Global Economic Monitor - June 2017

Transcription

1. June 2017 Economic Monitor May 2014 Highlights Contents (as of 16th June, 2017) Highlights 1 Global Economic Growth & Inflation 2 Global Financial Markets 11 Oil Market 16 Saudi Arabia 18 UAE 22 Economics Department Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia ChiefEconomist@samba.com  Global economic activity is reasonably firm. In a role reversal, much of the growth impetus is coming from the Eurozone, which is offsetting flagging US consumption and receding expectations about President Trump’s “reflation trade”, as his legislative programme becomes bogged down. Soft inflation did not deter the US Fed from raising interest rates by 25 bps, though this has only helped to flatten the yield curve. Despite all this, global trade is robust, with East Asian exports leading the way. China has tightened monetary policy more than anticipated, but various indicators suggest that the economy is holding up quite well.  Global financial markets are relatively buoyant, with plentiful liquidity and low volatility. The flat yield curve has helped support US equities, with the tech sector leading the way. Many feel that the S&P is overvalued, but it is not clear that there is a correction due. With bond yields so low in both the US and especially the Eurozone and Japan, there is still plenty of appetite for risk assets. US High Yield has been one beneficiary, while EM assets have, in the main, also done well.  Extended OPEC production cuts through Q1-18 have failed to prop up oil prices which have slipped back below $50/b as US shale oil continues to surge and stocks remain elevated. A rebalancing of fundamentals is still on the cards but rests on strong compliance with cuts, healthy oil demand growth, and muted supply from Libya and Nigeria. None of these factors are a given, and we have revised down our price projections, with heighted downside risks.  Gulf tensions have had only a moderate impact on key financial gauges in Saudi Arabia, with activity largely confined to the 5 year CDS. The main interbank rate remains subdued—notwithstanding a small uptick following the Fed’s rate hike—reflecting plentiful local liquidity. However, this is in turn a product of weak domestic economic activity, which has been underscored by five consecutive months of deflation.  The UAE is one of the most diversified economies in the region, but it remains substantially influenced by oil prices, both via reduced public spending, and through negative spill overs from slowing neighbouring economies and on confidence. While consolidated finances are comfortable, the current weakness in prices thus presents headwinds, but we still expect non-oil GDP PUBLIC growth will pick up to 3 percent this year, with further gains1 in 2018.
2. June 2017 Global Economic Growth and Inflation World Economic Outlook 2014 2015 2016e 2017f Real GDP (percent change) World 3.1 3.0 2.9 3.1 US 2.4 2.4 1.6 2.0 Japan -0.1 0.5 1.0 1.4 Euro area 0.9 1.5 1.7 1.7 China 7.3 6.8 6.7 6.6 Emerging Markets 4.0 3.3 3.3 3.8 Saudi Arabia 3.7 4.1 1.4 -0.5 Official policy rate (end period) US 0.25 0.50 0.75 1.50 Japan 0.10 0.10 -0.10 -0.10 Euro area 0.15 0.05 0.00 0.00 Oil Price ($/b period average) Brent 100.0 58.0 47.0 55.0 Samba estimates and forecasts 2018f 3.2 2.3 1.1 1.6 6.2 4.0 1.9 2.25 -0.10 0.00 58.0 Following years of US economic vigour and European underperformance, there now appears to be something of a role reversal. European activity is increasingly firm as labour market improvements continue to drive domestic demand, helped in part by diminished political risks. The US, by contrast, is at the other end of the cycle with employment growth slowing and household consumption faltering. Normally by now wages and inflation would be rising. The fact that they are not has complicated the Federal Reserve’s calculations: nevertheless, it decided to push ahead with another 25 bps rate hike in June if only—many say— to provide it with something to cut again if the economy begins to tip into recession. Elsewhere, China’s authorities are taking a much firmer approach to shadow banking than many were anticipating. While banking stocks have been hit as a result, the real economy appears to be coping quite well. East Asian exports are also picking up, responding in large part to enhanced European demand, though China remains their most important market. The build-up of credit in the region is a concern, though economic fundamentals are stronger than in the 1990s. The slowdown in the US has led us to reduce our US growth forecast to 2 percent this year. Assuming that President Trump does manage to pass his infrastructure spending package, then growth next year should accelerate to 2.3 percent. With Eurozone output firm and China holding steady we expect global GDP growth of just over 3 percent this year and next United States President Trump on the back foot as campaign promises founder Donald Trump’s presidency can be described, optimistically, as a work-in-progress. The first five months have been marked by dismal approval ratings; increasingly testy exchanges with the press, Congress, and various federal agencies; and little progress on key campaign pledges such as tax reform and the repeal of the Affordable Health Care Act (“Obamacare”). Dogged by accusations that his team colluded with Russia during the election campaign, the President has spent much of the past few months on the back foot, lashing out at his accusers (often via social media) and dismissing most of the claims against him as “fake news”. If the charge of Russian involvement is proved, then impeachment of the president remains a possibility, though still unlikely given Republican control of both houses of Congress. That said, the odds on Mr Trump leaving office before the end of PUBLIC 2
3. June 2017 his term —voluntarily or otherwise—are not much more than even. Hopes for reflation are being revised There have been some achievements, though these have mainly come through Executive Orders rather than legislative passage. These include imposing restrictions on officials becoming lobbyists, freezing most federal hiring, withdrawing from both the Trans-Pacific Partnership trade accord, and the Paris Climate Accord, and approving the US-Canada Keystone energy pipeline. A bill to repeal the Dodd-Frank reforms (which strengthened oversight of the financial sector in the wake of the 2008 crisis) has passed the House. However, it will face a rougher ride in the Senate, where the Republicans have a majority of just two. Moreover, the bill will have to vie for attention with others on the Trump wish-list, such as another effort at healthcare reform, tax cuts, and an infrastructure spending package. The debt ceiling must also be raised, with the current ceiling likely to be breached in September. All in all, key reforms that underpinned the Trump “reflation trade” seem unlikely to become law until well into the second half of the year at the earliest—and more likely 2018. Indeed, their economic impact might not become apparent until well into 2018. More positively, the President’s domestic travails have largely diverted him from disrupting global trade. His approach to China has so far been largely conciliatory, and there are also hopes that NAFTA will be restructured rather than dismantled; talks are due to begin in August. US data mixed There might well be a bounce-back from an exceptionally weak Q1, but underlying consumption trends are not especially encouraging, particularly as unemployment growth is also faltering Economic data have generally been mixed, but with the emphasis tilted towards the negative. April retail purchases rose, albeit less than forecast, after a March gain that was revised up from a decline. But May data were disappointing, with sales sliding 0.3 percent, badly missing estimates that they would hold steady. These uneven consumption data are at odds with consumer sentiment indicators. The closely watched University of Michigan index is close to all-time highs. More importantly the Michigan expectations index, which tracks households’ views about their financial future, is also high and trending up. But this might not be a precursor to a fresh burst of consumption: those without college degrees are significantly more upbeat than those with degrees; given that the latter have more disposable income, the outlook for consumption might be less rosy than the overall gauge suggests. PUBLIC 3
4. June 2017 In terms of business indicators , the latest PMIs are generally reassuring. A weighted average of the ISM’s manufacturing and non-manufacturing PMIs is at a level consistent with growth of 3 percent annualised in the second quarter (though note that the PMIs were badly out of synch with Q1 GDP results). Employment growth appears to be faltering Much less encouraging is weakening employment growth, with May payrolls falling well short of expectations, and sharp downward revisions to April and March. This does not appear to reflect the higher costs of labour: in fact, average hourly earnings fell back sharply in April and May. Overall, while the second quarter might register a bounce in GDP given the weak first quarter print, there is a sense of an economy that is beginning to run out of momentum. This reflects the fact that the business cycle is at a very late stage (even though price pressures remain subdued) and the realisation that the implementation of the Trump economic agenda will be neither soon nor straightforward. Indeed, for some a flattening yield curve and weakening Federal tax receipts points to an imminent recession (see US markets, below). We are not of this view, but we have decided to reduce our GDP forecast for this year to 2 percent. ...but the Fed pushes ahead with a rate hike Despite weak inflation readings, the Fed pushed ahead with a 25bps increase to the Fed Funds target rate in June. The next step will be to begin reducing its balance sheet. This will have to be carefully choreographed to avoid upsetting markets Weakening employment and wage growth, allied to core inflation trending well below 2 percent provided an uncomfortable context for the hawks on the FOMC during their mid-June meeting. As expected, the Fed went ahead with a 25 bps hike in the Fed Futures target rate—credibility would have been questioned had it not proceeded. However, the soft backdrop has cast doubt on the possibility of a third hike this year. We are holding with our view that there will be an additional hike this year, but we have pushed this back to December. Many on the FOMC are keen to see rates rise not just to reassure markets that it is “normalising” monetary policy, but also because it provides some ammunition (through potential rate cuts) should the wind-down of its $4.5tn balance sheet not go according to plan. Some details have now been announced: the Fed will let maturing paper run off at a capped monthly limit of $10bn a month initially; the timing is unclear, but it seems likely to be H2. The Fed will be at pains to make sure that the unwind is broadly anticipated and well understood by the market in order to avoid a re-run of the 2013 “taper tantrum” when markets reeled on the back of signals that bond purchases could be reduced. The complicating factor is that a large amount of government debt is maturing over the next couple of years. It is also possible that the PUBLIC 4
5. June 2017 fiscal deficit will expand sharply through tax cuts , which in turn would mean further debt issuance. Finally, the debt ceiling has to be raised. All this points to an uncomfortable H2 for the Fed. Europe and Japan ECB on hold The ECB remains committed to its €60 billion monthly asset purchase programme which is scheduled to run to the end of this year. That said, given healthy economic growth, and some easing of political risks, markets are increasingly looking for clues as to when, and at what pace, the ECB will taper these purchases, as only once they have ended will interest rates be raised. It is generally thought that the ECB will announce in September this year that tapering (i.e. gradually reducing monthly purchases to zero) will start in early 2018, with a probable 6-9 month time frame. In the meantime, the ECB’s forward guidance is preparing investors for the pending gradual tightening in policy, while trying to avoid any pre-emptive market over reactions (taper tantrums). Already the ECB communication from the June meeting saw the removal of its interest rate easing bias. Although 2019 is still the favoured date for a first ECB rate hike, absent a major political shock (in the Italian elections in particular), markets are beginning to factor in a chance that it could take place in late 2018. Inflation uptick not seen as durable without sustained accommodation EZ headline inflation bounced back to 1.9 percent in April, while the previously muted core rate (excluding food and energy), jumped to 1.2 percent, before both retreated in May (1.5 and 0.9 percent respectively). Movements in oil prices have played a part in the headline rate, and the ECB maintains it view that underlying inflation remains weak, and that’s its target of “sustained” inflation below, or close to, 2 percent, will only be achieved gradually over the medium term with continued monetary accommodation. This principally reflects the existence of still large unutilised resources which continue to weigh on domestic wage and price formation. In particular, although the unemployment rate has been falling, it remains high, holding back wage growth. EZ growth remains healthy Available indicators show that the economic recovery in the EZ is becoming increasingly solid as labour market improvements continue to drive domestic demand. Second quarter GDP rose by 0.6 percent Q/Q, up from 0.5 percent in the first quarter, and more timely data suggest economic activity remains healthy. The PUBLIC 5
6. June 2017 EZ composite PMI was confirmed at 56 .8 in May, a six year high, driven by strong employment growth, high levels of business optimism, and strong manufacturing exports. Business confidence has improved with the election of Macron in France and improving prospects for a Merkel victory in Germany. Credit conditions also remain favourable, although growth remains muted at around 2 percent. Overall the outlook has brightened in the EZ, and we now see growth holding at 1.7 percent this year and 1.6 percent next – a bit below the ECB’s new projections of 1.9 and 1.8 percent. Although they have eased in recent months, political risks continue to present some downside risks. Euro continues its move upward Having flirted with parity to the US dollar at the end of last year, the Euro has climbed steadily and was holding above $1.12 in June. An easing of political risks in France, a pick-up in the EZ economy, and a weakening of the dollar as markets reassessed prospects/timing of fiscal stimulus, have all played a part, and hedge funds have now cut bearish bets on the Euro to the lowest level in 3 years. While the Euro remains susceptible to pull-backs on political risks, with the ECB preparing the market for eventual tightening, we expect that it will hold on to gains by year-end, with upside potential. Italy and Greece keep political risk elevated While elections in the Netherlands and France have passed without major shocks (although it should be noted that negotiations on forming a new government have stalled in the Netherlands), political risks remain in the spot light as Italy moves closer to holding its elections this year, possibly in September. Italian parties are nearing agreement on the design of a new electoral law based largely on proportional representation under which such elections can take place - they must be held before May 20 2018. While this will probably make it hard for the Eurosceptic populist 5 Star Movement (5SM)to form a government, markets are now looking more closely at the risks 5SM has been matching the ruling Democratic Party in the polls, although it has suffered significant defeat in recent local elections . Meanwhile the impasse over the issue of debt relief for Greece continues. Greece will probably eventually get the cash its needs from the EU (and possibly IMF) to avoid debt default in the near term, but clearly the underlying debt crisis remains unresolved, and a fourth bailout programme is looking likely in 2018. As does the UK elections results In the UK, the governing Conservative party failed to secure a majority of seats in the June 8 elections. Nonetheless, they are have moved to form a minority government, relying on an alliance PUBLIC 6
7. June 2017 with Northern Irish Unionists , to secure a slim parliamentary majority to get policies passed (out of 650 seats Conservatives 318/ Democratic Unionist Party 10 V Labour 261). Having called early elections to boost the Conservatives former majority in parliament, Theresa May’s position as Prime Minister now looks at risk. In general the unexpected result throws up a number of uncertainties that could lead to delays in the Brexit process, with the prospect of both a much softer Brexit and a no-deal “chaotic” Brexit now seen as more likely. Softer UK growth, higher inflation, unchanged monetary policy Having performed unexpectedly well since the Brexit vote in June last year, the UK economy is showing signs of softening which could be exacerbated by the new political uncertainties. Critically, consumer spending now looks to be weakening, and overall GDP growth slowed to 0.2 percent in Q1 from 0.7 percent in the previous two quarters. On the plus side, exporters have benefited from the slump in sterling, and investment has been solid, but the latter is expected to falter in the face of new political uncertainties. At 2.9 percent y-o-y, inflation exceeds the Bank of England target. Much of this reflects the weaker pound, and we expect that the overshoot will be tolerated for longer as the BOE focuses on Brexit risks. As such expect interest rates will remain unchanged till 2019. Data confirm steady Japanese growth Final data confirm that first quarter GDP growth came in at an estimated 1 percent Q/Q annualised (0.3 percent q/q), supported by healthy external demand and, to a lesser extent, consumer demand. The latter has been boosted by the decline in unemployment to a 23 year low of just 2.8 percent. Although wage growth remains muted, retail sales data (3.2 percent y-o-y in April) suggest that consumers are spending. Investment is still lack lustre and, while industrial production has held up, more recent PMI survey data point to a softening in the second quarter. Nonetheless, this is still consistent with steady growth, and we forecast real GDP growth of over 1 percent in both 2017-18. But normalisation of monetary policy is a long way off Although the economy continues to perform well by Japan’s standards, inflation is far from exceeding the 2 percent price stability target and remaining above this in a stable manner as targeted by the BOJ. The headline inflation rate was 0.4 percent in April, while the core rate (excluding fresh food and energy) favoured by the BOJ was zero. Under the circumstances there appears little chance that the BOJ will alter policy this year. Monthly asset purchases will thus continue in order to achieve its 10 year government bond yield target of “around zero”, and the PUBLIC 7
8. June 2017 The Japanese yen has benefited from safehaven flows . However, we expect it to resume weakening against the USD as the respective monetary policies continue to diverge policy rate will remain negative (-0.1 percent). If the economy continues to do well and there is a pick-up in inflation, then the BOJ may look to tighten policy next year, initially through raising the target for 10 year government bond yields. However, the BOJ has continued to dampen any expectations of tighter monetary policy. Yen gains after post-US election depreciation After its sharp depreciation in the wake of the US election, the Yen has steadily gained ground this year, and was trading around Y110/$1 in early June. While the divergence in monetary policy with the US remains stark, the Yen continues to benefit from safe haven trades following adjustments in market expectations of stimulus policies in the US amidst bouts of political uncertainty. However, with the US Fed still expected to raise rates once more this year, we still expect the Yen to hold above Y110, and see scope for further weakening later in the year. China and Emerging Asia Authorities step up efforts to stabilise credit growth as Party Congress looms As President Xi Jinping approaches the half-way point of his tenyear presidency, the long-standing dichotomy between GDP growth and the dangers of an ever-increasing credit bubble remains in place. The stakes are getting higher as the Communist Party’s 19th Congress, scheduled for this autumn, looms into view. This once-every-five-year set-piece is a crucial opportunity for President Xi to ensure that his supporters secure senior positions in the Communist hierarchy—not simply to cement his power base as President but to help forestall political attacks on him (or rather “corruption investigations”) once he leaves office. For President Xi, a backdrop of robust economic growth would clearly be welcome. But he is also increasingly mindful of both the attendant credit bubble, and the “quality” of growth. Credit (that is, debt) is estimated to have reached 277 percent of GDP at the end of last year, up 133 percentage points since the financial crisis, most of it driven by a banking system that uses off-balance sheet vehicles of varying quality to channel credit to local governments, property developers and the like. Meanwhile the quality of growth has been compromised by endemic urban pollution and runaway house prices. The president signalled his unease about the credit bubble in April when he told a Politburo meeting that financial stability was “strategically important” for economic and social development. PUBLIC 8
9. June 2017 This appeared to be the cue for the central bank to step up its efforts to deflate the bubble . China’s ambitious new banking regulator, Guo Shuqing, has set his sights on the Wealth Management Products (WMPs) that are at the heart of the shadow banking system. These WMPs, which were worth some $3.6tn at end-2016, are marketed by banks to customers as a high-yielding alternative to traditional banking deposits. They typically include a range of assets of varying quality (the lowerquality ingredients being classified as “non-standard”). Since taking office in February Mr Guo has issued a flurry of new rules aimed at getting to grips with an asset that many see as akin to those that brought the US financial system to the brink of collapse in 2008. WMPs are now no longer allowed to invest in nonstandard assets, but should be confined to standard assets such as bonds, stocks and money market assets. Other new rules being implemented include standard leverage ratios for structured WMPs, since borrowed money has often been used to raise their yields even higher. In addition, WMPs will be forbidden from using other WMPs as their underlying assets—a practice reminiscent of synthetic collateralised debt obligations, popular in the US before the financial crisis. New rules catch market off balance… The new rules have not gone down well with market participants. With the PBOC also drawing some liquidity from the financial system, a broad-based sell-off has pushed bond yields to two-year highs and even led to a rarely-seen inversion of the yield curve. Meanwhile, banks’ share prices have taken a $38bn hit in just two months on the Shanghai stock exchange. The sell-off suggests that investors have been caught short by regulators’ resolve— understandable given years of half-hearted and ineffective attempts to get to grips with the shadow banking problem. …but the policy appears to be having the desired impact Yet there is nothing so far to suggest a credit crunch. Certainly, liquidity has tightened, and short term repo rates remain jumpy. Yet overall credit growth seems to be easing at a pace that the authorities are probably comfortable with. Credit growth slowed in April but only to 14.4 percent, from a peak of 16.6 percent a year ago. But drilling down it was the shadow banking elements, such as local government debt, entrusted loans and bankers’ acceptance that were most under pressure. Real economy adjusting with no obvious pain Just as encouragingly, there are no signs (yet) that the real economy is suffering from the authorities’ tighter monetary stance. It is notable that corporate profits and land sales are much higher than a year ago. That means businesses and local PUBLIC 9
10. June 2017 governments have funds to cover operating costs , debt repayment and capital spending even as lending slows. Also helpful is the fact that local government debt (estimated at RM10tn) has been restructured and interest rates have been cut by 165bps since late 2014. Finally, the central bank is continuing to make net injections by giving more loans via its Medium-term Lending Facility. All of this has helped to soften the impact of monetary tightening. There have been eight corporate defaults this year which is a high number for China, but negligible for most economies. The unofficial manufacturing PMI fell for the third successive month in May, and although the non-manufacturing surveys (both official and nonofficial) picked up, they are both lower than at the turn of the year. Export growth has also held up, rising 15.5 percent in RMB terms in May, up from 14.3 percent in April. Although this is largely a reflection of decent external demand— especially from Europe—if sustained it will serve as another useful cushion for the leadership and the economy more generally. Overall, therefore, the sense is that the authorities are showing greater resolve and a more sophisticated approach to dealing with the credit bubble. So far, President Xi will be pleased with the results; however, he will know that the process is not straightforward and is far from complete. China’s productivity growth has slowed dramatically in recent years, meaning that ever more credit is required to generate the same amount of output. Unwinding this credit—even if the process is gentle—is bound to mean lower overall GDP growth. President Xi has indicated that he is comfortable with lower growth, but the forthcoming Congress will test his resolve. An unexpected lurch down in output could yet trigger another fiscal injection, which would be unhelpful to the central bank’s efforts. Credit build-up also a concern in many East Asian economies China is not the only East Asian economy with credit bubble risks. East Asian economies have in general promoted extremely loose monetary policies since the global credit crisis in a bid to offset weak export growth. This in turn has translated into a rapid buildup of private sector credit growth. As Capital Economics notes, roughly speaking an increase in private credit-to-GDP of more than 30 percentage points over a decade is worrisome. China is the clear outlier here, but there other countries that look vulnerable on this metric, such as Vietnam, Malaysia, South Korea, Thailand and Singapore. Vietnam is at the head of this group with a 55 percent gain in private sector credit over the past decade, followed by Singapore and South Korea. In fact credit growth has picked up in these three countries and, of even more concern, is outpacing GDP growth. PUBLIC 10
11. June 2017 South Korea is taking some (belated) steps to deal with its bubble: raising the maximum loan-to-value for commercial property and introducing measure to deter speculation in the residential market. The Korean authorities appear reluctant to use higher interest rates to combat credit growth, since this would put a further strain on household and corporate balance sheets. This is a quandary that most governments face, though not in Singapore since the exchange rate regime means that interest rates are effectively set by the US Fed. The likely shallow trajectory of US interest rate rises suggests that Singapore’s credit bubble should gradually deflate. This cannot be guaranteed of course, but the local banking system has considerable capital buffers which should help to contain any shocks on this front. A 1997-style crisis seems unlikely… The 1997 Asian financial crisis was born from an excess of easy credit and a benign interest rate environment. This began to change as the US raised policy rates in the mid-1990s, which led some “hot money” to retreat from the region as dollar assets became more attractive. To protect their fixed exchange rate regimes, Asian central banks responded with their own rate rises. However, this hurt their export competitiveness, pushing their current accounts further into deficit, while also putting pressure on domestic balance sheets as financing costs rose. As bankruptcies mounted, panic ensued and credit began to dry up, debt burdens became unmanageable and a number of Asian currencies were heavily devalued. Given that US rates are now rising, could the same dynamic be about to unfold in the region? It seems unlikely mainly because, with the exception of Singapore and Hong Kong, Asian countries no longer have fixed exchange rates. This means that the region’s central banks are not required to move in line with the US Fed. In addition, both the ECB and the Bank of Japan are still in quantitative easing mode, meaning that there is still ample global liquidity around to fill the gaps that might be left by USD outflows. More fundamentally, most East Asian economies enjoy current account surpluses (or at least small deficits) and the crony capitalism that was such a feature of the region in the 1990s has been replaced (or modified) by more transparent regimes. One concern is the amount of USD debt that the region’s corporates have taken on over the past decade: a stronger US dollar—which is likely to be one by-product of US rate rises—has the potential to raise financing costs for corporates. However, many East Asian firms are hedged, and from a macro perspective a stronger USD should help generate more US demand for East Asian exports. PUBLIC 11
12. June 2017 ….but complacency could be the biggest danger East Asian economies are in general much better equipped to withstand financial stocks. However, the build-up in private sector credit in countries such as Vietnam cannot be taken lightly—as the authorities seem to be doing All in all, the fundamentals are much more supportive than in the 1990s. As such, the principal problem might be complacency. For Capital Economics, the main concern is Vietnam, where credit is growing at three times the pace of GDP but the authorities are showing no inclination to raise interest rates given a (surprisingly) benign inflationary environment. Indeed, far from attempting to deflate the credit bubble, the authorities say they are targeting 17 percent credit growth this year, the same rate as in 2016. This lackadaisical approach is made more troubling by the fact that Vietnamese banks’ balance sheets are still recovering from problems in 2011 when a credit crunch led to a spike in NPLs. As Capital notes, the government is not well-placed to provide a fiscal offset given a debt-to-GDP ratio of 65%--the highest in the region. Global Financial Markets Equities Bears warn of a bubble, but US stock market continues to push upward The bull run in US equities—which is now into its eighth year— shows no signs of abating. The S&P500 touched a new record high in early June and by the middle of the month was some 9 percent up on the year. Much of this has been driven by the tech sector, with the S&P500 IT segment up 18 percent year to date. Tech’s surge has come despite increasing concerns that the sector is a bubble waiting to burst. A record 44 percent of fund managers polled in a recent Bank of America Merrill Lynch report considered equities to be overvalued. The technology-heavy Nasdaq Composite was named the most crowded trade, with 57 percent of investors saying internet stocks are expensive, and 18 percent calling them “bubble like”. It is perhaps no coincidence that a couple of days after the survey was released the Nasdaq was subject to a two-day rout, shedding some 3.5 percent before making up about a third of that loss in subsequent days. Growth stocks are in vogue as bond yields remain low There is a good reason why tech stocks are in vogue, namely low long term bond yields. For equities, low long-term yields boost the value of future cashflows, while also sending a signal of modest growth and inflation expectations. In this environment, those stocks that have the potential to buck the trends, such as PUBLIC 12
13. June 2017 tech , become popular. Financial stocks, meanwhile, tend to struggle as the yield curve flattens, since they borrow short and lend long. Thus, US bank shares surged after Donald Trump’s election on the expectation of rising net interest margins for the banking sector as inflation (and hence yields) rose. As the president’s legislative agenda has become bogged down, so banking stocks have fallen back. Overall, market looks stretched especially given consumption outlook But it is not just banking stocks where profitability is doubtful. The general tone of the US economy is not particularly supportive, especially for consumer-led stocks. True, the higher earnings power of the S&P’s “mega corporations” might mean that they deserve to trade at higher multiples, but it is difficult to justify an overall p/e for the S&P of 20-plus, especially if one assumes that the tightness in the labour market will eventually lead to significantly higher wages and put pressure on margins. Even if this does not materialise, the outlook for corporate profits appears dim, for this year at least. European stock market rally stalls Macron’s victory in France significantly reduces political risk in the EZ and has helped boost investor confidence and supported equities. With economic activity also on a healthy upswing and monetary policy seen to remain highly accommodative this year, European stocks have done well. Markets have come off their highs in early June, but the broad EuroStoxx Index was still up around 7 percent at time of writing, and the German and Italian bourses up by more. Corporate earnings are solid and have benefited from low cost pressures, particularly from wages. Exporters have had to deal with a strengthening of the Euro, but this has been offset by the general uptick in global trade and growth. Looking ahead, headwinds could come from political risk concerns around the Italian general election and the likely tightening of monetary policy in 2018. Japan’s Nikkei up modestly year-to-date While the economy appears to be steadily growing, stock prices remain heavily influenced by developments in the Yen, with a weaker currency supporting exporter earnings and, in turn, the market and vice versa. In this context the strengthening of the Yen this year has been a headwind. First quarter results were encouraging, although they owed much to cost cutting measures, with revenue growth being more muted. Assuming the Yen falls back later in the year as the US Fed raises rates, the Nikkei should keep posting solid gains, underpinned as well by relatively PUBLIC 13
14. June 2017 attractive valuations compared with past history . As of June 15 the index was up 4 percent, or 11 percent in dollar terms. Credit markets US yield curve flattens as reflation expectations recede The yield on the US Ten Year remains becalmed at around 2.2 percent, having drifted down in the light of weak inflation and employment readings. Indeed, only 13 bps of the Fed’s 25bps rate hike in mid-June showed up in the 10 year yield. More importantly, the difference in yield between the Two-Year and the Ten-Year has narrowed sharply, meaning that the yield curve is at its flattest since Donald Trump was elected. This is a sign that markets are dialling back their expectations of a fiscal-led reflation trade as the Trump administration struggles to push forward its legislative programme of tax cuts and higher infrastructure spending (see US, above). A flat yield curve can be a harbinger of a recession, though it should be noted that yields at the long end are being suppressed by heavy buying of US paper by European and Japanese investors, who can find little in the way of yield in their home countries. High Yield debt appears increasingly attractive With such paltry yields on government paper, it is no surprise that High Yield bonds are still in favour despite the threat of higher interest rates and oil price weakness (a large segment of HY is in the shale sector). The Barclays option adjusted spread narrowed to its lowest level since mid-2014 even as Treasury yields have continued to ease. Much of the appetite is coming from traditional buyers of high grade debt, such as insurance companies and pension funds. Portfolio managers who invest in high-quality US corporate debt have enjoyed a wave of capital commitments, driving them into riskier, BB-rated and longerdated debt in a bid to achieve return targets. The background to the shift is ongoing monetary easing in Japan and the Eurozone, very high equity valuations, low volatility and a Federal Reserve that is expected to normalise interest rates only gradually. As a risk asset, HY bonds tend to move in line with equities. But given that equities are seen as overvalued, the HY rally might have further to go if nervous stock market investors rotate towards higher yielding paper. Indeed, HY debt will become more attractive if the Trump reflation trade runs out of steam, inflationary pressures continue to subside, and the Fed decides on an extended pause in its tightening cycle. A further tailwind for HY would be a recovery in oil prices (which we are anticipating). Energy firms account for around 10 percent of the HY universe. PUBLIC 14
15. June 2017 EZ interbank rates still exceptionally low amid excess liquidity There has been little change in EZ interbank rates , with the EONIA holding at -0.35 percent and 3 month Euribor at -0.33 percent. Exceptionally loose monetary policy continues to support liquidity, both through ECB asset purchases, and the final targeted longer-term financing operation (TLTRO–II) which took place in March and provided cheap funding to banks. Banks have been passing on the decline in their funding costs through lower EZ lending rates, although credit growth to the private sector remains weak. This principally reflects continued fragility in a number of banking sectors in peripheral countries (Italy, Spain, Portugal), where non-performing loans remain a challenge. EZ sovereign bond markets content with gradualist ECB policy EZ bond markets appear comfortable with the ECB’s gradualist approach to monetary policy changes, and remain bolstered by its monthly asset purchases and muted inflation outlook. Yields on the benchmark German 10 year are up just 5 bps so far this year, and were holding at 0.25 percent in June. Meanwhile, the majority of EZ 5 year sovereign yields remain negative, with the exception of Lithuania, Spain, Italy and Portugal. The election of Macron has seen French 10 year bond spreads (v German bunds) fall back from 75bps to under 40bps, and EZ spreads in general have tightened somewhat. That said, Italian spreads continue to hold at near 200bps, and remain vulnerable to election related strains. Looking ahead, we would expect yields to start moving up in a more sustained manner once the ECB starts to flag its “tapering” intentions in September. EZ corporate bonds follow suit Euro corporate bond markets have generally followed the sovereigns. As part of its asset purchase programme, the ECB continues to buy around €6-7.5bn worth of corporate bonds a month. Together improving economic activity, this has helped support a tightening of spreads in both investment grade and high yields. As with the sovereigns, though, there appears little room for further compression, and credit valuations are starting to look somewhat stretched. According to Bloomberg indices, Euroinvestment grade spreads (OAS) have fallen 23bps to 47bps in the year-to-date, and High Yield 76bps to 244bps. PUBLIC 15
16. June 2017 Emerging Markets EM investors sanguine in face of Fed rise and Trump Emerging Market bonds shrugged off the Fed ’s 25 bps rate hike. The JP Morgan EM bond spread widened slightly, but only by a few bips, and the spread is down to levels last seen in 2014. The narrowing in spreads has been all the more remarkable this year given that the yield on the benchmark US Ten Year has also fallen. Meanwhile, the IIF show debt inflows to EM picking up sharply this year following a sharp net decline in the second half of last year. There has been a similar, if less pronounced trend in flows to EM equities, while the MSCI EM was up 17.5 percent in the year to mid-June. Much of the recent rally is based on relief that President Trump’s bellicose campaign rhetoric about the evils of global trade have, so far, not translated into meaningful action. His decision to withdraw America from the Trans-Pacific Partnership trade accord is likely to have a long-term impact, but for the moment EMs can draw a sigh of relief that tariffs and non-tariff barriers have not been deployed by the US administration. In fact the outlook for global trade appears to be very good. The Morgan Stanley Global Trade Leading Indicator, which is a composite of various indicators such as the Baltic Dry Index, the US Manufacturing PMI, the German Ifo Business Expectations index, etc, is at its highest level since 2013 (albeit having fallen back in the past few months). US weakness should be offset by Eurozone and Japanese demand strength The outlook for global trade is mixed. US consumption weakness could well persist, and even deepen, which would be a major headache for many EM exporters, especially in Latin America and East Asia. However, European growth is rebounding forcefully after a long period in the doldrums, and Japan too is picking up. For all its structural issues, China’s economy continues to be a major source of import demand, with imports in local currency terms up 22 percent in the year to May. It seems unlikely that such a robust rate will be maintained given tightening monetary conditions, but barring a catastrophe, China’s import demand this year is set to be significantly higher than in 2016. EM has matured as an asset class as economies have become more robust Even if global trade were likely to slow significantly, EM securities are unlikely to simply be discarded, given the ongoing hunt for yield. EM as an asset class has matured substantially over the past PUBLIC 16
17. June 2017 twenty years in line with growing economic sophistication . For example, most Emerging Asian countries now run current account surpluses. Even if they did not, the fact that most of the region’s exchange rate regimes are flexible provides a natural shock absorber, and means that the various central banks do not have to assiduously hoard foreign reserves. Foreign currency debt is also low across most of the region, which defrays the risk associated with higher US rates or a stronger US dollar. The main exceptions are Singapore and Hong Kong where, because of their exchange rate regimes, higher US rates are passed through to local rates. This might not be such a bad thing in Hong Kong if it takes the heat out of a property market which, after a correction in 2016, is showing signs of another unsustainable rise. Oil markets OPEC and partners extend cuts Given the slow pace of stock drawdown and fragile oil prices, there was no surprise when OPEC and its other partners agreed to extend their production cut at their May meeting. The 9 month extension to March 2018 will see OPEC sustain its 1.2mb/d cut from the October 2016 reference level, and non-OPEC partners their 0.6mb/d cut, half of which is accounted for by Russia. OPEC also reiterated that the primary goal of the cuts was to drive global stocks back down to their 5 year average. But prices fail to rally Despite the agreement, markets have failed to rally, and dated Brent has fallen back below $50/b. Much of this reflects the fact that markets had been expecting deeper cuts, as had been discussed by OPEC. As we have noted before, record levels of speculative futures trading volumes are also accentuating price moves based on shifting sentiment. And at the moment investor sentiment, which was so bullish at the start of the year, has fallen away – despite the fact that it is still thought that markets will rebalance. However, with investors focused on the relentless rise in US rig counts and output, the anticipated tightening in supply is not proving enough to change attitudes. While stock levels are now starting to draw- albeit erratically - they remain at exceptionally high levels, and the projected rebalancing of fundamentals rests on strong compliance with agreed cuts, sustained healthy global oil demand growth, and muted supply from Libya and Nigeria which remain exempt from cuts. None of these factors are a given, and it will take large draws in stocks to convince markets to raise long oil exposure. PUBLIC 17
18. June 2017 US shale production resumes rapid growth The unexpectedly rapid response by US shale oil to the earlier /premature pickup in oil prices (recall that Brent averaged $57/b Dec-Mar) has been the main stumbling block to tighter fundamentals. Rig counts have risen sharply, and US production has surged back from an 8.4mb/d low in July last year, to 9.3mb/d in May this year. Remarkable technical and cost efficiencies have seen break-even costs fall sharply ($40-50/b for many) which, combined with the hedging of forward production, is now expected to see US shale oil return to adding near 1mb/d a year to supply in the years to come. There are debates about the pace of growth, and the likely increase in break-even costs as capacity constraints, inflation, and rising interest rates come into play. But what does not seem in doubt is that markets will need to adapt to surging US supply. Market rebalancing this year still on the cards That said, although US oil production is clearly growing strongly, average output is projected to rise by just 420,000b/d this year. Assuming reasonable compliance with agreed cuts, this will be more than offset by declines in average OPEC supply of around 700,000b/d, with additional small-scale support coming from non-OPEC. With global oil demand growth expected to hold up at 1.3mb/d, the overall supply/demand dynamics should be sufficient to lead to the desired draw down in global stocks through Q1 2018. But medium term outlook still challenging Samba Global Oil Market Balance annual change mb/d 2015 2016 2017 Demand 1.7 1.5 1.3 Non-OPEC supply 1.3 -0.7 0.6 USA 1.0 -0.5 0.4 OPEC NGLs 0.2 0.2 0.2 OPEC crude 1.1 0.9 -0.7 Total supply 2.5 0.4 0.1 Balance (-deficit) 0.8 -1.1 -1.2 2018 1.2 0.9 0.9 0.1 0.9 1.9 0.7 However, even assuming markets start 2018 in better shape, with lower stocks and more or less balanced fundamentals, the critical question remains as to how OPEC exits it production cut agreement. There are also concerns that some delayed projects implemented back when oil was $100/b are still to come on stream, at least in 2018, adding to likely US output growth averaging around 850,000b/d pa. Factor in a consensus view that annual global oil demand growth is set to slow to between 11.2mb/d, and it is hard to see where oil prices will find support. It is true that both OPEC and the IEA have been warning that the 2014-16 slump in conventional oil investment, combined with accelerating decline rates at existing fields, is setting the stage for a supply crunch and price hike down the road. But this will probably not materialise until 2020. In the meantime, it looks like nimble US shale oil producers will put a cap on prices, even if markets start to anticipate forthcoming tighter supply conditions. PUBLIC 18
19. June 2017 Price projections reduced and downside risks raised Given recent developments and the current weak market sentiment we have revised down our price forecasts to $55/b average this year, and $58/b next. This is predicated on solid compliance with agreed production cuts, and a tightening of market fundamentals that helps push prices towards $60/b in the later months of this year. We think that OPEC will find ways to manage an exit from agreed cuts in Q2 2018, but that prices will fall back somewhat, only firming again late in 2018 as markets begin to look at the reduced pipeline in non-US, non-OPEC supply, and the price needed to encourage necessary investments. Perhaps more than usual, our forecasts are hostage to downside risks, especially if stocks draw by less than anticipated, and prices could be contained at $45-50/b for some time. SAUDI ARABIA Saudi Arabia: Economic Indicators There has been only modest stress on Saudi financial metrics in the wake of heightened Gulf diplomatic tensions 2016 2017f 2018f 2019f 2020f Nominal GDP ($bn) 640 579 601 644 688 Real GDP growth (% change) 1.4 -0.5 1.9 2.1 3.4 Inflation (average %) 3.5 1.5 2.0 2.9 3.5 Current account (% GDP) -3.7 -0.2 2.4 7.8 10.0 -16.7 83 3.5 2.2 -13.7 82 -2.2 2.0 -10.7 74 3.1 4.0 -6.0 74 6.1 4.0 -3.5 78 8.0 6.0 Fiscal balance (% GDP) Net Foreign Assets (% GDP) Bank deposits (% change) Private sector credit (% change) Sources: national authorities, IMF, Samba Gulf tensions have moderate impact on Saudi financial gauges Diplomatic tensions in the Gulf have had a mixed, but essentially moderate impact on Saudi financial indicators. The stock market largely shrugged off the situation, continuing its downward trend in line with this year’s oil price direction. The local interbank rate (3 month Saibor) ticked up, but only a little, reflecting still-decent local liquidity conditions (a subsequent small increase reflected the US Fed’s rate hike, which was replicated by SAMA). There was more “action” from external market participants, with the CDS on the Saudi five year spiking more than 20 bps in just four days. The Saudi riyal’s peg also came under moderate pressure, with the two-year forward gaining 300 points over the same period, pushing it back to the level prevailing at the turn of the year. However, some of this at least is likely related to oil prices, with Brent shedding three dollars in just a few days in early June. The move on the CDS aside, the general feeling among external market participants is that the Kingdom is unlikely to be materially affected by the dispute. The internal market is large, PUBLIC 19
20. June 2017 liquidity is good , financial buffers are substantial and corporate exposure to Qatar is modest. However, foreign investors will be reminded that even in the Gulf region, which has historically been stable (Iraq and Kuwait excluded) disputes have the capacity to flare up with little warning. It also calls into question GCC economic co-operation and co-ordination on issues such as VAT rollout. Q1 fiscal data shows reduced deficit, largely thanks to improved oil prices… While the diplomatic tensions have grabbed headlines, of potentially more interest is the government’s fiscal performance. In the interests of enhanced transparency the Ministry of Finance duly released Q1 fiscal results, the first such quarterly data. The figures showed a welcome 70% fall in the deficit in Q1-17 compared with a year earlier. The main reason for the improvement was a surge in oil revenue, reflecting the very weak oil price performance in Q1-16. There was only a marginal gain in nonoil revenue, the raising of which is the centrepiece of the Vision 2030 plan. …though additional spending squeeze also helped In terms of spending, the government cut back hard on procurement during the first quarter (though lower costs also played a role). Public sector remuneration was also trimmed, though this has since been partially reversed by the reinstatement of public sector allowances. Overall, while encouraging, it will take another quarter of data to get a firm sense of the pace of fiscal consolidation this year. Investors puzzled that foreign assets have not stabilised, especially given recent bond issues One issue that has puzzled investors is why SAMA’s foreign assets have continued to decline at a steady pace given this improved fiscal performance and two successful external bond issues. Official NFA dropped below $500 billion in April for the first time since 2011, and are down from a peak of $730 billion in 2014. In fact, the monthly rate of decline this year, $8.9 billion, is higher than the average for 2016 ($6.7bn). This is despite the government’s maiden $17.5 billion external bond issue in October 2016 and a $9 billion external sukuk issued this April. It’s probable that the bond proceeds remain offshore, or have not been used for fiscal financing Dealing with the October bond first: the fourth quarter balance of payments data show the $17.5 billion entering the country and, PUBLIC 20