Issue 103 – December 7, 2015
Geopolitics & Markets
The latter half of 2015 has witnessed a remarkable set of global events. From the potential exit of Greece from the Eurozone, to the challenges accompanying the rise of the consumer society in China, to the economic agreement with Iran, to the incredible refugee exodus, to the tragic terrorist attacks; markets have had far more to consider than traditional economic and market inputs. We are not macro investors. We do not invest in countries or based on geopolitical winds. We invest in companies and high quality loans. However, the pace and the magnitude of the recent events will certainly have implications for central bankers as well as individual markets and instruments as we move into the new year.
In This Edition
Geopolitics & Markets
Chinese Consumers take Center Stage
Iran’s Re-entry into the Energy Markets
The Rise of Volatility
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The founding documents of the Eurozone, the 1992 Maastricht Treaty and
its Schengen Agreement which allows for the free flow of goods and persons
among 26 nations, did not contemplate or provide any consideration for steps
to handle a refugee crisis. This was
certainly not the fault of those who worked to design this union almost 25
years ago. What we are seeing is not
something out of the 21st century.
However this crisis has laid bare in terms far more stark than any
previous economic challenge, that there is indeed an “Achilles Heel” in its
design. The Eurozone has never truly
operated as a fully functioning integrated entity and its member countries
have never subjugated their national interests and self determination to
their leaders in Brussels. The
economics have always been challenging but the events of Paris have now
catalyzed discussions around ways to form potentially smaller unions of those
countries with more similar economics and needs.
In terms of impact to securities markets, a crisis is never a welcome event. However, if we think back to the summer
where we were once again struggling with the dilemma as to how to fit a Greek
economy into a German framework; a fresh start outside of the current
Eurozone for Greece is precisely what many had suggested would be the
ultimate reality. The level of
economic mobility that we enjoy here in the US has never been present in the
Eurozone. Greeks don’t easily move to
Finland for example and the common currency has made it impossible for the
weaker financial members like Greece to correct for their trade
imbalances. These countries are for
all practical purposes on an inflexible “gold” Euro standard. To the extent then that the geopolitical
events force a new mindset and the open discussion of previously taboo options,
then we may be finally seeing the beginning of the next chapter rather than
the end of the Eurozone. A more
rationalized union or set of unions rather than the current one size fits all
structure could prove to be enormously therapeutic. It could provide the environment for the
struggling members to clear their debts while promoting more efficient trade
among the others. The original premise
of the union was not exclusively to promote economic activity but to bolt the
largest signatories, Germany and France, together in such as a way as to
preclude further warfare. The thinking
then followed that a combined “Europe” would be an economic powerhouse on par
with the US. These founding principles
could be argued to have now run their effective course. The technology and needs of 21st century
diverse Europe will drive these conversations and potential changes.
As to the investing implications, these challenges will likely add tailwinds to the quantitative easing programs currently underway across the Eurozone. Lower interest rates, a weaker currency, and low energy input pricing will be used to offset weakness brought about by any potential changes in the flow of goods. Large cap international companies continue to trade a meaningful discount to their US S&P peers and thus the sector will continue to capture flows from value oriented investors.
Chinese Consumers Take Center Stage
While the drop off in the growth rate of Chinese demand for raw materials has been front page news since the summer, the coincident rise in their service sector has been largely missed or ignored. David Rosenberg of Gluskin Sheff in Toronto, wrote on November 23rd;
“The new Chinese super-cycle in services, which are accelerating at double digit annual rates and now account for over half of GDP…China’s service sector has been expanding for 40 months in a row.”
This is precisely the transition that the entire world wants to see
China make and while it will not be smooth nor easy to accurately measure, it
will be no less real and a vast improvement over the reckless building
bridges to nowhere etc. Furthermore,
we have remarked on many occasions as to the dubious accuracy of our own US
economic releases. Measuring any
society which is driven by consumer behavior rather than manufacturing will
continue to be more art than science whether it be here or abroad.
In addition to the positive strides in service consumption, China’s
currency, the Yuan, was added to the International Monetary Fund’s Special
Drawing Rights basket on November 30th.
The SDR was established in 1969 as a global reserve currency to
increase the available float of acceptable currency to settle accounts
between central banks. The other
members of the SDR are the US, Japan, the United Kingdom, and the
Eurozone. While this event may strike
many as an “inside baseball” type of an event, it does mark the end of a five
year effort to include the Chinese currency into the SDR and more importantly
it demonstrates that China is willing to work within the parameters of
established Global financial structures.
China’s overall slower growth rate should be viewed within the context of the fact that it a vastly larger economy today than it was a decade ago and thus their absolute level of demand remains robust. Emerging markets indices and commodity centric producers have been hit hard by Chinese weakness real and imagined, as well as the strengthening of the US dollar. But not every company is under stress and the value proposition in the emerging markets remains compelling.
Iran’s Re-entry Into the Energy Markets
October 18th marked the official Adoption Day of the “Joint
Comprehensive Plan of Action” for Iran.
From here, Iran will notify the Atomic Energy Agency of a future date
(Implementation Date) when they will provide the Additional Protocol to allow
the inspectors to do their work. This
would then mark the point when economic sanctions could be lifted. The biggest impact in this regard would be
the return of Iran to a fully functioning member of OPEC. Oil markets have throughout the year
reacted to Iran’s return and their potential additions to what is already a
currently oversupplied crude oil market.
We have noted in previous newsletters that there is great deal more to
be done before Iran will be able to substantially improve upon its current
three million barrels per day production.
The Wall Street Journal on December 2nd ran a thorough summary of
these issues in an article entitled “Iran’s Oil Revival Springs a Leak”. http://www.wsj.com/articles/irans-oil-revival-springs-a-leak-1449061601.
Included in their concerns:
· The age of the oil field infrastructure, in most cases 40+ years old.
· The lack of sophistication in maintenance operations as western expertise has been absent.
· Contracts for new business which prohibit either the owning of reserves or independent operation.
· Tehran’s demands to control the destination of crude oil.
· Interest by foreign companies at today’s low prices.
Energy markets have been searching for equilibrium since the 4th
quarter of 2014 when the Saudis took the unprecedented action of increasing
their production into what was already a well-supplied market. Their potential motivations for this action
have been debated for the past year. Was it to put economic pressure on the
Iranians given their imminent return to OPEC?
Or perhaps was it to crowd out or potentially collapse higher cost
producers in areas such as those deep offshore, the Arctic, or the US shale
regions. Whatever the precise
reasoning, their actions have caused pain for all producers themselves
included. The financial strain on the
Kingdom has become readily apparent as they have had to liquidate some $100BB
of sovereign savings to help support their large social service payments. In addition, they are looking to the New
Year to begin issuing debt. Other cartel member are furious with the Saudi’s
all out production approach. The
dramatic drop in price has created enormous social and financial challenges
for the likes of Venezuela, Libya, Nigeria, and Iraq. Meanwhile, US producers have perhaps fared
the best as they have become dramatically more disciplined in their practices
allowing them to continue production at 2014 levels with cost reductions of
some 40%+. From their collaborative
approaches and sharing of technical expertise, the industry has confounded
those who prematurely announced their demise.
The question then of where do oil prices go from here appears to be
more one of timing than of direction.
More than $200BB of high cost exploration projects have been scrapped
in this downdraft with certainly more to come. However with global proved developed
producing oil field depletion rates of 5-7% per year and global growth requirements
of 1-2% expected, there will come a time when the world very quickly tips
from over to under supplied at current prices.
With short term, yield-oriented investors on edge over the potential of a modest rate increase coming later in the month, prices of income producing energy related assets are being sold recklessly. But these short term distressed sales should prove to be just that. As energy markets find stability once again, investors will recognize the opportunity in these securities.
The Rise of Volatility
We referenced in our September 2015 newsletter the changing nature of
modern markets. With more exchange
traded funds, smaller bond coupons, and fewer market makers, volatility is
going to be higher. These structural
changes have proven to be a very unwelcome development for those investment
firms who have focused on short term results.
Hedge funds have had a miserable 2015 with many prominent firms
returning client funds and closing strategies. The reason is simple: increased volatility is unmanageable for
those who operate in 90 day cycles.
Consider for example the recent performance of the S&P. The index was down almost 7% for the second
quarter but is already up some 9%+ thru this writing. That is a 16% swing in the matter of a few
months and on the largest presumably most stable equity index in the US
market. A wrong footed hedge fund
cannot recover from such a whipsaw given their quarter to quarter
existence. Investors, on the other
hand, with a longer term horizon can consider what a down 7% market has on offer
and does not need a snapback recovery to enter into a successful
position. Their risk return is
predicated on value rather than value which must be recognized in a short
time frame; an investor versus what is essentially a short term option
The final weeks of 2015 will feature the last Federal Reserve meeting
of 2015. Many now believe that the
committee will vote in favor of raising their benchmark rate by 25 basis
points. We have argued for some time
that the devil is in the details and regardless of what the committee may
say, the actual increase in short rates will be negligible given the
mechanics required. This reality is
further exacerbated by the timing of year end which always puts additional strain
on the back offices of financial markets.
As we head into the final few weeks we want to wish you all a safe and happy holiday. We appreciate the trust you all place in us and we look forward to working with you in the New Year.
Jen & Patsy