On global markets: don't cry because it’s over, smile coz it happened

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” – William Arthur Ward

Both optimists and pessimists contribute to our society as they help us strike a balancing act between expectations and reality. But the case for capital markets is very different as expectations change in a blink of an eye and reality is always so fluid; the result is an ever changing investors’ perceptions that create market booms and busts and cause joy for some and agony for others.

For finance professionals and investment advisors, there is another challenge. Their work is often assessed on a short term basis relative to the long term nature of their investment views. The investment calls you would have made a couple of years ago may be perfectly materializing today, but it does not matter much if your last week call is not paying off well. How many investors were really surprised by the economic slowdown in China? Or the structural challenges facing the so-called emerging markets? Or the impact of a strong US dollar on emerging currencies?

The world is not short of fundamental analysis. Investment banks’ research houses, international organizations and think tanks are all stuffed with piles of paperwork that discussed the implications of the end of the long investment cycle in China on commodities, equities and emerging economies several years ago. But the question is always about the timing events would unfold, the trigger and the tipping point. And here come central banks, speculators and traders who make the most of the fact that fund managers thrive to report a timely positive performance.

Ironically, some investors who viewed me a pessimist for my negative calls on markets a couple of months ago are almost the same ones who today think I am an optimist when I say “it is not over, oil will go up from here and equities still provide some interesting stories”.

Well, it is not enough to know the rules, you need to accept them! And I still see great opportunities in the world, if and only if we accept the new rules of the game. Having said that, below are some few thoughts on global developments and their impact on MENA markets

- This is far from being a third “taper tantrum”: Some global media sources insist to compare the current markets rout to the so called “taper tantrum”; when bond yields surged and stocks plummeted on news that the Fed will imminently tighten the monetary policy. This happened before in October 2013 and in the summer of last year. But this summer is different. Today, we are seeing a significant re-pricing of risks across all asset classes on a structural shift in global economic engines. The massive overcapacity that China built over the last 15-20 years makes it impossible to sustain high growth rate without a market-based reform, which will come at a substantial costs to the world economy. The drop in China’s investment rate and the shift towards a more balanced domestic consumption growth model had already blown the long lasted commodity bubble which caused a significant harm to commodity exporters in emerging markets. Non-commodity exporters in EM were not shielded from capital migration towards developed markets and safer asset classes. The result is a massive currencies devaluation and fiscal challenges for the so-called emerging economies.

 - …so the timing of the Fed rate hike is irrelevant: the rise in US dollar value may have exacerbated the EM economic woes, but it is far from the roots of their challenges. The recent media speculation about the likelihood of the Fed delaying its expected interest rate hike from Sept 2015 to March 2016, in light of global markets meltdown, remains pretty much irrelevant. Global volatility should remain high until a new economic model is shaped and, obviously, this will take time.

The case is no longer DM vs. EM, but the US vs. the World: We should stop referring to EM as a separate asset class. Otherwise, you will have to convince me that the fate of commodity exporters and importers is the same just because they were growing at higher rates in the past! In fact, research shows that EM has done very well historically during previous policy tightening, but this time is different! The correction in EM equities is structural not cyclical, and hence the investment community might need to revisit the classification of assets classes to reflect the new reality; the US is one of few markets today that is seeing a real economic recovery, at least from a fundamental perspective.

…Even though, the correction in US equities was inevitable: US equities have greatly outpaced earnings growth over the last three years. The fact that 30-35% of S&P earnings are generated from outside the US did not bode well with a rising US dollar value, and this have signaled a strong downside risk to valuations. The price of “puts” have reached historical levels relative to call options and this is a clear sign of growing risk aversion. A considerable part of the US outperformance since 2010 was driven by massive corporate share buybacks and cash dividends. This should slowdown this year onwards.

Beijing current model is a “wild goose chase”: Authorities in China have recently cut lending rates to 4.6%, reduced the reserve requirements ratio for banks and injected some billion dollars to stimulate the economy. Well, try harder! The real problem is that the investment community seem to have lost confidence in the Beijing’s ability to maintain things under control, not to mention the growing skepticism over official growth figures. Beside, a focus on growth figures in China downplay another big challenge; the sustainability of current debt levels. China’s debt to GDP has risen to more than 240% today from 150% in 2008, but still this is not the most challenging point. The problem is that the buildup in debt levels was somewhat concentrated in the hands of local government and specific sectors that are cyclical by nature; both would need a healthy growth to deleverage, but growth is limited by a slowdown in investment rate led by the massive overcapacity that China itself had built over years by directly and indirectly subsidizing input costs to boost growth…and so on.  To get out of this vicious circle, China will have to adopt a market-based kind of reform eventually. Otherwise, do not expect much from any stimulus package or monetary measures no matter how big they are.

But oil prices will still go up from here on supply not demand: US$40-45/bbl range is already below the average global cost of production. Yes there is a great deal of uncertainty over the actual breakeven level for the US shale producers, but even when you exclude the US from the equation, approx. 40-45% of today’s global oil supply would breakeven above US$50/bbl and 20-25% would breakeven above US$60/bbl. For current prices to be sustainable, one must assume that global oil demand would fall by at least 15-20%. Well, this is possible on the long term but not in 2015-2016. Investors are surprised by the resilient production levels in the US despite the fall in rig count by more than 60% year on year. It should be clear that the fall in rig counts impact the incremental production from the new shale fields and not the existing wells. Hence, the US production will have to go down in the medium term and this should further support prices around the US$60-65/bbl range.

Putting MENA equities into the picture: falling oil and commodity prices increased the fiscal challenges across the board and turned the tide for the region’s overall risk profile. However, the region could still provide a better risk-adjusted returns than the rest of EM from a pure fundamental perspective. The GCC currency peg should remain in place, at least in the medium term, supported by massive foreign reserves accumulated during the last commodity boom, and this should relatively lower the region’s risk premium compared to EM (Dubai is a major beneficiary, however this has a neutral effect on Saudi equities due to its reliance on oil prices). Some countries should benefit from recently adopted economic reforms and this should bring some selective domestic stories (Dubai, Egypt, Morocco).

Top five investment themes to consider in the next 12M

1. Oil prices will recover to the US$60-65 range: Globally, US energy stocks, MLPs should be on your radar screen. In MENA, petrochemicals stocks should outperform their peers, particularly as they should be the least impacted by any rise in domestic gas prices
2. Long WTI/Short Brent: The strong expansion in crack spreads has provided strong incentive for refineries to increase running rates. In the US, however, the expected drop in production should either i) raise WTI prices to incentivize more domestic supply or ii) lower refinery margins so as to push running rates down, or both. Healthy gasoline demand in the US suggest that WTI should outperform Brent in the next 12M.
3. Refinery margins should peak (Long oil/Short crack spread): consider hedging a long position in petrorabigh (2380.SE) by a short position in cracks spread. 2380.SE should weather the impact of lower oil petrochemicals prices by virtue of higher refining margins. At the same time, it would benefit from any recovery in oil prices by virtue of its petrochemicals cracker (100% ethane feedstock at US$0.75/mmBtu) 
4. Saudi Arabia will raise industrial input prices: lower oil prices and the relatively sticky nature of government’s expenditure means the current fiscal deficit (cUS$120 billion) is sustainable. This could fully draw down on the kingdom’s reserves over four to five years, unless oil prices recovered or capital spending is cut significantly. Plus, the ultra-cheap domestic fuel and utilities prices will have to rise to ease some of the fiscal burden. Politically, it looks a bit challenging to raise prices for households today. However, input prices for industrials should rise. That said, I am short Saudi cement, fertilisers and ceramics plays. A cut in the kingdom’s CAPEX program also means one should have a negative outlook on construction plays. On contrary, the cost of gas is very small to petrochemicals players (particularly ethylene crackers), hence my long position in Saudi petrochemicals. Any recovery in oil prices would further support this position. 
5. Egypt’s currency devaluation is inevitable: Egypt’s rising trade deficit, together with the expected decline in the GCC economic and financial aid should further pressure the country’s current account deficit over the next 12 months, not to mention any drop in the transfers of Egyptians living abroad, or any threat to tourism revenues from the existing war on terrorism. Therefore, attractive capital inflows to the country is becoming a key source of economic and stability. Attractive foreign capital can be achieved if, and only if, the Egyptian pound devalues by at least 20%. This excludes any significant jump in the US dollar/Euro exchange and the risks of any social instability in the country. That said, short EGP and consider a long position in real estate names and export oriented producers (such as OW and SKPC)

Conclusion: you cannot change the direction of the wind, but you can adjust the sails!

Have a nice weekend!