Month: February 2018

Geopolitics and Asia’s growing role in the Oil Markets

British Petroleum’s annual energy outlook published this week (BP -energy-outlook-2018.pdf) highlights the enormous shifts taking place in the supply and demand for oil and other fuels. Energy consumption drives development and higher living standards, and, over the past 100 years, oil politics have heavily influenced international relations. Much of Post WW II geopolitics has been influenced by the growing dependence of the industrialized world on unstable sources of oil supplies from the Middle East. But the future is now starting to look very different, as dependence on the Persian Gulf oil  is moving from the U.S. and Europe to China and India.

Long the dominant oil importer, the U.S. will soon be self-sufficient, because of rising shale oil production. As shown in the charts below, U.S. oil output is returning to levels last seen in the early 1970s, and imports are approaching zero compared to a peak of 12.5 million barrels per day 15 years ago.

On the other hand, Asian demand, mainly from China and India, is ramping up.  China started to have a significant impact on oil markets in the early 2000s, and now  it is India’s turn. Asia’s growing share of global imports is shown below in a chart from the BP report.

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As I discussed in a previous blog ( India-urbanization-and-a-new-commodity-bull-market), India is having  growing impact on commodity markets. Indian oil consumption has increased by nearly 5% a year since 1990, growing from 1.2 million barrels/day to 4.2 million b/d. In 2016, India surpassed China has the largest contributor to marginal global demand for oil. India’s production meanwhile it around 700,000 b/d, and not expected to grow much, so India’s impact on the oil market will only increase with time. China and India are expected to import 9.5 million  and 3.7 million b/d in 2018, respectively.

Over the next twenty years, according to BP, demand for oil will start to decline in the OECD countries. As shown in the chart below, almost all demand growth will come from Asia.

The global oil market over the next decade will become almost completely Asia-centric. With its geographical proximity to the Persian Gulf and its historical and cultural ties, it is highly likely that India will become increasingly influential in the region. Both India and China will step into the vacuum left by the U.S. as it loses interest in the region, and this may lead to fascinating developments in our increasingly multi-polar world.

Fed Watch:

India Watch:

China Watch:

China Technology Watch:

  • China on the leading edge of science (The Guardian)
  • China’s Uber killer ((Wired)
  • How China became a tech superpower (Wired)
  • China shows of tech in Spring Festival Gala (SCMP)

EM Investor Watch:

  • Unlocking Indonesia’s digital opportunity (McKinsey)
  • Transparency International 2017 Corruption Index (Transparency)
  • Turkey’s challenges in the Black Sea (CSIS)
  • The future of economic convergence (Project Syndicate)
  • The decline of governance in Turkey  (The Economist)

Investor Watch:

 

 

 

Where are we in the Emerging Market Cycle?

 

The increase in volatility in global financial markets over the past several weeks has raised concerns that the rally in emerging markets equities may come to an end. The market uncertainty is caused by the conflicting stances of U.S. monetary and fiscal policy; while the Federal Reserve is intent on tightening monetary policy, the Republican Administration has embarked on massive fiscal expansion. The fear is that fiscal pump-priming in an economy near full-capacity will boost inflation and compel the Fed to accelerate interest rate hikes, which could impact demand for riskier asset classes such as EM equities.

There is no question that the fiscal expansion being engineered by Washington is unusual policy this late in the business cycle. The current U.S. economic expansion, now in its ninth year, looks mature, given low unemployment and scarce idle capacity in the economy.  The Republicans hope to trigger a sustainable boost in U.S. GDP growth, to 3% or above. However, given expected labor force expansion of 0.5% and recent annual productivity growth of 1%, any growth above 2% will be ephemeral. Unless higher growth does materialize, the policy is expected to engender huge fiscal deficits in the years to come. This will happen at a time when private savings have collapsed to record low levels. This means that fiscal deficits will have to be financed by foreign savings, resulting from higher trade and current account deficits. U.S. personal savings and expected fiscal deficits are shown below.

In the past, rising current account deficits in the U.S. have been favorable for  emerging market asset prices. Large U.S. deficits signify a strong, late-cycle U.S. economy. This is typically accompanied by a weakening dollar and increased global liquidity,  which is  very beneficial for emerging markets. The last time we saw this was between 2003-2008 when twin deficits in the U.S. led to a weak dollar and booming asset prices in emerging markets. The reason that this happens is the following: 1. The overheated U.S. economy results in large current account deficits; 2. Surpluses accumulate in foreign central banks which intervene in currency markets to avoid accelerated appreciation; 3. These surpluses are very difficult to sterilize and stimulate credit and economic activity;4. As investors see currencies and markets appreciate they pile into the markets, causing additional upside pressure on asset prices.

As the U.S. economy strengthened over the past two years and the output gap was closed, this process already started. EM currencies and asset prices had reached very low levels in 2015. Now, after outperforming developed markets for two years, EM equities are no longer dirt cheap, but they are still very inexpensive relative to U.S. equities. We are probably about mid-cycle for EM. Economies are starting to gain some traction and equities are reasonably priced, at about historical averages. If the cycle progresses normally, we should see increasing liquidity push asset prices considerably higher for at least the next twelve months.

In contrast to the U.S., most EM economies are in the early or mid-stages of their business cycles, and the commodity-rich economies are just exiting from the deep slump caused by low commodity prices in recent years. Commodities also benefit from the overheated U.S. economy and the weak dollar, adding fuel to the emerging market cycle. The chart below shows were EM countries lie in the business cycle.

Of course, there are risks to this scenario. What could abort the global liquidity cycle?

  • An acceleration in U.S. inflation, triggering more aggressive Fed policy is a possibility. If U.S. inflation where to spike above 3%, the Fed would likely respond aggressively and could provoke a recession.
  • Trade Wars. U.S. tariffs and subsequent retaliations, would be inflationary and create uncertainty.

The most benign scenario for emerging markets is for a continuation of the trends of the past several years; this is a “Goldilocks” scenario of disappointing GDP growth and stubbornly low inflation, which allows the Fed to pursue its gradualist, “asset-friendly,” strategy. This is probably the most likely scenario at this time, and it could mean the extension of the business cycle for another year or two, in an environment of ample global liquidity.

Higher volatility in financial markets could also be a positive new element, to the extent that it caps enthusiasm for U.S. equities and allows emerging market equities to attract more flows and continue to outperform.

Fed Watch:

India Watch:

  • India is starting to move the oil markets (Oil price)
  • India needs to create salaried jobs (Livemint
  • RBI warns on Modi’s budget (QZ)
  • India’s protectionist budget (Swarajyamag)
  • India launches Modicare (Swarajyama)

China Watch:

  • China’s shadow banking system (BIS)
  • Shandong Ruyi textile group buys Bally luxury shoes (SCMP)
  • Cruise ship industry is booming (WSJ)
  • China and free trade (NYtimes)

China Technology Watch:

  • China is winning the battery war (WSJ)
  • China and the AI war (Science Mag)
  • Interview with JD.com’s Richard Liu (Youtube)

EM Investor Watch:

  • The enlightenment is working (WSJ)
  • Costa Rica runs 300 days on renewables (VT)
  • Inflation stalks Macri in Argentina (WSJ)
  • Why South Africa matters (FT)
  • Which emerging market is emerging (Seeking Alpha)
  • PDVSA’s workforce is jumping ship (Oil Price)
  • Traders warn EM rally is ending (Bloomberg)
  • Brazil’s hedge-funds boom again (Bloomberg)
  • Reasons for Brazil’s credit dysfunction (AQ)
  • Brazil’s PagSeguro IPOs on NYSE (Bloomberg)

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

  • The decline of buy and hold (Seeking Alpha)
  • Munger says bitcoin is noxious poison (FT)
  • On the future of active investing (Forbes)

 

 

Big Macs and Emerging Markets

The Economist’s Big Mac Index looks at the dollar cost of a hamburger sold by McDonald’s restaurants in some 60 countries. The index shows a remarkable range of prices around the world. In the latest survey, the most expensive burger was found in Switzerland ($6.80) and the cheapest could be bought in Ukraine ($1.60). Presumably, these hamburgers are identical, with the same combination of bread, beef patty, lettuce and sauce in every unit. The price in each country should reflect the cost of the materials, labor and rent, as well as profit margins and taxes. The index pretends to shed some light on the relative costs of doing business in different countries, and, given that it has been measured for some 30 years, it can also provide an indication of the evolution of business costs. Moreover, it can be used as a proxy to  measure the relative competitiveness of currencies around the world.

The results of the January 2018 survey are shown below.

A Few observations:

  • No surprise to see Switzerland and Scandinavian countries at the top, where they have been for a long time. This makes sense, given high labor costs and value added taxes in these highly productive economies.
  • The high ranking of the United States is relatively new. The U.S. had ranked in the third and fourth decile, until 2016. This is the consequence of U.S. dollar strength, and a very surprising 4.1% annual increase in prices, more than twice U.S. inflation.
  • Brazil is back in the top decile, and it secures its place as the most expensive burger in emerging markets. Brazil is a complete anomaly, the only EM country in the top 20, and this in spite of being an extremely competitive producer of beef and other agricultural product. The high ranking is caused by the chronic overvaluation of the real, excessive business regulations and very high taxes. It will be interesting to see whether the recent labor reform can result in lower costs and if a significant fall in interest rates over the past year will lead to a weaker currency.
  • Turkey has fallen to the bottom decile for the first time in over a decade, the result of a weak economy and currency devaluation.
  • The traditional export-focused countries all maintain competitive currencies and cheap burgers. Of the Asian countries, only South Korea appears in the top half. In Latin America, Mexico remains very competitive.

The charts below show Big Mac prices relative to the U.S. price over the past twenty years, by region.

Asia is characterized by consistently stable and low prices. Chin has seen the most appreciation, caused by the appreciation of the yuan.

Latin America is characterized by unstable prices, with episodes of high overvaluation. Mexico is the exception, maintaining a more stable and competitive peso which is essential for its export-driven economy.

In Europe and Africa, Turkey behaves more like a Latin American market. After several decades of abusing with current account deficits, Turkey has had to devalue the lira to regain competitiveness. Russia, on the other hand, has managed its currency relatively well in spite of the volatility of oil prices.

For comparative purposes, the table below shows the REER (Real effective exchange rate), since 1995.

  • High volatility in Brazil and Turkey.
  • Gradually appreciating currencies China and Indonesia.

Fed Watch:

  • Gray Shilling on the Fed (Shilling)
  • World Finance in peril (Telegraph)
  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

  • RBI warns on Modi’s budget (QZ)
  • India’s protectionist budget (Swarajyamag)
  • India launches Modicare (Swarajyama)

China Watch:

  • China and free trade (NYtimes)
  • China mulls gambling on Hainan (SMH)
  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)

China Technology Watch:

  • China and the AI war (Science Mag)
  • Interview with JD.com’s Richard Liu (Youtube)
  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)

EM Investor Watch:

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch:

Emerging Markets and the Global Allocation Process.

Emerging market countries now represent over 40% of the global economy, and over 60% of its growth. This will only increase in the future. The IMF forecasts that emerging markets will grow a nearly three times the pace of developed markets over the 2017-2022 period, led by India and China. These two countries increasingly dominate EM investing. The two markets are relatively easy to invest in because of an abundance of large firms with liquid stocks, and they are becoming more and more attractive as companies tap into the world’s two fastest growing pools of middle class consumers.  Yet most investors in wealthy countries have very little invested in EM, and consider anything above a 10% allocation to be near-reckless. This is mainly because of “home-country bias” and investor preference for the familiar. However,  given the nose-bleed valuations in the U.S. and the relatively cheap stocks in EM, it is a risky allocation strategy to pursue. This was the point made recently by GMO strategist Jeremy Grantham when he encouraged his clients to put as much of their assets in EM as they can possibly stomach (GMO).

In addition to providing growth, emerging markets also provide significant diversification benefits. With only little over 40% correlation with the U.S., combining EM with an investment in the S&P500 reduces volatility by about 2.2%.

The diversification effect occurs because EM and the U.S. market tend to trend in opposite directions for extended periods of time. Because of links to the U.S. business cycle, Federal Reserve policy and the U.S. dollar, EM tends to perform well when the U.S. dollar weakens, providing a strong diversification benefit to dollar-based investors. The dollar typically weakens when global growth is strong and investors raise their appetite for “risky” EM assets. The weak dollar creates liquidity and credit in EM economies, resulting in strong upswings which are very rewarding for equity investors.

A simple strategy of rebalancing an EM index and the S&P500 provides surprisingly positive results. Rebalancing a 50/50 portfolio with the two assets increases returns while significantly reducing volatility over long holding periods. This is shown in the table below.

Moreover, significantly enhanced results can be achieved by adding some complexity to this strategy.

First, adding a timing tool, such as one-year relative momentum or a 200-day moving average, is effective. This allows the investor to stay fully invested during the long uptrends and avoid steep drawdowns. Such as strategy pursued over the past twenty years has produced annual returns of 13%, nearly double the returns provided by a 50/50 mix of and EM index and the S&P500 Index.

Second, the EM portfolio can be tilted towards the cheaper countries, also re-balanced on a periodic basis. Countries coming out of large down-cycles and trading with valuations well below their historic averages can be over-weighted as they initiate their recovery processes  (The Next ten years in EM ).   Boom-to-bust cycles are a feature of emerging markets, and the investor should have a well-defined methodology to exploit them for enhancing returns.

Lastly, an astute investor can create additional value (alpha) by  methodically tilting the portfolio to certain factors and picking superior stocks. My personal experience is that this can be achieved most effectively with a replicable,  formulaic approach. My preference is for a “Warren-Buffet-like” ranking of stocks in terms of both quality and profitability, building a screen which identifies stocks with the ability to compound high returns over time and that are valued at relatively low valuations.

 

Fed Watch:

  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

China Watch:

  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)
  • Davos; MNCs troubles in China (Holmes Report)
  • China’s rise is over (Stanford Press)
  • Dockless bike-sharing in China (Bikebiz)
  • Bridges to Nowhere, Michael Pettis (Carnegie)

China Technology Watch:

  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)
  • China’s rental market takes off, led by techs (bloomberg)
  • The life of an express delivery man (FT)

EM Investor Watch:

 

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch: