Taal selectie



Pascal Blackburne & Luc Synaeghel 2017-10-09

We begin this letter on what might seem an incongruous note for a financial publication: the end of the ban on women driving in Saudi Arabia. We are even tempted to paraphrase Neil Armstrong, considering it “one small step for Saudi women, one giant leap for Saudi Arabia”. Yes, we view this development as momentous, in so far as it underlines the speed at which the Kingdom of Saudi Arabia (KSA) is evolving under the influence of the young Crown Prince. A more acceptable form of society to “developed world” eyes will allow the KSA greater support from Western countries. Ties with US have already grown noticeably stronger during the past year.

With the US much less dependent nowadays on oil imports, the economic gains of a closer relationship with the KSA are not obvious. Perhaps the thinking is financial? As the Federal Reserve rolls back quantitative easing, buyers will need to be found for US Treasuries. But that does not fit with the current state of Saudi finances. Burdened by a mounting budget deficit, the KSA is busy seeking – rather than providing – funding. Which leads us to think that President Trump’s motivations may rather be geopolitical, particularly since his cabinet is populated with retired military officers.

Indeed, notwithstanding its “America first” slogan, the new US administration has been increasing its international involvement. Strengthening ties with Israel and the KSA is but one facet of this trend. President Trump’s attitude regarding North Korea, taking the (dangerous or deliberate) risk of nick-naming its leader in front of the United Nations General Assembly, has to do with broader Asia-Pacific considerations in our opinion. It is affording the US new military bases in South Korea, and perhaps Japan, without having to bear the cost of building them. And then there has been the pressure exerted on NATO – also resulting in stronger US military power without footing the bill. President Trump probably never really intended for the US to pull out of NATO. But his threat to do so succeeded in making European countries up their military funding, with French President Macron now even proposing that a European Union army be constituted.

Ultimately, these geopolitical shifts are likely to result in a four-block stalemate situation, somewhat akin to the Cold War era. The dominant forces, each equipped with dissuasive nuclear capabilities, will be the US, China, Russia and Europe. Of course, this assumes that small rogue countries can be prevented from developing nuclear weapons. And it does not preclude the route to a new geopolitical equilibrium from being turbulent, particularly in the Far East.

Investment-wise, we thus intend to reassess our exposure to Japanese equities. As regards the oil price, geopolitics obviously matter but we continue to believe that, once excess inventories have been eliminated, supply-demand fundamentals will prevail. Finally, gold should normally also benefit from geopolitical winds – although that did not materialise in September.

US military build-up in the Far East

China is worried by the North Korean situation. Not for the sake of North Korea per se, but because of the resulting greater US military involvement in the region.

Escalating North Korea provocations caused some – admittedly brief – equity market pullbacks during the summer. Many observers are now calling for Chinese authorities to act as a possible mediator between North Korea’s Supreme leader Kim Jong-un and US President Donald Trump – both notorious for their seemingly “dangerous” gesticulations.

Our recent discussions with Chinese-based fund managers do indeed suggest that China is worried by the North Korean situation. Not for the sake of North Korea per se, but because of the resulting greater US military involvement in the region.

More specifically, the US army has been deploying a missile defence system close to the South Korean border with China. It is designed to protect South Korea against North Korean missiles but its radar reaches over into Chinese territory – much to Chinese leaders’ distaste, who obviously resent any US preying capabilities. Further deployment of this antimissile battery has been suspended for now, officially due to environmental considerations, but this has not prevented China from beginning to impose economic sanctions on South Korea. The measures have not been publicly acknowledged, but it seems that Chinese travel to South Korea – which in recent years has replaced Hong-Kong as “the” shopping destination – is no longer possible.

China’s fear of mounting US presence in the Far East extends to Japan. There too, the North Korean threat is proving a convenient argument to increase US army capabilities, as part of the long-standing US-Japan military alliance. There is apparently currently talk of building a missile launch base – financed by Japan – in Okinawa, an island at the Southern tip of Japan which has long hosted numerous US troops. Okinawa lies near the group of islands under territorial dispute between China and Japan, a dispute related not just to shipping routes, fishing opportunities and potential oil & gas reserves, but perhaps more importantly to the vying between the US and China for Asia-Pacific military dominance.

Also making news is Prime Minister Shinzo Abe’s call for a snap general election – to be held on October 22 – stating that the Japanese people’s vote will serve as an appraisal of his handling of the North Korean crisis. He intends to resign should his party fail to win a majority. Remember that, back in December 2013 already, Shinzo Abe put forward a plan for military expansion in Japan, described as "proactive pacifism". His promise was to provide Japan with more "normal" ability to defend itself, breaking away from post-World War II constitutional constraints.

So, yes, Chinese leadership has reasons to take on a greater role in “resolving” the North Korean situation and acting fast – before the US garners too much presence in its neighbour countries. Not to mention the prospect, however remote, of a Korean unification, which would involve countless refugees crossing into China.

German elections: A missed opportunity for Europe

We now travel back west, to discuss the outcome of recent German elections which we – regrettably – view as a non-event for Europe. Complicated domestic political negotiations lie ahead in order to form a governing majority. And without strong German leadership, very little change can be expected in the institutions and functioning of the European Union.

Fortunately, though, French impetus does seem to be building. If structural changes can be successfully carried out by President Macron in France, resulting in faster economic growth and less government (lower taxes), then the Eurozone economy at large will benefit. In turn, fellow member countries’ unemployment and public finance problems will gradually dissipate.

But even in such a rosy scenario (which by the way also precludes any mess-up in forthcoming Italian elections), the moment of truth will come when the European Central Bank (ECB) terminates quantitative easing. The weaker countries of the continent have grown their public debt to GDP ratio in recent years – with the associated interest burden held down by ECB bond purchase programs.

As western monetary authorities begin (or prepare for) a momentous policy reversal, rolling back the huge amounts of liquidity pumped into the financial system since the crisis of 2008, risks are considerable. Central banks have effectively been the lenders of last resort for governments, accumulating sovereign bonds on their balance sheet. How much the cost of this debt will increase when spreads are no longer artificially compressed is an open question.

Scary also is the fact that decision-taking, hence the risk of making a policy mistake, is concentrated in the hands of very few people. Of whom one, Federal Reserve (Fed) Chair Janet Yellen, has publicly acknowledged that she does not understand current inflation dynamics. But even without the upward price pressures that would be usual at this point of the economic cycle, she has decided to proceed with the normalisation of US short-term interest rates, and will soon begin to contract the balance sheet, because she wants the Fed to be in position to loosen policy when the next recession eventually hits. And her stance makes all the more sense as economic growth is now improving across the globe and other major central banks remain in easing mode. The risk of a marked US dollar appreciation or domestic slowdown appears limited, providing the Fed with a window of opportunity to tighten monetary reins.

But what when the other central banks leaders join Janet Yellen in her thinking? We confess to feeling that market participants are like passengers of the Titanic, enjoying a good journey but headed for an accident. All agree that financial assets are broadly overvalued, posing a risk at some point down the road, yet most choose to continue to listen to the pleasant music for the time being. We, on the other hand, are preparing for the life boat.

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