead institutions. New entities including the entertainment vehicle, the military investment vehicle have been created. This centralization has prompted a quick moving passage of legislation, but implementation is more challenging given the need to bring the bureaucracy along. A key test case remains the new anti-corruption apparatus and future legal process – establishing clear rules could increase confidence of the local private sector and also foreign investors, many of whom remain concerned about further reprisals despite dismissals from political bodies like the chamber of commerce. Similarly the management of the stakes in companies yielded to the government bodies as part of the last crackdown will be key measures to watch. Centralization of policymaking and the recurrence of the same effective names is nothing new in the gulf, though it takes on a different guide in a country like Saudi Arabia with a larger labor pool to choose from. How Saudi Arabia decentralizes after the past centralization will be key.
The scale of investment including high profile projects like NEOM and broad localization goals suggest that Saudi Arabia needs to attract foreign portfolio and direct investment capital. Still there may be some capacity constraints in absorbing it even in a country as relatively large and populous as Saudi Arabia (compared to some of the smaller GCC peers like the UAE, Kuwait and even Qatar).
Military and Nuclear equipment: The military ties between Saudi Arabia and the U.S. are long standing, and have increased in recent years despite a greater push from Saudi Arabia to seek goods from a range of different markets including European and Asian suppliers and to ask all of these producers to consider producing more in Saudi Arabia to meet jobs requirements. With the Chinese piloting some equipment co-investment and transfers, expect the U.S. military contractors to follow suit, though it remains to be seen how many Saudis will be employed. Watch also for the details on any nuclear program – U.S. interests are loath to see it go to an Asian or European competitor but it remains to be seen that congress will support enrichment programs. Negotiations will likely continue just as efforts to “fix” the Iran deal continue. It could be an issue that divides the republican party.
Technology focus and technology transfer: A big part of the U.S. visit includes stops in Silicon Valley, where MBS is likely to check in on existing investments, announce new ones, look to consider new ones and encourage tech companies to set up operations in Saudi Arabia. Many of the existing investments include at least implicit quid pro quo considerations that would encourage local investment. At this point, the focus on the tech investments seems to be primarily about having marquee investments and greater clout with technology transfer secondary. Again this is a key area of diversifying within the USD portfolio. Expect the Saudis to seek assurances that their pledges will be allowed to go ahead in the environment where more tech deals are blocked.
Local issuance goals - for Capital raising or local transfers: While the focus has been on the Aramco IPO, Saudi Arabia is becoming a more major player in EM/Frontier credit and equity may follow. Already in 2017, the GCC, led by Saudi Arabia was one of the dominant USD debt issuers and along with Argentina one of the largest at a time when many countries are focused on local issuance. Although Saudi Arabia and peers are off index (not in the JPM sovereign indices), they are an increasing part of an asset class that has been facing lower issuance. Watch for this to continue in 2018 despite the rise in oil prices, leveraging the interest of USD-tied investors including many in Asia.
Privatization on the equity side is key too. Expectations have already been lowered about the timing and near-term international footprint of the Aramco IPO, especially during the British leg on the trip. Explanations for the delay vary but mostly seem to reflect questions about valuation, transparency and local market development. Recent statements from the Aramco leadership point to concerns about NYC cases against major oil companies, while concerns linger about litigation related to JASTA and some U.S. activists are hoping for a chance to use competition rules on OPEC. Beyond concerns about disclosure and price, it remains to be clear how the Saudi authorities will approach the IPO and which of the priorities will win the upper hand. Is the primary goal to unlock capital to re-capitalize the Public investment fund and other projects? How does that interact with or interfere with securing a high valuation? Is Aramco comfortable with So far, the only thing that seems clear is that there will eventually be a local IPO, which is hoped to boost liquidity on the Tadawul (a challenge since the drop in oil revenues which reduced, and which could serve in part as a wealth transfer to select Saudis as IPOs have done in the past. The recent announcement that oil revenues in excess of the budget will find their way to the PIF, may relieve some of the pressure to issue equity in the near-term.
Rachel's musings on macroeconomic issues, policy and more.