Checking for a pulse

Published at 14:26 22 Nov 2019 by . Last edited 15:52 22 Nov 2019.

Please note that, owing to the Thanksgiving holiday, there will be no Macro Digest next week. The following week, we will be reporting on the OPEC meeting and will publish updates as needed from Vienna. Normal Digest service will resume on 13 December.

This time last year, both credit and equity markets were weakening, leading to major capitulations in risk assets. Markets, fearing a repeat this summer, were positioning with a number of risk assets pricing in a recession that has not materialised. With the Fed cutting rates three times since August and hopes still lingering for a US–China trade deal, investors have been unwinding their end-of-the-world trades. Crude’s outsized moves in the last two weeks relative to news flow and fundamentals would reinforce this view.

Notably, there has been an unwinding of these ‘recession trades’. Value stocks have been outperforming growth stocks, emerging market (EM) equities have outperformed the US, and the dollar is off of its highs of the year. To be clear, and again unlike last year, these are not uniform price moves across asset classes. Rather, those assets that had been heavily discounted in anticipation of a recession before year-end are bouncing back, as it looks like the Fed has, for now, managed to stave off the worst.

Fig 1: WTI vs 200 day moving avg, $/b Fig 2: Brent ($/b) vs USG 10 year treasury yield
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Whether proper reflation trades are entered in earnest still depends on how the US–China trade dynamic evolves. If the negotiations still have a pulse, then the market is quite happy to wait for the mid-cycle adjustment, as espoused by the Fed, to pan out. But whether that materialises or not could depend on whether the US and China can continue to kick the can down the road as they have done for the last year (a deal was mooted at the Buenos Aires G20 last year, delayed to spring, then summer, and then to APEC, which was then cancelled).

To that end, Chinese negotiators are pressing the US hard on the US to relax tariffs—both existing ones and those set to take effect on 15 December. At the same time, Chinese officials have been resisting US requests to guarantee China’s offer to buy more US agricultural products. Moreover, disagreements remain over how to get Beijing to better protect American intellectual property and stop pressuring US companies to hand over technology. In short, we are pretty much where we were last April. Not much has changed. But they continue to talk.

Beijing believes that it has leverage over President Trump, who needs a win in the midst of the impeachment inquiry and his bid for re-election next year. But the Chinese leadership, which wants a deal to relieve pressure on the economy, risks overplaying its hand. Anti-China voices in Washington are growing louder, which could pressure President Trump to toughen his position, too.

Interestingly, while the hard data have yet to show a major turnaround in global economic conditions, some of the soft data are beginning to signal a rebound. Certainly, some risk assets look like they are pricing for a rebound. The next month will be crucial in determining whether the global economy will accelerate again in 2020, or if doom and gloom is set to return.

Fig 3: Global equities vs PMIs Fig 4: Growth vs value stocks (%)
Source: Bloomberg, ISM, Energy Aspects Source: Bloomberg, Energy Aspects

The Fed believes it has done enough and has firmly shifted from tightening to easing. For the first time in many years, you have the Federal Reserve, the European Central Bank and the Bank of Japan all easing at the same time. The Fed is injecting liquidity at a time when budget deficits are going through the roof. With both fiscal and monetary policy loose, the belief is that this will ultimately be inflationary. If the economy does not move into recession, risk assets will benefit from this posturing, especially as the Fed has clearly signalled that it will be reactive, meaning it will risk much higher inflation to stave off another downturn. The real question is whether this is simply a dead cat bounce from the structural trend of the last 10 years or if the narrative has changed. The pervasive view in the market is that all of the negativity this year has been triggered by the trade war. Thus, so long as the trade war does not materially worsen from here, we think this will be positive risk. The next month is likely to set to the tone for 2020.

Neither country has any incentive to capitulate on the trade demands of the other. But at the same time, they also stand to lose a lot if they pull the plug on these negotiations. Both sides lose in such a scenario. Could the market be lulled into a false sense of security if the US and China continue to simply ‘kick the can’? We think yes. As long as the US–China trade talks still have a pulse, the narrative does not worsen, and the Fed remains accommodative, the markets will focus on the data and the liquidity being injected by central banks. Such a scenario should be risk positive.

Fig 5: US broad dollar index Fig 6: S&P sector performance (%)
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

The last straw
This year will be marked by civil unrest in all four corners of the world, and there seems to be a common theme among several of the ongoing protests. In France, the yellow vest movement was triggered by an increase in the gasoline tax. In Chile, the APEC summit had to be cancelled following violent civil unrest triggered by a 30-peso (roughly 4-cent) increase in subway fares. In Lebanon and Iraq, demonstrators have taken to the streets to protest against bad governance and economic conditions. And most recently in Iran, protests against a gasoline tax increase that many see as inequitable have led to over 100 deaths.

Central banks keep saying that inflation is nowhere to be found, and of course that can be true when they strip out important inputs like energy and food. This matters because employers do not feel obligated to increase wages due to the lack of uplift in inflation (even the protesters in Hong Kong have reportedly chanted defiantly that they do not fear jail cells since they are larger than the apartments they can afford). But the reality for most people is that each month they have less and less in their bank accounts. If central banks cannot find inflation, then they simply are not looking hard enough.

In Iran, the response from the regime has been swift and somewhat reflexive. Given what they have seen in Iraq, Lebanon, Chile and France, there is perhaps some urgency within the Iranian leadership to ‘nip this in the bud’ before it takes on a life of its own. After all, who could have known that the self-immolation of a Tunisian vegetable vendor in December 2010 would be the spark to ignite the Arab spring and lead to the toppling of the regimes in Egypt, Tunisia and Libya within a year. For Iran, which used to be able to claim that the Arab spring was a purely Sunni phenomenon, the uprisings in Lebanon and Iraq had a distinctly Shia flavour. Supreme Leader Khamenei’s claims that they had ‘pushed back the enemy in military, political and security war arenas’ is the reliable refrain that most autocratic regimes default to in blaming outsiders and externalities for their woes.

Iran’s sensitivity to these demonstrations is being amplified as its conflict with the US intensifies across the region. The pressure from US sanctions, and people’s anger about the lack of any benefit from the nuclear deal, all serve to reinforce the Trump administration’s narrative that the Iranian regime should spend less on arms and weapons and more on its people. The Iranian leadership now fully understands that the sanctions are going to be in place for a very long time, perhaps even outlasting the current Trump administration. Khamenei himself noted in a speech earlier this week that ‘hope that [the sanctions] will end in a year or two is false, and these sanctions will remain for a while’. But also, cognisant of the social tinderbox that was building in his country, he also noted that ‘Islam believes in producing wealth and increasing social welfare. Some have more, but [distributing] public resources must be fair. Naturally in an Islamic system, there isn't that class divide.’ Indeed, the government is attempting to soften the impact of the gasoline price increases with cash handouts for the majority of its poorest citizens. These demonstrations are not insignificant.

For both Iran and Iraq, the immediate threat to oil production remains limited, unless oil workers join calls for strikes. Even then, it would depend on what the goals of the strikes would be.  

Saudi Inc.
By publishing a prospectus on 10 November, Saudi Aramco has begun the countdown for its much-anticipated IPO, which will list it domestically on the Saudi stock exchange. Most international investors have balked at the $1.6 trillion valuation, leading the Kingdom to cancel its international road shows and instead focus on domestic investors.

The consensus among western investors is that there is too much risk associated with Aramco relative to an over-ambitious valuation. In short, the key incremental value add for the stock is higher oil prices. The company has committed to paying a $75 billion annual dividend through 2024, after which the dividend would become discretionary. The company is also committed to paying royalties of 40% if oil prices stayed below $70 per barrel, 45% with oil prices at $70–100 per barrel, and 80% over $100 per barrel. But if the upside is capped (via the royalty regime, and possible OPEC production constraints, etc.) many investors are asking why they should buy such an asymmetrically negative instrument like the stock—which still leaves them exposed to downside, while capping the upside—at an inflated valuation, especially with Aramco 10-year bonds yielding 3.1%. As one investor said to us, ‘if you want yield and limited downside, just buy the bond’.

The reality is that much of the ‘value’ of Aramco is derived from the assumption that is made on oil prices going forward. The math matters. For example, if one assumes an operating income starting point in 2018 of roughly $213 billion—which was earned in a year when Brent crude prices averaged just over $71 per barrel—the valuation is very different than if based on a 2017 baseline when oil prices averaged $54 per barrel. With the futures curve currently pegging Brent at $60 in 2029, many investors were reluctant to adopt a higher price assumption. Operating income using a 2017 baseline comes in closer to $156 billion, which would drop the valuation by 25–30%. We have seen estimates that peg the valuation at under $1 trillion. As with most things in life, the outputs are only as good as the inputs.

Aside from the fuzzy math, there are many risks associated with owning shares in Saudi Inc. Ultimately, investors are asking themselves what they are actually investing in: a company or a country? The demarcation between corporate Aramco and the Saudi state remains murky. Increasingly, investors view themselves not as shareholders but simply as capital providers. Moreover, there is tremendous country risk now associated with the Kingdom, given the conflict with Iran and Saudi Arabia’s adventurous foreign engagements in Yemen, Libya and Syria. The attack on Abqaiq only amplified this risk. Moreover, there is political risk associated specifically with the Saudi leadership. Crown Prince Mohammed Bin Salman may be the driving force behind economic reform, but he has also proven to be an erratic leader, and questions regarding how long he will remain a reformer still linger.

The domestic listing remains a first step for the Kingdom, and it is very important from a domestic credibility standpoint. The royal family wants to make sure that the ‘people’ can benefit from this to avoid any semblance of impropriety. Whether there will be an international listing will depend on a number of factors, chief among them how Aramco internalises and incorporates the feedback that it has received. Time will tell.

If the Saudis really want higher oil prices, then they should use some of the IPO proceeds to buy US agricultural products on China’s behalf and help catalyse a US–China deal. That could be the cleanest way to secure higher prices in 2020.

Yasser Elguindi
Head of Macro Energy
+1 646 760 8100 (direct)

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