There is absolutely no doubt that the next OPEC ministerial meeting in June will pit Saudi Arabia and its Gulf allies against Iraq, Iran and Venezuela, three founder members of the oil exporters organization. Saudi Arabia has increased its production 140,000 barrels a day above its 10.058 MBD output ceiling in the pact the kingdom had brokered between OPEC, Russia and non OPEC oil producers. There has been a significant shift in Saudi oil policy since early May and the kingdom wants to increase output to bring down oil prices, probably in response to pressure from the Trump White House. Saudi Arabia has always feared oil price spirals that could cause global recession and decimate demand for its sole major export commodity. Russia has also increased its oil production in May to almost 11 million barrels a day, in response to pressure from the cash strapped oligarchs who run Lukoil, Rosneft and Gazprom Neft. If history is any guide, the kingdom’s closes OPEC allies Kuwait and UAE will also increase output this summer.
I track the impact of the Saudi oil policy shift in real time on my Bloomberg screen. Net longs in the West Texas Intermediate crude contract have plunged by a third since their January peak. A similar pattern exists in the North Sea Brent futures contracts. Speculative money no longer expects oil prices to rise. If Russia, Saudi Arabia, Kuwait and the UAE supply 1 million extra barrels a day of crude oil to a market that faces no real shortages, the optimal strategy is to remain short oil with an $60 Brent crude target.
It is also rational for Iraq, Iran and Venezuela to protest Saudi Arabia’s determination to engineer lower oil prices. Iraq exports 3.62 MBD of Basra Light and cannot easily expand production while Baghdad has not resolved all its political issues with the Kurdish regional enclave in Erbil. Iran and Venezuela cannot expand output due to US sanctions and chronic financial crises. The geopolitical fissures in OPEC will resurface in Vienna.
The 2014 – 16 oil crash was brutal in its sheer scale. Brent crude was $115 in June 2014, the month Daesh terrorists seized the Iraqi city of Mosul, and plunged to $28 by February 2016, when Saudi Arabia finally signalled its intention to resume playing its role as OPEC’s “swing producer”, the de facto central bank of oil. The kingdom then led a 1.8 MBD output cut with Russia and two dozen other oil producing countries worldwide. The harsh reality of OPEC is that climate change, electric cars and new gasoline engine technologies lead to a peak in consumption at the same time as the Permian Basin shale oil drillers turn to global export markets. This means the primary trend for crude oil is to fall since OPEC supplies only a mere third of global demand. Unlike in the 1970’s, OPEC is a price taker, not a price maker.
Saudi Arabia and Iraq, with the world’s biggest long life reserves and lowest lifting cost, will be in a competitive race to produce and export as many barrels as they possibly can before technology makes fossil fuel obsolete. Oil gluts, not oil shortages have seen the swords of Damocles for oil producers ever since John D. Rockefeller created the Standard Oil trust in the later 1890’s.
International politics and the economics of drilling suggest a stable price is one that enables Saudi Arabia to finance its development plan and maintain its goodwill in Washington but also enables North America’s 4000 odd shale oil wildcatters and Big Oil to earn an economic profit. Economists estimate this stable, crude oil price at current prices is $50 – 56 Brent. This is the reason the smart money bets Brent will drop from its current $75 to $60 or lower by year end. This is the reason I ignore ostensible “bargains” in Wall Street oil and gas stocks.
With its vast reserves, low extraction costs and high spare capacity, Saudi Arabia will continue to remain the dominant powerbroker in OPEC and the international energy markets. However, it is no longer in Saudi Arabia’s national interest to restrain output and act as “swing producer” if shale, climate change and new electric car technologies is going to erode long term demand for crude oil. In fact, the mathematics of Von Neumann’s game theory suggests Saudi Arabia, Iraq and Russia will all seek to produce and export as much as they can, to monetise reserves before demand for black gold shrinks over the next decade. As each nation in OPEC (and Ropec!) seeks to maximise revenue, the only credible scenario is a Darwinian battle for market share – a price war!
Currencies – What next for the Mexican peso, Pakistan rupee and Turkish lira
Mexican dictator Porfirio Díaz is immortalised for his lament “Poor Mexico. So far from God, so close to the United States”. This is so true even though Diaz did not live long enough to see Donald Trump in the White House, whose campaign fanned xenophobia against Mexican immigrants (“bad hombres”) with his promise to build a border war that he would force Mexico to pay for. Trump has also threatened to tear up NAFTA and has imposed tariffs on Mexican steel, aluminium and, in the future, cars. It is no wonder that the Mexican peso, the most liquid currency in the emerging markets, has been a profitable short after the 2016 Presidential election, to all-time lows against the US dollar. A new spasm of pessimism over NAFTA, contagion from Brazil and Argentina, lower oil prices and Wall Street angst over the imminent election has seen the Mexican peso slammed 13% since mid-April. It is entirely possible that the next President of Mexico could be the populist, leftist candidate Andrés Manuel López Obrador in the July election. This is the reason every macro hedge fund manager I know has been short the Mexican peso, a license to print money ever since the latest emerging market crisis. (“it is not a crisis” the UBS and Credit Suisse EM strategists robotically intone on CNBC. Yean right. Like when Bernanke assured us that subprime would be contained!).
A Lopez Obrador win would mean a breakdown in relations with Washington and a tsunami of capital flight from los gatos gordos (fat cats), the financial elite of Mexico. This could also mean the Mexican peso plunges below its December 2016 levels, possibly to as low as 22. The Mexican peso will be a victim of not just Trump/NAFTA and Lopez-Obrador but also King Dollar and higher US Treasury yields. More than two-thirds of Mexican peso government debt is owned by Wall Street – and Gringolandia is bailing out as the peso tanked. There is no respite in sight as the smart money is still short the Mexican peso, if the Chicago futures positioning data is any guide. As in 1994, a Mexican peso crisis will wreak havoc in emerging markets.
The third Pakistani rupee devaluation since December 2017 was as swift as it was inevitable. Pakistan’s dismal $10 billion foreign exchange reserves and sheer scale of external debt means Islamabad will have no choice but to seek an IMF loan, which mandates a lower rupee, possibly as low as 128 – 130 against the US dollar. I doubt if a populist like Imran Khan, despite his close ties with the Rawalpindi GHQ, who is viscerally anti-American can implement a classic IMF program to address Pakistan’s balance of payments crisis. This means the State Bank will be forced to squeeze consumers/imports with a much lower rupee. With foreign reserves now at a mere two months of imports, the electorate may well vote PML-N back to power, despite Nawaz Sharif’s disqualification by the Supreme Court. Ironically, the PLMN’s managed float and failure to address the $27 billion trade deficit and capital flight (Mianomics, Mayfair flats and Panama trusts!) Made a draconian rupee devaluation inevitable. A hostile Trump means Pakistan’s white knight might not be the IMF but the People’s Bank of China.
The Powell Fed raised interest rates at the June FOMC and projects two more rate hikes in 2018. This means the US Treasury debt yield curse could well invert sometime next summer. This is a terrible prospect for the Turkish lira, 4.70 to the US dollar as I write. This means the desperate rate hikes by the Ankara central bank are in vain as the Fed goes hawkish and the global liquidity pump sputters.
I expect the Turkish lira to continue to fall despite its rate hikes as its current account deficit will be hit by the slowdown in Germany and France, critical destinations for Turkish exports. As if the macro storm clouds on the Bosphorus was not bad enough, President Erdogan has threatened to lend an “operation” against rating firm Moody’s after it placed Turkish sovereign debt on review for a downgrade. In the past, Erdogan has blamed an “international interest rate lobby” for Turkish macro woes. No wonder Fitch has shut down its Istanbul office. If AKP wins the June 24 election, confidence in the Turkish lira will plunge and it could trade as low as 6 to the US dollar.
Macro Ideas – Value traps and value buys in European equities
The Euro has fallen to 1.15, as I predicted last week. It is difficult to be bullish about Europe\s Stoxx 600 index, 386 as I write. The G-7 debacle in Quebec and Trump’s tariffs demonstrate that Europe is far more vulnerable to international trade tensions than the US. Italian government bond yields are still elevated at 2.85%, a metric of sovereign risk. German and French industrial production data has slumped and the growth data momentum has decelerated. This is negative for 2Q Eurozone growth. European earnings estimates are still far too optimistic sine key sectors and industries will be hugely impacted by exposure to distressed emerging markets – Brazil, Turkey, Argentina, and South Africa. For instance, French supermarket chain Carrefour derives 17% of global sales from Brazil alone. Unicredit owns a strategic stake in the Turkish Yapi Kredit Bank. The Spanish bank Santander and BBVA have huge listed subsidiaries Brazil and Argentina. Glencore, Anglo-America and Barclays have significant exposure to South Africa. Europe is not immune to an emerging markets crisis. The ECB’s scale of bond buying will eventually decline, a bearish prospect for equities.
Valuations in Europe are optically “cheap” but the Old World abounds in value traps. Without a credible FANG growth names, Europe exports risk capital to Wall Street and China. Russia is under sanctions. Brexit still unnerves markets. Trade wars negate the synchronized global growth argument that still boosted Europe in 2017.
Value buys? Spain’s Country index fund could be a profitable investment in th second half of 2018. Socialist Prime Minister Pedro Sanchez seized power from Mariano Rajoy, who lost a vote of no coincidence in the Cortes due to a corruption scandal. Even though Podemos helped Sanchez win power, he has unveiled a pro-EU, pro-Euro, centrist Cabinet. Spain’s Ibex 35 has been the second worst performing stock market index in Europe since the trauma of the Catalan secessionist vote and Rajoy’s political woes in 2017. Spanish equities have been derated to a mere 12 times earnings, well below their 13.5 times fire year average even though GDP growth has accelerated to 2.7%, the property market is booming, tourist arrivals have beat records and earnings momentum revision is positive. If Sanchez consolidates power and defuses the Catalan time bomb, Madrid’s Ibex 35 could be a candidate for a valuation rerating.
Swiss financial colossus Zurich Insurance has been unjustifiably slammed by 8% in the stock market due to its $10 billion Italian government bond exposure. Zurich Insurance is now a steal at 12 times forward earnings and a 4.6% dividend yield, a compelling buy at 280 Swiss francs for a 340 – 360 CHF target. There are multiple catalysts for a rerating in Zurich Insurance shares. One, investment yields have crept up to 2.9%, above its accounting yield. Two, its Farmer subsidiary is in turnaround mode. Three, the decision to slash its loss making commercial motor business in North America and cut costs by $400 million will improve the firm’s combined ratio. Zurich Insurance is a favourite for Swiss/German income obsessed fund managers, who will buy the shares now that the new Italian Finance Minister Giovanni Tria has reassured the markets on the Euro. My other favourite stocks in Switzerland are Novartis, Adecco and UBS (though not at current prices!).
Trump has threatened 25% tariffs on European auto imports. This will be devastating for BMW, which sells one tenth of its global vehicles in the US and Daimler sells 8% of its global volumes in the US, though Volkswagen sells only 3%, despite the global fallout of its Dieselgate scandal. If the companies pass on tariffs to consumers, they will erode their competitive position in the US auto market. A double whammy for Daimler is that its profitable US truck business will be hit by higher steel and aluminium prices due to Trump’s tariffs. For now, I would avoid German autos. BMW can well fall to 75 Euros, despite its electric car momentum and uber-modest seven times earnings valuation multiple.
While French oil supermajor total met and exceeded by 50 Euro price target, I would once again buy the shares if they fell below 45 Euros, which can well happen if Brent crude trades down to $65 as Saudi Arabia and Russia expand their oil output. The geopolitics of Iran sanctions is also negative for Total. I am not a fan of European defensive sectors but believe Danish diabetes firm Novo Nordisk and Swiss immune-oncology giant Roche Holdings are both unique global franchises.
