Middle East and Central Asia – Canary in the Coal Mine?
(June 15, 2006)
Dear Subscribers and Readers,
As I mentioned in our weekend commentary, I stated that you can't hedge what you cannot know – especially for folks who are worried about potential energy price spikes as current data indicate that the probability of such a spike due to interruption of Gulf Coast supplies this Hurricane Season is next to impossible (for now). The same applies for Bird Flu, potential hedge fund blowups, or some kind of emerging market crisis. Of course, we can always make a guess – and this author has been making “reasonable guesses” based on the record mutual fund inflows into international and emerging markets, implied volatility levels, as well as record low bond spreads just before the latest swoon in the emerging and international markets over the last six weeks.
As this author has mentioned earlier this year, many of the Middle Eastern and Central Asian markets (as well as the NASDAQ Composite and Dow Utilities) topped out late either late last year or earlier this year and have already recorded substantial declines by the time the Dow Jones Industrial Average topped out on May 10th (e.g. Kuwait in February, Saudi Arabia in March, Egypt in February, and Turkey in March). Obviously, many of the Middle Eastern and Central Asian markets ultimately turned out to be the “canary in the coal mines,” but the important question today is: Will they continue to be the canaries in the coal mine? And if so, what are they signaling now?
At the peak of many of the Middle Eastern and Central Asian markets earlier this year, valuations hit all-time highs with some of these markets experiencing trailing P/E ratios in the 30 to 40 range. Following is a chart from the most recent May 2006 IMF “Regional Economic Outlook” publication on the Middle East and Central Asia charting the most recent stock market booms in the major Middle Eastern countries:
In many ways, the rise of these markets was a function of both higher “discretionary” savings in the region due to rising oil prices and rising speculation in the region due to ample global liquidity. From October 2005 and onwards, I had continued to pound the table telling our subscribers that “liquidity was disappearing” and given the huge appetite for risk at that time, there was a high probability that the emerging and international markets were going to experience a huge decline at some point. The peak and subsequent declines of the Middle Eastern and Central Asian markets (mostly earlier this year) finally confirmed the tightening of global liquidity and the increased aversion of risk – and this would come back to haunt those who were continuing to buy domestic, European, and Japanese equities (not to mention commodities) from March to early May this year.
With many of these markets taking huge hits over the last three to four months, valuations have come down very quickly and are now actually attractively priced. Obviously, liquidity is no longer as easily available as it used to be. Investors' stomachs are also now less tolerant – but unless these Middle Eastern and Central Asian markets continue to tank (perhaps an additional 25% to 30% from current levels), there is no reason to believe that any of these economies are in significant trouble. This is important, as the 1997 Asian Crisis was indirectly responsible for triggering the Russian, Brazilian, and LTCM crises in 1998 – which ultimately led to a 20% decline in the S&P 500 in a little over three months from July to October 1998. At the risk of sounding like a broken record, the world is more globalized than ever – and the ups and downs of the world economy are only as strong as its weakest link.
Subscribers may point to our previous pictures of the sheer number of construction cranes in Dubai as “evidence” that the Middle Eastern economies are about to crash. Or you may point to the Palm Islands, or the fact that Dubai houses the world's tallest and most luxurious hotel as signs of excess. Surely – if those “landmarks” did not represent an impending crash (much like the Empire State Building that was proposed in 1929, the Malaysian Petronas Twin Towers proposed in 1997, or the Enron Building that was finished just a few months before the entire company collapsed) – then perhaps the Hydropolis Hotel would surely be it? The following picture shows the preliminary design of the hotel – it is designed to be the world's first “underwater hotel.” All the 220 guest rooms will be located 66 feet below the surface, and construction costs are estimated to top US$500 million:
But short of spending their reserves and additional petrodollars on landmarks and “bridge building that leads to nowhere,” many of the Middle Eastern and Central Asian countries have actually saved the majority and have used it to reduce debt and to increase their Dollar/Euro reserves. The following chart courtesy of IMF shows the ratio of the increase in current account balance to the increase in oil export receipts from 2002 to 2005 – which is essentially a measurement of how much each country has saved from each additional dollar increase of oil receipts due to rising oil prices:
On average, the oil exporting countries have been very cautious with the rise in oil prices since 2002 – having saved approximately 66% of each additional dollar they have received through rising oil prices since that time. This cautiousness is exemplified by the following chart showing total government debt as a percentage of GDP for the Middle Eastern and Central Asian region (MCD) as well as a breakdown of oil exporters, low income countries, and emerging markets in this region:
As an aside, following is a direct quote from the IMF outlining which countries fall under the three breakdowns of the region: “Oil exporters comprise Algeria, Azerbaijan, Bahrain, Iran, Iraq, Kazakhstan, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Syria, Turkmenistan, and the United Arab Emirates (UAE). LICs are Afghanistan, Armenia, Djibouti, Georgia, Kyrgyz Republic, Mauritania, Sudan, Tajikistan, Uzbekistan, and Yemen. Emerging markets comprise Egypt, Jordan, Lebanon, Morocco, Pakistan, and Tunisia. Afghanistan is included in the data tables but was excluded from the averages for the country groupings, as were Iraq and Turkmenistan, because of incomplete data.” As can be seen on the above chart, government debt levels as a percentage of GDP have generally halved since 1998 with the exception of the emerging market countries. But nonetheless, government debt levels in these countries remain relatively healthy. Especially encouraging is the fact that the low-income countries (which are not oil exporters) have also managed to grow their economies and reduce their debt at the same time.
Just before the Asian crisis hit (starting with Thailand on July 1, 1997), many of the countries known as the “Asian Tigers” have been running current account deficits equal to 4% to 5% of their GDPs – a wholly unsustainable levels given that speculation in both their stock and real estate markets were running widely rampant. When a country runs such a high current account deficit (as in New Zealand, Spain and the U.S. today), one better make sure you have enough attractive assets to go around (or in the case of the U.S., both the assets and the fact that her currency is the world's reserve currency) for your creditors. The Asian Tigers did not have many of these assets – and once the stock and real estate markets stopped going up, it was all over as foreign investors and hedge funds withdrew their monies en masse. Today, the Middle Eastern and Central Asian countries have no such problem, as foreign direct investments in these countries remain high and as many of these countries have improved their current account balance situations since 1998. Following are the relevant charts from the IMF:
The final lender and defender of last resort – the Central Banks – did not have enough reserves to stem the “capital flight” (not to mention an attack by speculators) from the Asian Tigers in 1997. As a result, many of the world's central banks have significantly increased their foreign reserves over the last ten years. This has not been lost on the Middle Eastern and Central Asian countries, as they have also in general significantly increased their foreign reserves since that time:
In other words, while the Middle Eastern and Central Asian region may continue to be the canary in the coal mine, this author does not expect any trouble and certainly no spillover effects from this region anytime soon. As this author also discussed in last weekend's commentary, I also don't expect any trouble from the Gulf Coast area during the 2006 hurricane season. If anything, there is still currently a shut-in production of 300,000 barrels a day of light crude oil in the region – and this additional capacity should gradually come online over the next six months. Assuming one more rate hike from the U.S. Fed (I still believe that the June 29th rate hike will be the last one) and two more from the ECB, there is no question that crude oil prices will significantly come down in the next six months. Even with an oil price of $50 a barrel, many of the economies of the oil exporting countries should continue to do very well. At the same time, an oil price of $50 a barrel will provide great relief to the U.S. consumer – to the tune of approximately $400 million a day (U.S. consumption of 20 million barrels a day x $20 a barrel in savings). In other words, a declining oil price is in everyone's interest at this time.
Of course, as this author and many others have mentioned before: “Nothing is obvious.” But one cannot even begin to predict the world economic cycles without having a grasp of the state of the world – and this commentary has hopefully served that purpose. With the exception of the American consumer and the competitiveness of Western Europe, this author does not see any impending storm clouds on the horizon. On the contrary, the balance sheets of most countries in the Middle East and Asia remains very sound – not to mention the balance sheets of the world's Fortune 1000 companies. Again, this author believes that the U.S. large caps remain the most attractive asset class in the world today.
Henry K. To, CFA