Disequilibrium

Doug Nolan


Much to the consternation of our allies, President Trump withdraws from the Iran nuclear deal. WTI crude adds another 1.5% (up 17% y-t-d) this week to the high since November 2014. Iran and Israel moved closer to direct military confrontation. With even 40% rates unable to staunch the bleeding, a stunned Argentine government warily negotiates an IMF bailout. Italy's far right and far left parties - both populist, anti-establishment, anti-euro and anti-immigration - begin negotiations to form a coalition government. Malaysians elect 92-year old Mahathir Mohamad, ending the 60-year reign of the Barisan Nasional party (including Mahathir as prime minister between 1981 and 2003).

Some astounding developments, but not enough these days to shake financial markets. Why fret a complex and increasingly unstable world, not with the timely return of Goldilocks. She's back… Headline U.S. April CPI was up 0.2% vs. expectations of 0.3%. Core CPI was up only 0.1% against expectations of 0.2%. April Import Prices were up 0.3% vs. estimates of 0.5%. Forget surging energy prices, rather quickly the rosy narrative shifts to peak inflation.

May 11 - Reuters (Howard Schneider): "St. Louis Federal Reserve Bank President James Bullard on Friday spelled out the case against any further interest rate increases, saying rates may already have reached a 'neutral' level that is no longer stimulating the economy… 'We should be opening the champagne here,' not raising interest rates with unemployment low and inflation in no seeming danger of accelerating, Bullard said… 'The economy is operating quite well right now.'"

I suggest the Fed and global central bankers hold back on carting out the bubbly. "Opening the champagne" is reminiscent of Citigroup CEO Chuck Prince's summer of 2007 "still dancing." Bullard focuses on traditional yield curve analysis. "I would say the yield curve inversion is getting close to crunch time." "The yield curve inversion would be a bearish signal for the US economy if that develops."

I would argue the yield curve has become an especially poor indicator for gauging the appropriateness of monetary policy or predicting imminent recession. "Whatever it takes" monetary management fundamentally altered the structure of global interest rates. Long-term bond prices now incorporate a significant premium based on the expectation for aggressive future rate cuts and bond purchase programs (QE). And the longer the artificially depressed interest rate structure fuels Bubble excess, the greater the long-term bond premium (lower yields) and the flatter the curve. Bubble Dynamics

Bullard proffered additional interesting analysis: "'This is an equilibrium process, not an inflationary one,' Bullard said, and 'it is not necessary to disrupt' it with higher interest rates."

"Equilibrium" with short-term rates between 1.5% and 1.75% - with the Fed having avoided actually tightening financial conditions? Equilibrium with annual Current Account Deficits approaching $500 billion? With the Dow up 18.5% over the past year and the Nasdaq Composite surging almost 21%? With historically low housing inventory and home price inflation significantly above after-tax borrowing costs - and accelerating? With the unemployment rate at 3.9% and businesses struggling to find qualified applicants? With Trillion dollar U.S. fiscal deficits in the offing? With the ECB and BOJ still monetizing debt in large quantities? With 10-year JGB yields at five bps and Italian yields at 1.87%? With still Trillions of negatively-yielding debt instruments globally? Equilibrium with most central banks around the world hesitating to tighten policy - with global monetary policy nowhere in the vicinity of a semblance of normality? Disequilibrium.

May 10 - Financial Times (Robin Wigglesworth): "The investor withdrawal from emerging markets accelerated over the past week, with equity funds suffering their worst outflows in nearly a year and bond funds losing money for a third week running - the longest streak of withdrawals since late 2016… EM equity funds had outflows of $1.6bn in the seven days to May 9, the first weekly outflow since February and the biggest since August 2017… Fixed-income funds focused on the developing world saw their outflows accelerate. Investors withdrew $2.1bn from EM bond funds, the third consecutive week of outflows and the worst one since February. EM debt funds have now suffered outflows of more than $4bn since mid-April."

A decade of ultra-easy monetary policies has ensured deep structural maladjustment. Importantly, "activist" policies have nurtured way too much "money" playing global risk assets. Indeed, global financial speculation has become one historic Crowded Trade. And too much "money" in the game alters market dynamics. The bastardized yield curve is one momentous manifestation. Serial market boom and bust dynamics is another.

The speed by which the EM boom has faltered offers a warning to all. After all, it was only weeks ago that EM prospects were viewed as exceptionally bullish. And with "money" flooding into "developing" markets, it was too easy to disregard structural vulnerabilities and mounting risks. As always, there was ample "hot money" originating from leveraged "carry trades," derivatives and the leveraged speculating community more generally. But these days, with the broad menu of available hot international ETF products, it has never been so easy for retail "money" to jump aboard the EM boom cycle. Jump they did, late definitely not better than never.

This long cycle's EM excesses have been unprecedented. A down-cycle is long overdue. Let's hope the downside can somehow avoid being proportional to this cycle's unprecedented excesses. Outflows have just begun.

May 8 - Financial Times (Benedict Mander and John Paul Rathbone): "Seventeen years ago, economic policies backed by the IMF brought Argentina to its knees. Five years later, then-president Néstor Kirchner severed IMF ties, swearing never again. This week, a run on the currency forced President Mauricio Macri to return to the international lender. On Tuesday, in a televised address to the nation, a sober-faced Mr Macri said assistance from the International Monetary Fund would help 'avoid a crisis like the ones we have faced before . . . [it] will allow us to strengthen our programme of growth and development'. It was a stunning reversal for the 59-year-old former businessman who came to power in December 2015 vowing to make Argentina a 'normal country', after 12 years of leftist rule…"

Argentina was not without its share of responsibility, yet unfettered global finance ran roughshod through Argentine financial and economic structure. At U.S. and IMF insistence, Argentina in the nineties adopted a U.S. dollar-based currency board system. This was to ensure that money supply growth did not exceed dollar reserve holdings, thereby containing inflation and, supposedly, ensuring financial stability. Inflation did collapse, but the Washington-dictated policy regime was a powerful magnet for global "hot money" flows. The currency board held narrow money supply growth in check, yet it did the very opposite for Credit. The onslaught of international inflows spurred massive government and corporate debt growth - too much of it denominated in dollars. The Argentine miracle economy boomed and became the poster child for enlightened "Washington Consensus" policymaking. It was all a Bubble Mirage. Conventional wisdom could not have been more detached from reality.

The Bubble inevitably faltered (2001/2002), and "hot money," as it does, raced for the exits. There were no buyers, no liquidity and meager real wealth to make good on all the debt that had been extended. It was a horrendous collapse and tragedy for the Argentine people, for which they're still suffering some 17 years later. Like many Bubbles before and since, it's amazing how long markets remain oblivious to financial imbalances and mounting structural impairment.

Brazil's 2001 crisis sealed the fate for their neighbor Argentina's flawed dollar currency board regime. Might the unfolding Argentine crisis this time push Brazil over the edge? It's worth noting that Brazil's sovereign CDS rose above 200 bps Wednesday for the first time in eight months. And while it doesn't compare to the Argentine peso's 5.8% drop (down 11.5% in 2-wks), Brazil's real fell 2.0% this week. The Brazilian real is down 4.0% over two weeks and 8.1% y-t-d. Brazil's local currency 10-year yields spiked Wednesday to a 2018-high 10.25% (closed the week at 10.0%).

Mexican local 10-year yields jumped to 7.75% Wednesday, just below multi-year highs, before ending the week at 7.58%. Mexico's peso traded to a 2018 low in Wednesday trading. Now down 5.1% y-t-d, the Indian rupee ended the week at 15-month lows. Hungary's local bond yields jumped 19 bps to an eight-month high 2.80%.

Turkey, another recent EM "darling," saw its currency drop another 2% this week, boosting its two-week decline to 6.3% and y-t-d losses to 12.0%. Turkey sovereign CDS rose another 13 bps this week to a 14-month high 238. Turkish government 10-year dollar-denominated yields jumped 14 bps to 6.66%, nearing the high going all the way back to 2009.

May 11 - Reuters (Ali Kucukgocmen and Behiye Selin Taner): "Turkish President Tayyip Erdogan called for lower interest rates on Friday and described them as the 'mother and father of all evil', triggering a fresh slide in the lira as investors worried about the central bank's ability to rein in high inflation… 'If my people say continue on this path in the elections, I say I will emerge with victory in the fight against this curse of interest rates,' Erdogan said in a speech to business people in Ankara…"

"Evil" is not possessed in too high interest rates - but rather in too much debt. And foreign-denominated debt, which Turkey has accumulated aplenty, can prove the "mother of all evil" when currency crisis devolves swiftly into a full-fledged financial panic. With the lira sinking and inflation surging, Turkey's central bank will likely have no alternative than to raise rates - perhaps aggressively - heading into June 24th snap elections. Lira 10-year bond yields spiked above 14% to an eight-year high in Wednesday trading.

May 9 - Financial Times (Gabriel Wildau): "China credit spreads hit their widest level in nearly two years this week following new regulations that undermined long-held assumptions about implicit guarantees on debt linked to local governments. Chinese localities have long used arm's length local government financing vehicles (LGFVs) to skirt restrictions on direct fiscal borrowing and to finance infrastructure, contributing to a surge in economy-wide debt since 2008. LGFVs are among the biggest borrowers in the local bond market. The spread between yields on 5-year Chinese government bonds and 5-year medium-term notes rated double A minus reached 3.6 percentage points on Monday and remained at that level on Tuesday… Six months ago the spread was only 2.51 points."

May 9 - Bloomberg (Lianting Tu and Carrie Hong): "The average yield on China's junk-rated dollar bonds rose above the 8% mark, fueling concerns of further gains amid a bulging issuance pipeline and the absence of a strong demand from mainland investors. Yields on dollar junk bonds from Chinese firms rose to the highest since April 2016, while those from the broader region yielded 7.4%... It took just 43 days for China's average yield to rise from 7% to 8%, after having taken more than four months for the move from 6% to 7%. BNP Paribas Asset Management expects credit spreads in the region to widen by a further 25-50 bps."

Turkey, China and others may hold crisis at bay for now. Argentina, an EM Bubble weak link, has rather precipitously succumbed. Even as the central bank (with a reasonable quantity of international reserve holdings) hiked interest rates to 40% and the Macri government sent a delegation to Washington to negotiate with the IMF, the currency plunge ran unabated. Argentina less than 11 months ago sold $2.75 billion 100-year bonds at a 7.9% yield.

May 11 - Financial Times (John Paul Rathbone): "A hundred years ago, at about the same time that the Titanic hit the iceberg, Argentina was among the 10 richest countries in the world. Today it ranks 87th. In all, it has defaulted on its debt eight times, suffered hyperinflation twice, and gone through 20 IMF-supported economic programmes in 60 years. The most brutal of these ended in 2001, triggering a $100bn default and crushing devaluation. The spectacular collapse left one in five Argentines unemployed, and with an understandable allergy to anything associated with the IMF. It also led to 12 years of populist rule. All this has made Mr Macri's subsequent quest for 'normality' harder still."

The S&P500 jumped 2.4% this week. EM instability worked to hold 10-year Treasury yields back from the 3.0% breakout level. Timely reports of less-than-expected inflation data didn't hurt either. The S&P500 bouncing off the 200-day moving average helped spur a bout of short covering - and short squeezes can take on lives of their own.

But, mainly, it was another week where U.S. markets were content to disregard myriad risks. And why not? A focus on risk can lead to untimely hedging and reductions in long exposures - and resulting underperformance. And underperforming active managers risk losing only more assets to the ballooning passive index ETF complex. In a world of too much "money" and Crowded Trades prevailing throughout the risk markets, it regresses into a dysfunctional game of disregarding risk and chasing performance. Buy and hold an equities index is, these days, pure genius.

This speculative dynamic, however, is coming home to roost in the emerging markets. At the same time, "developed" market outperformance spurs a rush to play - and talk of Goldilocks and dreams of new eras of permanent prosperity. Serious issues are in play at the "Periphery." It's an inopportune time for complacency at the "Core," let alone exuberance. That Bubble at the Periphery - it's been absolutely historic.

May 11 - Wall Street Journal (Chelsey Dulaney, Jon Sindreu and Saumya Vaishampayan): "The dollar's rise is squeezing bond markets in developing countries like Argentina, Indonesia and Turkey, gutting what had been a popular trade for investors seeking stronger returns. Countries in the developing world have been borrowing heavily, supported by upbeat expectations for global growth and a long period of low to negative interest rates that drove investors into emerging markets to get any sort of yield. Emerging markets added on $7.7 trillion in new debt last year, including bonds and other types of loans, with about $800 billion of that denominated in foreign currencies, according to data from the Institute of International Finance."


How the Beijing elite sees the world

The charms of democracy and free markets have withered for China’s leaders

Martin Wolf



How does the Chinese ruling elite view the world? Over the weekend, I participated in a dialogue between a handful of foreign scholars and journalists and top Chinese officials, academics and business people, organised by the Tsinghua University Academic Center for Chinese Economic Practice and Thinking. The discussion was franker than any I have participated in during the 25 years I have been visiting China. Here are seven propositions our interlocutors made to us.

China needs strong central rule. This idea went with the notion that China is in important ways a divided society: one participant even remarked that 500m Chinese people love Deng Xiaoping’s reforms, while 900m favour the world view of Mao Zedong. Another pointed to the fact that the central government spends only 11 per cent of the total by all levels of government and employs just 4 per cent of all civil servants. Others emphasised that China is a developing country with huge challenges.

The conclusion participants drew was that the Chinese Communist party, with some 90m members, is essential to national unity. Yet corruption and factional infighting has threatened the legitimacy of the party. One senior official even stated that Xi Jinping “has saved the party, the country and the military”. This perspective also justifies the suspension of term limits on the presidency, which, it was stressed, does not mean perpetual one-man rule.

Western models are discredited. The Chinese have developed a state system run by a technocratic elite of highly educated bureaucrats under party control. This is China’s age-old imperial system in modern form. The attraction that western-style democracy and free-market capitalism may have exercised on this elite has now withered. They stressed the failure of western states to invest in their physical or human assets, the poor quality of many of their elected leaders and the instability of their economies. One participant added that “90 per cent of democracies created after the fall of the Soviet Union have now failed”. This risk is not to be run.All this has increased confidence in China’s unique model. Yet this does not mean a return to a controlled economy. On the contrary, as a participant remarked: “We believe in the fundamental role of the market in allocating resources. But government needs to play a decisive role. It creates the framework for the market. The government should promote entrepreneurship and protect the private economy.” One participant even insisted that the new idea of a “core leader” could lead to strong government and economic freedom.
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China does not want to run the world. This sentiment was repeated. Its internal problems are, in the view of participants, too big for any such ambition. In any case, it has no worked-out view of what to do. But, as a senior policymaker insisted, in the specific context of relations with the US, “we must co-operate, to deal with shared problems”.China is under attack by the US. One participant argued that “the US has now shot four arrows against China: over the South China Sea, Taiwan, the Dalai Lama and now trade”. This then is a systematic attack. Many expect this to get worse. That is not because of what China has done, but because Americans now view China as a threat to US economic and military hegemony.

US goals in the trade talks are incomprehensible. People closely engaged in the trade talks are puzzled by what the US is after. Does Donald Trump even want a deal, they wonder, or is his aim just conflict? In any case, top officials say they understand and accept the legitimacy (and value to China itself) of demands for better protection of intellectual property. They also understand the case for unilateral liberalisation, including of financial services. China would, one official suggested, like to make the Made in China 2025 programme a “win-win for the world”. But China’s technological upgrade is non-negotiable. Also, how is China expected to reduce the bilateral imbalance with the US if the latter imposes tough controls on exports of strategically sensitive goods and lacks the infrastructure to ship coal or oil competitively?



China will survive these attacks. The Chinese participants seemed reasonably confident that their country could endure the tests to come. One noted that China is already a huge industrial country. Its manufacturing sector is almost as big as those of the US, Japan and Germany together. It has enormous numbers of skilled people. The economy is also less dependent on trade than it used to be. Furthermore, noted another, US business is highly involved with and dependent upon the Chinese economy. The Chinese people, stressed others, are probably better able to bear privation than Americans. They are also highly resistant to being bullied by US power. Indeed, the Chinese leadership could not ignore public opinion in considering concessions. Whatever happened, some insisted, China’s rise was now unstoppable. (See charts.)



Furthermore, they noted, while China cannot challenge US global military dominance, that is less the case in the western Pacific, where China is increasingly potent. In the longer run, China will develop a “first-class” military.This will be a testing year. China and the US will have a complex and fraught relationship over the long run. But, one participant remarked, “this will be a testing year. If it goes in the right direction, it will be fine; if it goes in the wrong direction, it will be earth-shaking.” The progress made over Korea, an area of Chinese and American co-operation, could be a harbinger of the former; friction over trade presages the latter. The direction taken may reshape our world.


Managing the Risks of a Rising Dollar

Mohamed A. El-Erian



NEWPORT BEACH – Argentinian President Mauricio Macri’s government has asked the International Monetary Fund for a loan that it hopes can stem a peso rout that has driven up interest rates, will slow the economy, and threatens the reform program. This reversal of fortune for the economy partly, though far from fully, reflects broader pressure created by the US dollar’s recent appreciation – a process that is set to accelerate, because both monetary-policy and growth differentials are now favoring the United States.

For a while now, the US Federal Reserve has been well ahead of other systemically important central banks in normalizing monetary policy – that is, raising interest rates, eliminating large-scale asset purchases, and starting the multi-year process of shrinking its balance sheet. This was amplified this year by another catalyst of the dollar’s recent appreciation; a growing, and less favorable, divergence between economic data and expectations in the rest of the world.

During most of 2017, markets were scrambling to catch up to indications of growth outside the US that were markedly more favorable than anticipated. As a result, the most widely followed measure of a trade-weighted dollar index depreciated by 10% last year. Capital flows into Europe and major emerging economies picked up, as investors sought to benefit from the expansion, while enjoying both higher yields and the possibility of capital gains from currency moves.

But, in recent months, measures of economic “surprises” have turned negative, as growth momentum has weakened in Europe and beyond. To cite one dramatic example, declining economic indicators caused the implied market pricing of an interest-rate hike ahead of the Bank of England’s policy meeting this month to plummet from over 90%, or a near-certainty, to 20% in just a few weeks.

Now, there is less external capital chasing returns in Europe and the emerging economies, and some that was there has already flowed back home. So economic and financial factors can be expected to continue to fuel the appreciation of the US dollar. The only way to ease that upward pressure, and to mitigate spillovers, is with effective policy responses.

The good news is that there are sufficient tools to reduce the risk of dislocations. But there is a need for broader implementation within individual economies, and better coordination across borders.

To be sure, some may view the US dollar’s appreciation as consistent with a longer-term rebalancing of the global economy. But, as Argentina’s situation demonstrates, excessively sharp and sudden appreciation of such a systemically important currency risks unbalancing things elsewhere.

Emerging markets have long been particularly vulnerable to this phenomenon. In the run-up to the Asian financial crisis of the 1990s, many emerging economies kept their currencies rigidly pegged to the dollar, and governments tended to borrow heavily in dollars, despite generating most of their revenues in the domestic currency (what economists labeled “original sin”).

As the dollar appreciated in international markets, these economies became less competitive and experienced sharp deteriorations in their current-account positions. Actual and potential capital outflows forced central banks to raise local interest rates, intensifying economic contractionary pressures and undermining the creditworthiness of the domestic corporate sector. Currency devaluation was not an easy option, either, as it would boost inflation and send the costs of servicing external debts soaring to prohibitively high levels.

Many developing countries now have flexible exchange rates, and, by shifting to domestic sources of borrowing, they have reduced the currency mismatches associated with their liabilities. Yet two vulnerabilities remain.

First, the recent extraordinary period of repressed volatility in financial markets, ultra-low interest rates, and dollar weakness unleashed another surge of capital flows to emerging countries, including “tourist dollars,” which tend to flow right back out at the first sign of trouble. Second, empowered by exceptionally generous global financing conditions, a growing number of emerging-market corporates have resorted to external dollar borrowing, materially increasing their financial vulnerability to higher interest rates and adverse currency moves.

Externally driven changes in financial variables have thus become a source of serious risk, especially in countries, like Argentina, with a history of economic mismanagement, large current account deficits, other financial imbalances, and a habit of pursuing too many objectives with too few instruments. With the emerging-market economies still structurally subject to short-term risks of contagion, it is usually just a matter of time until a few countries’ problems result in a tightening of financial conditions for the asset class as a whole.

Beyond challenging emerging markets’ stability, a sudden and sharp appreciation of the US dollar – and, specifically, the losses in trade competitiveness that it causes – threatens to complicate already-delicate trade negotiations. In particular, efforts to modernize the North American Free Trade Agreement (NAFTA) and to establish fairer trade relations between the US and China could be put at risk.

Against this background, policymakers should be implementing measures that take pressure off foreign-exchange markets. This includes, first and foremost, pro-growth policies, particularly for Europe, which, despite recent economic gains, faces significant structural headwinds. Emerging economies, meanwhile, should focus on maintaining solid balance sheets, improving their understanding of market dynamics, and safeguarding policy credibility.

Country-level measures should be reinforced by better global policy coordination, especially to help avoid or break vicious cycles. The IMF, which may soon face more requests for financing, has an important role to play here. Using a bit of extra precaution now is obviously preferable to risking a mess that will need to be cleaned up later.


Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.


Saudi Arabia’s Race Against Time

By Xander Snyder


Saudi Arabia is in a race against time to implement massive reforms that it hopes will minimize its economy’s dependence on oil and, in doing so, insulate it from social unrest once oil prices inevitably fall. And the government must do this without surrendering its control of the country. It’s a tall order for Crown Prince Mohammed bin Salman, the heir apparent to the kingdom who, by all accounts, appears to have consolidated enough power to at least try to pull it off.

There’s plenty of reasons to doubt that he will actually succeed, but that’s a problem for a later day. Right now, Brent crude is at about $75 per barrel, slightly above what the International Monetary Fund lists as Saudi Arabia’s breakeven point, giving the government some more revenue and thus a little more breathing room to change its ways.

Time and Money

It’s hard to say how long that will last, though. Prices have been rising, thanks to a combination of OPEC cuts, production agreements between Saudi Arabia and Russia, decreased U.S. inventories, and fears that a U.S. withdrawal from the Iran nuclear deal will take Iranian supply offline. And they have gone up despite increased U.S. shale production – which counterintuitively makes sense, considering shale producers will up production as soon as oil prices exceed their own breakeven points, which tend to range between $35 and $70 per barrel.

Increasing production, however, takes time and money. The cost to finish uncompleted wells must be accounted for, as must the cost of transportation to market. Pipelines are a good option in this regard, but some pipelines are nearly at maximum capacity. (The delays have prompted producers to offer discounts of as much as $9 per barrel, according to some reports.) Another option is to transport by truck, something that requires more time and money. Other cyclical factors, including the demand for components such as the sand used to fracture a well, likewise drive costs up and forestall oil coming to market.

The delays mean that oil prices will stay high until shale producers can overcome their short-term barriers to production. As it happens, they are beginning to do just that. The number of active rigs in the U.S. has been increasing steadily since the middle of 2016. (As of April 2018 that number is 1,013.) Production has predictably surged. In May, the Energy Information Administration estimates that U.S. oil production will increase to 7 million barrels per day, a 15 percent increase compared to last May.

So while $75 per barrel of oil may allay some of Saudi Arabia’s immediate financial concerns, the long-term trend remains: More U.S. production will drive prices down. Saudi Arabia knows this and so must move quickly to take advantage of the current high prices. How quickly it acts depends on how much money it actually needs to fund its ambitious reforms.
 
Believable Rumors
And how much money it will earn remains to be seen. The International Monetary Fund puts Saudi Arabia’s breakeven price at $73 per barrel, in theory netting Riyadh a nice budget surplus at current prices. There are, however, some issues with the IMF’s breakeven figure. For starters, the formula it uses to calculate this figure is publicly available. Second, according to a paper published by the Council on Foreign Relations, IMF estimates vary by as much as 20 percent, even in the same year. Either way, as shale production responds to the market, oil prices are likely to decline, putting greater strain on the Saudi budget.

It’s no wonder, then, that the Saudi government is desperately trying to diversify its sources of non-oil revenue. And it has been somewhat successful, so long as you don’t look too closely. Non-oil revenues as a percent of the government’s total budget have increased from 8 percent in 2012 to almost 37 percent in 2017, an annualized growth rate of about 20 percent.

Still, in this same period, oil revenue has decreased so much that the total budget has declined by almost 45 percent, from about $330 billion to $185 billion (using the current riyal/USD exchange rate). In other words, the non-oil share of revenue appears to have increased so much primarily because its total budget has shrunk nearly by half. If Saudi Arabia was earning as much in non-oil revenues in 2012 as it is today, then non-oil would account for a much smaller share of the budget, about 18 percent.



The Saudi government expects spending to outpace revenue in 2018, estimating a deficit of more than $50 billion, or roughly 7 percent of gross domestic product. Aside from raising taxes – something it has steadily done despite the political risks – there are only three ways it can account for this shortfall: dip into its reserves, seek foreign investment or confiscate assets from the elite. As of February 2018, Saudi Arabia had approximately $487 billion in reserves, a 5 percent decline from last February and a 33 percent decline from its peak in 2014. If the kingdom were to maintain deficit spending at the same rate as is anticipated in 2018, it would have about 10 years of runway. Of course, if oil revenue declines without a commensurate decrease in its reform expenditures, the deficit will grow, and its cushion will shrink.

Unsurprisingly, Saudi Arabia prefers to raise foreign investment. The most publicized measure in that regard is the initial public offering of Saudi Aramco. This offering, however, continues to be delayed, and while the Saudi energy minister may be citing “litigation and liability” complexities, the real reason is most likely the inability of Saudi Arabia’s bankers to reach the $2 trillion valuation that Mohammed bin Salman has sought. At that valuation, the anticipated sale of 5 percent of the company would raise $100 billion for Saudi Arabia, while somewhat more conservative market valuation estimates, ranging from about $500 billion to $1 trillion, would raise only between $25 billion and $50 billion.

Riyadh has also turned to the debt markets, issuing $17.5 billion in its first dollar-denominated debt offering in 2016, and another $11 billion this month. Though Moody’s A1 rating may give some assurance to investors, the reality is that Saudi Arabia remains bogged down in a proxy war in Yemen and preoccupied by Iran, its regional rival that is well positioned to gain more power. Any new developments in the broader Middle Eastern conflict that threatens to lure Saudi Arabia in either financially or otherwise – say, a war between Iran and Israel – is sure to make foreign investors wary and limit Saudi Arabia’s access to external capital.

Saudi Arabia has also confiscated assets from its elite. The arrest of 400 oligarchs last year netted $106 billion in confiscated wealth, according to the Saudi attorney general. This no doubt helps to plug the gap for now, but there are limits to how much the government can seize without facing a more concerted resistance.

All told, Saudi Arabia isn’t on the brink of collapse, but nor are the rumors of a palace coup from last weekend all that surprising. They attest to the difficulty of the government’s position. It needs to radically transform its political-economy in a relatively short time, all while it contends with regional security threats. The need to move quickly, then, is paramount, since a divided, weak homefront will preoccupy the regime’s focus and prevent it from confronting its external threats effectively.

A lot must go right for Saudi Arabia to achieve its far-reaching reform goals, and in the annals of history, countries are rarely so lucky.

 When Investor Psychology Turns Dark, All News Is Bad News  

Big companies report blow-out earnings. Home prices soar. North Korea promises to end its nuke program, possibly averting another Asian war.

And stocks fall.

Does this mean the news no longer matters? That’s exactly what it means. But it never did matter. In a world this complex, big things both good and bad are always happening. So the events themselves are less important than our interpretation of them. In other words investor psychology is everything.

And that has suddenly turned dark.

Grumpy Investors Can’t Find Anything to Look Forward To
(New York Times) – The stock market is forward-looking. That’s a problem when there’s not much to look forward to. 
Stocks sank for the fourth-straight day on Tuesday, as investors looked past a series of outwardly positive earnings reports and fixated on threats to the nine-year-old bull market. 
Foremost among them is the Federal Reserve. Super-low interest rates from the central bank have fueled the rally, pushing up the prices of stocks and bonds since the Great Recession. 
But that was then. Now, the Fed is slowly withdrawing some of its support. It is shrinking its portfolio of government bonds and lifting interest rates. As a result, a yearslong tailwind for the stock market is disappearing. 
The new environment is evident in interest rates on government bonds, closely watched by many investors. The yield on the 10-year Treasury note touched 3 percent in trading early Tuesday. That benchmark interest rate — which influences the price of borrowing for both consumer loans and corporate bonds — has not been that high since early 2014. 
Other pressures rattled the markets, and worries began to set in after 3M and Caterpillar reported a gloomy Outlook. 

The threat of a trade war, or even a real war, is unnerving investors. Oil prices have surged higher because of tensions in the Middle East, as well as President Trump’s public musings about withdrawing the United States from its nuclear deal with Iran. 
Those rising commodity prices represent something of a double worry for investors.  
For one, they feed into price inflation, making it even more likely that the Fed will continue to raise interest rates. (One of the Fed’s main objectives is keeping prices stable.) At the same time, higher commodity prices eat into profit margins for companies, which is bad for their stock prices. 
Investors were heartened by the tax cuts, said Evan Brown, director of asset allocation at UBS Asset Management. But their focus has shifted since then. 
“The market’s attention is rotating to other things, and one of those things is rising inflation and rising yields,” Mr. Brown said. “One of those things is the potential for increasing trade tensions.”
 
The above article presents a litany of things to worry about. But in a different psychological environment (2017 for instance) investors would just ignore them and focus on how rising earnings will turbo-charge corporate share buybacks or how higher interest rates revive fixed income profits or how a stronger dollar implies that foreign capital is pouring in. Or how Amazon and Google were going to take over their parts of the world.
 
All of these good things are real, but none matter if they don’t fit into the prevailing mental landscape. And this landscape is as cyclical as anything else, with long happy stretches being followed by long dark ones.
 
Historically this kind of a shift has put air pockets under the prices of investments that depend on extrapolating good times to infinity. The Nifty Fifty of the 1970s, junk bonds of the 1980s, tech stocks of the 90s and bank stocks of the 00s all plunged when investors decided that a bird in hand was worth more than two in a distant bush. Now it may the turn of the FANG stocks and their peers.
 
Most are great companies, but they might still be worth only half as much to a pessimist.

Investor Psychology Netflix Share Price


Privacy Is Dying, Like It or Not

By Patrick Watson


The funny thing about breakthrough technologies is that we rarely see the break. They tend to sneak up on us. Every now and then, something revolutionary comes out of nowhere, like the iPhone in 2007, but it still took a few more years to take off.

The other thing that changes slowly is us. Technology modifies our attitudes and beliefs so gradually that we don’t realize it’s happening, but the changes are real and usually permanent.

Just a few decades ago, it was unthinkable to share the kind of personal images and information many of us routinely show to strangers today. Internet access and social media have radically changed our attitudes about privacy.

This evolution has economic and investment consequences that we’re not always aware of.


Photo: Getty Images


Eyes in the Sky

Aside from the now-ubiquitous mapping services, satellite imagery helps businesses from farms to shipping companies run more efficiently.

The photos got even more useful when Google Earth began offering 3D versions that made it possible to assess topography.

Almost everyone, however, is still missing the fourth dimension: time.

Most publicly available satellite images are weeks or months old, sometimes even years. That means there’s a lot of untapped potential. Being able to see live satellite images of some faraway location would certainly be useful—though technically it’s hard because low-orbiting satellites can’t hover over one spot like a drone or helicopter.
 
 
 
 
The latest idea: deploying large numbers of small, inexpensive satellites. Get enough of them up there, and one will always be in range.

Last week, a Bellevue, Washington startup called EarthNow announced plans to deliver real-time satellite video of almost anywhere on the planet.

EarthNow is not someone’s garage idea. Its investors include Microsoft founder Bill Gates, Japan’s Softbank Group, and European aircraft maker Airbus. Raising capital won’t be a problem.

The company’s website lists some possible applications:

  • Catch illegal fishing ships in the act

  • Watch hurricanes and typhoons as they evolve

  • Detect forest fires the moment they start

  • Watch volcanoes the instant they start to erupt

  • Assist the media in telling stories from around the world

  • Track large whales as they migrate

  • Help “smart cities” become more efficient

  • Assess the health of crops on demand

  • Observe conflict zones and respond immediately when crises arise

  • Instantly create “living” 3D models of a town or city, even in remote locations

  • See your home as the astronauts see it—a stunning blue marble in space

All very nice, but there’s a dark side to this too.


Photo: Getty Images

Au Naturel

Real-time satellite imagery of the whole planet means all of us will be on camera any time we step outside. That’s kind of chilling.

Yes, it’s already possible to locate people via their smartphones, but you can stop that by ditching the phone. The satellite, on the other hand, will still see you or your car wherever you may go.

This will have benefits. For example, police could solve crimes by simply rewinding video to track everyone at a crime scene. However, a more malicious government could use it to silence dissidents or journalists.

For EarthNow, your lost privacy will be a revenue opportunity. Its press release says, “Initially, EarthNow will offer commercial video and intelligent vision services to a range of government and enterprise customers.”

They’re also careful to say their video will cover almost anywhere on Earth.
 
You can bet the US government will redact sensitive places. The Pentagon won’t let anyone reveal whatever the heck it’s doing at Area 51.

The rest of us will get less consideration. If you like au naturel sunbathing, you can still do it—but more than just the sun may be watching you.


Photo: Getty Images

We Don’t Mind

Combine this new snooping technology with the ones we already face, such as Facebook’s data gathering, and having any semblance of privacy is getting harder.

I think this won’t change, because most people don’t mind.

Intentionally or not, we’ve decided the benefits we get from sharing our personal lives outweigh the costs. We like…

  • Staying connected with friends and making new ones online

  • Having our phones direct us to restaurants whose menus match our tastes

  • Getting custom movie recommendations based on our viewing history

These little conveniences are slowly embedding themselves in daily life. Millions of people now have Amazon Echo and other audio devices in their homes. The little boxes don’t listen all the time… but we’re being prepared for the day when they will.

And we haven’t even talked about non-satellite video. Security cameras are now common in public places and increasingly in homes. Have we seriously considered whether their benefits justify making everyone an involuntary video star? No. It’s just happening.

I think we’re now beyond such debates. The genie is out of the bottle and not going back in. The trend will keep rolling, whether you like it or not.


Photo: Getty Images

Paying the Price

So, as time goes on, our lives will be increasingly open to everyone. We will share more personal info and expect others to do the same. Everyone will watch everyone else. What does that do to the economy?

For one, the same trend affects businesses. They’re already having a hard time protecting intellectual property. As John Mauldin wrote last weekend, some companies voluntarily give their valued secrets to the Chinese government, which gives them access to the Chinese market in return.

That’s the corporate equivalent of the deal web users make with Google. Give up your info and get something back without spending any cash. It will keep happening.

Another consequence of using data as a currency: these transactions have value that may not show up in GDP, but it’s not as negligible as you may think.

It also suggests one way to at least slow down this process: stop demanding free stuff. If you really value something, buy it with cash. If the seller won’t take cash, then maybe you don’t need it.

But that will be a temporary solution. The reality is that our concepts of privacy and modesty have changed radically and will change even more. Companies that admit this reality will probably be better investments.

You may not like what they do, but they’ll make money doing it. Pay attention.


After Donald Trump’s America First, Angela Merkel’s Germany First

The chancellor still has a chance to show that national and mutual interest can merge

Philip Stephens



Donald Trump and Angela Merkel are meeting this week at the White House. Like most Europeans, the German chancellor struggles to disguise her disdain for the US president’s America First nationalism. Yet in Berlin Ms Merkel’s coalition is humming its own parochial tunes. Eurozone reform? Too expensive. A bigger contribution to European security? Politically off limits. It all begins to sound like, well, Germany First.

Mr Trump exults in the elevation of narrow national interests over global rules and institutions.

Everything is a zero-sum game. He has disowned the Paris climate change accord and repudiated multilateral trade deals. He may soon blow up the international nuclear deal with Iran. Across the Atlantic, Germany speaks the language of a devoted multilateralist and guardian of the liberal international order. No one is keener on rules.

Leaders prioritise national interests. That is what they are elected for. The gap lies between those such as Mr Trump, who think in terms of might-is-right winners and hapless losers, and those who spy a landscape of swings and roundabouts — a positive-sum game in which national and mutual interests can be aligned. Ms Merkel champions this second group.

She has good reason. Germany has been the big beneficiary of European integration. Sure, it writes sizeable cheques to Brussels and underwrites financial risk in the eurozone. But look at the rewards. The common market was the route back to political respectability and economic recovery. The EU provided the framework for orderly reunification. And the euro has been the foundation for German prosperity.

The economy is booming. Growth and exports are strong, unemployment at record lows, and inflation barely visible. The public coffers — federal, state and municipal — are overflowing. Here, ironically, is the problem. Mr Trump exploits the grievances of poor white America; Ms Merkel’s parochialism reflects an unwillingness to disturb Germany’s present good fortune.

The outcome of September’s election was widely seen as troublesome. Ms Merkel’s Christian Democrats and its Bavarian sister party, the CSU, lost votes. So did the mainstream Social Democrats. The winners were the far-right Alternative for Germany (AfD) and the far-left Die Linke. It took months for Ms Merkel to assemble another coalition with the SPD.

For all that, Germans got more or less what they wanted. The experienced and trusted Ms Merkel returned to the chancellery, but this time with constraints. The march into parliament of the AfD strengthened her party’s conservatives. They push back against any temptation to show solidarity with weaker EU partners by deepening economic integration. And the result rules out a repetition of her decision in 2015 to open the borders to refugees. Ms Merkel did the right thing, most Germans say. But she must not do it again.

For many years Berlin complained that Ms Merkel did not have a serious partner in Paris. The old alliance — the Franco-German locomotive some called it — had broken down. President Nicolas Sarkozy was too unpredictable; his successor, François Hollande, paralysed by the office. If only Germany could share leadership, the lament went, the EU could be overhauled.

Well, in Emmanuel Macron, Berlin has just the politician it asked for. In the process of smashing the old political establishment, the French president has done a rare thing. He campaigned unabashedly for domestic reform and has lived up to his manifesto. He also defied the xenophobia of the far-right National Front by writing an elegant hymn to Europe. And the Germans? They are gripped by a sudden nostalgia.

Last year, I spent some time in Berlin as a visiting fellow at the Bosch Academy. Over and over again I heard policymakers warning against being misled by Mr Macron. The president was wrapping French interests in a European flag, they said — as if Berlin would never dream of such a thing. Surely, this is the essential purpose of the EU — the process of merging national and mutual interests. Negotiation is about finding the right point of compromise so that everyone can claim victory.

But no. Mr Macron’s plans for a eurozone budget and finance minister are too ambitious in Berlin’s eyes. They would promote moral hazard among fiscally irresponsible southern Europeans. As for completing the banking union, why should German taxpayers be at risk of being asked to bail out Italian banks? And so the objections run on. So much for solidarity.

Ms Merkel, one supposes, would say she is hemmed in by circumstance. True, as far as it goes. But here she is in her fourth and what must be her final term as chancellor. The economy will never be in better shape. If ever there was a moment to invest political capital — to show the leadership that takes risks — it has surely arrived.

A German friend, a shrewd observer of politics, tells me that the country is doing so well that it cannot see the world through the lenses of its neighbours. A harsher judgment would stir in a fistful of sanctimony — Germany is the sole author of its good fortune, so if others have problems they must look to themselves for a remedy. Now there is a worldview that Mr Trump would applaud. Ms Merkel still has time to prove him wrong.


Why Investors Need Caution in $1 Trillion Loan Market

The market for risky loans often used in buyouts has ballooned on investor demand

By Paul J. Davies


LEVER UP
Total volumes outstanding in U.S. risky loans and bonds*

Sources: ICE; S&P Global LCD
Note: As captured in ICE BofAML High Yield Index and S&P/LSTA Leveraged Loan Index


Demand for risky loans that fund private-equity buyouts and other highly indebted companies has pushed the size of the market beyond $1 trillion for the first time. Investors should be aware that rising interest rates will make life harder for borrowers.

Individual investors are pouring cash into mutual funds and exchange-traded funds that invest in leveraged loans because their income rises as interest rates go up. Bonds in contrast lose value as rates rise. Leveraged-loan funds have had nearly $5 billion of net inflows so far in 2018, according to Lipper. However, rising income for investors only works up to a point: higher rates eventually squeeze borrowers. 
The loan market has nearly doubled in size since mid-2012, according to S&P Global’s LCD research arm, and is expected to keep growing strongly as private-equity firms hunt for ways to invest record amounts of funds raised in the past couple of years.
.
     A Thomson Reuters electronic market board. Photo: marcos brindicci/Reuters 


Loans due to come to market soon include a big chunk of the $13.5 billion financing Blackstone needs to back the spinoff of Thomson Reuters’ information business.

The market has almost caught up with that for junk bonds, which has shrunk to $1.25 trillion from a peak of $1.4 trillion in the past couple of years. Junk-bond funds have suffered around $10 billion of net outflows in 2018, according to Lipper.

Borrowers like loans because they can be repaid or refinanced at any time and are cheaper: the yield on the S&P/LSTA U.S. loan index is 5.6% compared with 6.5% on the ICE BofAML U.S. high-yield index.

At the same time, covenants on loans—which historically allowed lenders to step in if a company started to get into difficulties—have been disappearing as investors became less discerning. The upshot is risky companies have refinanced maturing bonds with loans, leading to a shrinking junk market.

For investors, loans’ big attraction is protection against rising U.S. interest rates because loans pay a floating rate tied to an underlying market interest rate, known as Libor. High-yield bonds, in contrast, pay a fixed coupon, so lose value as rates rise.

However, rising rates will bite eventually. Right now, companies with leveraged loans have plenty of earnings before interest, tax, depreciation and amortization relative to their interest costs. According to UBS , this interest cover is more than three times. But borrowers can only withstand three more rate rises before interest costs start to become more painful—and UBS expects six increases by 2019.

The market is also riskier than it was in 2007, according to LCD. While the cost of loans is in a similar range, more than half of borrowers now are rated single-B+ or lower: In 2007, less than one-third of the market was that poorly rated.

The message for investors: a lot more caution will be needed as the year goes on.


Macron’s Real Limits

Hans-Helmut Kotz

Emmanuel Macron visits Berlin


FRANKFURT – When Emmanuel Macron was recently interviewed by two very aggressive journalists, the result was not exactly the “ideal speech situation” cherished by Jürgen Habermas, the towering German philosopher and great supporter of the French president. But, despite being repeatedly interrupted, Macron fared very well. Always concrete and willing, if necessary, to delve into the minutiae of an issue, Macron was clearly on top of his game. He needed no speaking notes, as he also admirably demonstrated in his speech condemning nationalism and populism at the European Parliament a few days later.

His meeting with German Chancellor Angela Merkel in Berlin that same week, however, was much different in both tone and substance. Most important, it demonstrated the limits of the méthode Macron: Seemingly compelling oratory does not necessarily translate into feasible policies.

Politics, at its core, reflects the interplay of interests at the national level. And that is precisely where Macron’s ideas about re-designing Europe’s institutional architecture arrive at an impasse. His proposals are too numerous and vague to judge, and they do not account for the state of debate at the national level, where skepticism is on the rise. Being positive about Europe comes at a cost.

For northern Europeans, two prospects raise particular concern: risk sharing (for example, in underwriting retail bank deposits) and a eurozone budget.

Of course, a fragmented banking system complicates a single monetary policy. Some academic economists, as well as the rare policymaker (such as the late Tommaso Padoa-Schioppa), called for centralized supervision of financial institutions long before the euro crisis erupted. At least in some respects, such “Europeanization” of supervision has been established, with the European Central Bank serving as the eurozone’s banking watchdog and the Single Resolution Board dealing with vulnerable banks.

But guaranteeing retail deposits remains a task for the eurozone’s individual member states. Hence, the quality of those guarantees varies, with some members vulnerable to bank runs. But in northern Europeans’ (quite reasonable) view, insurance after an accident has occurred (think of non-performing loans) is a form of redistribution that shifts the burden to innocent bystanders (in this case, northern taxpayers). As German and Dutch officials, in particular, have argued, banks’ financial health must be addressed before completion of European banking union can take place.

Europeanization of deposit insurance would also mean that eurozone member states would, if push came to shove, lose any authority over banking politics. A eurozone institution, democratically accountable, would have to be charged with this.

But it is in regard to the proposed eurozone budget that Macron’s ideas are the least specific. And it is here where political resistance is the strongest – again, for reasons that are not difficult to understand.

A common eurozone budget has been presented as both a stabilizing mechanism and an investment tool. But, under normal circumstances, national public-sector budgets already perform the stabilizing role automatically – through unemployment insurance, progressive taxation, and the like – and this is a derived role, not the primary objective. What is needed is a security valve for eurozone countries that face temporary – and particularly difficult – challenges. And an investment budget has little to do with the purpose of a stabilizing mechanism: to cushion economic shocks.

So the substance of Macron’s economic-policy suggestions is, frankly, confusing. And even if Merkel were to embrace them, she would be an easy target for political attack (and not just from the opposition Alternative für Deutschland, but also from within her Christian Democratic Union and its sister party, the Christian Social Union, not to mention the Social Democrats).

There is no avoiding the national political dimension in the EU, given that every leader needs to be elected, and that most want to be re-elected. Merkel’s idea of establishing a eurozone super committee that would partly substitute for the Eurogroup of eurozone finance ministers – which Dutch Prime Minister Mark Rutte already proposed, to no avail – would complicate things even further.

Yes, such a committee would bring Merkel the added political benefit of constraining the influence of Social Democrat Olaf Scholz, her Vice-Chancellor and finance minister. But, in terms of substance, there was no need for her proposal. Scholz immediately endorsed the schwarze Null (balanced budget) of his predecessor, Wolfgang Schäuble. Given the German public’s deep-rooted sentiment in favor of fiscal probity, anything else would have been politically self-defeating. Indeed, with even Macron pursuing it, the schwarze Null has come back with a vengeance. But that does not make it a less flimsy economic concept, one that cannot be found in any economics textbook.

This is the fundamental problem of the méthode Macron: his policy pronouncements – vague to the point of not being implementable – somehow lack the courage of his European convictions. Proposals by the French Treasury (from 2014!), for example, presented much more detailed policy options to achieve the ends that Macron appears to seek, as did proposals developed by Italian Finance Minister Pier Carlo Padoan in 2015.

Macron’s method is also marked by a strong reliance on an intergovernmental approach, which most likely reflects his understanding of French voters’ current mood. At least in this respect, the exchange between Macron and his two impertinent interlocutors last week was highly enlightening. The self-declared representatives of French society’s deep frustration did not touch on European issues at all.

They did so for a reason. Many French do not hold “Europe” (meaning the European Commission in Brussels) in high standing, and, as the 2005 referendum on a European constitution showed, that has been true for some time. So any vote based on the ideas sketched in Macron’s various speeches is unlikely to turn out favorably. In this context, Merkel’s insistence on the need to amend the Treaty on the European Union – which would require referenda in the member states – to establish Macron’s proposed European Monetary Fund is a barely hidden way of saying “Nein.”

Macron’s commitment to disinterested dialogue, à la Habermas, is admirable. But unless and until he gets his hands as dirty with European politics as he seems willing to do for the sake of domestic French reforms, those dialogues will remain ephemeral, if not just plain hot air.


Hans-Helmut Kotz, a former member of the executive board of Deutsche Bundesbank, is Program Director of the SAFE Policy Center at the Goethe University in Frankfurt and a resident fellow at the Center for European Studies at Harvard University.