Economic Outlook for 2014

Dear friends, following are some of the important economic themes for this 2014.

As always we welcome any feedback, I have mode detailed information about each of the topic discussed below but I have summarised the content to fulfil the purpose of this blog which is meant to be informative but not the place where to analyse in depth each subject. If anybody is interested in additional information please connect with me directly using the contact form at www.affinitasconsulting.ae or info@affinitasconsulting.ae.

Overview

We recommend a cautious investment approach to 2014. While at the turning of the year many media outlets run big optimistic titles for 2014 we remain instead very prudent and skeptical about the health of the global economy. We see several reasons for weakness especially in the equity sector. Clearly, as always even weaknesses or a downturn uncover opportunities for successful money making but we leave those strategies to the people in the field and we would rather concentrate the following analysis on long term trends likely to affect economic growth instead.

The tapering of the US QE exercise is bound to have ripple effects globally, especially across the emerging market economies.

We reckon the US economy is not as healthy as mainstream media believes and we expect the Feds to evaluate tapering sometimes after Summer when additional signs of weaknesses are going to appear. Now that the elections in Germany are over and done with, and the upcoming banking stress test from the ECB looming we expect the Eurozone to create some waves again. Spain and Italy are bound to catch the spotlight: the first because of weaker than expected banking system and the latter because we expect the government to be challenged in the coming months.

Bottom line: it may be time to cash out on the equity gains accrued over the last few months and wait for bargains during the volatility that is bound to take place due to the tightening moves of the next few months. Some institutional investors or asset allocators may look into specific infrastructure projects which have demonstrated a low correlation with equity markets oscillations.

Investors or asset allocators may also explore and evaluate financial instruments that have as objective the isolation of the interest rate differentials.

A STRONGER DOLLAR

The tapering program announced by the Federal Reserve is going to be one of the key elements behind a likely appreciation of the USD against the other G10 currencies.

I believe we will see an even appreciation of the currency throughout 2014. While portfolio flows in 2013 definitely favoured Europe we believe that strong equity valuation discounts eliminated any chance for further growth hinderances. 

In addition US Banks are decreasing their exposure against foreign borrowers and we see this as a clear sign that the USD is no longer used as a funding currency but rather as a destination for investment.

With specific regard to the USD/EUR rate we simply believe that in spite of the PR coming from the EU there are significant unresolved problems in the Eurozone that are bound to flare again at any time (more below on this topic - EU problems all over again).

We are forecasting the following key rate: 1.20 $/EUR 

USD Investment Destination (Graph)

PRESSURE ON CORPORATE PROFITS

This topic is directly linked to a phenomenon that many economists have been discussing for more than a decade: the decoupling of productivity and wage growth, the so called Jaw of the Snake.

The decoupling between productivity and wage started to appear around the beginning of the 80s, we believe that the spread of the personal computer and the adoption of information technology greatly favoured this trend. 

Fundamentally: since 1990 German labor productivity increased by 25% with no appreciable difference in wage growth; in the US labour productivity has increased to-date 85% versus only 35% of the hourly wage. In a study published in 2012 & 2013 by the International Labour Organisation we learned that the share of labor as part of the gross national income has declined since 1975 by more than 10% across the 16 high-income economies.

This allows for a redistribution of the national income away from labor and in favour of capital owners.

ILO (International Labour Organisation) research goes therefore at the core of the problem: the decline in the labor share of the national income hinders aggregate demand; that is because the consumption propensity from labour income is much higher than the propensity to consume out of capital income.

We therefore believe that pressure on corporate profit will come directly from the spreading income inequality that is accelerating in many of the G10 economies. In fact, lower aggregate demand lowers government tax collection, and further hinders the ability and willingness of companies to invest.

Adjusted Labor Income Shares (Graphs)

Increasing Income Inequality (Graph)

EU PROBLEMS ALL OVER AGAIN

While the marketing machine hails the Banking Accord of 2013 we believe that its positive effects will take very long time to take effect, and during this time a lot can and will happen. Be aware that the resolution fund part of the accord will not reach its target till 2026! 

Throughout 2014 there are going to be several junctures testing the solidity of the union and especially its banking system. We expect the upcoming banking stress test by the ECB to be one of such tests. It is likely that the test is going to uncover the requirement for additional capital especially in Spain, Greece and Italy. The stress test is promised to be more stringent than the previous one, especially since the previous one proved to be inconclusive since after passing it with flying colors the Spanish Bankia, the Cyprus Laiki and the Franco-Belgium Dexia went belly up just months later.

We also believe that the Spanish economy hasn’t sufficiently deleveraged, especially in its real estate sector.

The figure below shows that notwithstanding the collapse of property prices, Spanish mortgage debt has adjusted by only half the magnitude of the US adjustment. 

Any alarm in the banking sector would have repercussion on the valuation of the sovereign debt. The vast amount of Spanish government debt is in fact held internally by domestic banks.

IMF projections give the Spain structural deficit as one of the worst globally over the next five years. It is likely that additional fiscal tightening is going to be required in the upcoming future to meet the required targets.

We remain quite pessimistic in the future of the Euro zone in spite of the victory speeches of some of its leaders. 

Since the local governments are going to be forced to fund their own bank bailouts till the European fund gets up-to-speed we expect a continuing shortage of credit. With a chronic shortage of credit given to the private sector we expect growth to remain weak or non existent for most of the EU countries and deflationary forces will remain at play during the entire year.

Reality will seep through in 2014 and equity returns should start to be driven by corporate earnings instead than Quantitative Easing operations by the central bank. 

It is clear that Eurozone leaders have addressed some of the issues on hand and made significant steps forward, especially steps that have been blessed by the German leadership. Nevertheless these steps remain insufficient to resolve the disparity between the different countries in the zone and time may be running out before additional shocks are going to rock the system.

Reverse globalisation

Global trade hasn’t recovered to the same levels prior of the 2008 crisis and its growth remains below trend since 2011. Further note that additional data leads us to believe that there is an underlying trend of re-shoring currently in place.

The Manufacturing Advisory Services survey show that among 500 UK small and medium size companies interviewed a significant percentage of them was in the process of reshoring or thinking about it.

15% of the manufacturing business in the South East was already reshoring and an additional 25% of the companies was considering reshoring activities over the following 12 months.

Shipping Remains Subdued (Graph)

Similar trends are not exclusive to the UK manufacturing industries but also in the USA where industrial reshoring has been a key theme of 2013. In the USA the trend is predicated on the falling energy prices (“fracking revolution). 

Over the next decade as labor cost rise in China and other Asian exporters we predict this trend to gain pace.

Shipping Indexes (Graph)

Reasons for Re-Shoring (UK)

DEBT SERVICE BURDENS

As the monetary stimulus keeps on being retracted the lid that was put on government bond yields is going to be lifted little by little. It is therefore normal that interest rates sooner or later are expected to be raised.

Our point is that as this happens we expect service burdens for household to rise and therefore depress consumption expenditures.

Debt Servicing Costs

We indicate few countries that are likely to hit particular consumption degradation at the rising of interest rates: Canada, Netherlands and Sweden. These countries experienced a fair amount of household leverage during the last 10 years with no sign of decrease since 2008.

A study from the Canadian Chartered Accountants found that 29% of the respondents would struggle to keep up with payments if interest rate rose by 2% and further 29% would consider challenging more than 3%.

Canada, the USA and Sweden have a high proportion of non mortgage variable debt outstanding that is used for consumption. As monetary policy keeps on tightening over the course of 2014 investors are best to avoid any consumer centric type of equities.

Interest Rate Vulnerability (Graph)

Please contact the Affinitas Consulting team (www.affinitasconsulting.ae) for any additional query or information.

Bio farming opportunities in Georgia

This article provides a general overview of agricultural industry in Georgia, as well as the specific information about the challenges and opportunities that the country offers in terms of bio farming.

Preamble

The agriculture industry is a key element part of the daunting challenge facing mankind over the next 50 years. Figures show that humans need to produce over the next 25 years 70% more food resources than ever produced in the entire history of mankind.

An early perspective on the looming food shortage was presented more than a decade ago by Norman Borlaug, father of the Green Revolution and 1970 Nobel Laureate for Peace (Borlaug, 2000). In an article on world hunger, he wrote that “it took some 10,000 years to expand food production to the current level of about 5 billion tons per year,” and that to meet the needs of the planet’s growing population by 2025, “we will have to nearly double current production again.”
(Above paragraph from:  http://www.co2science.org/education/reports/foodsecurity/GlobalFoodProductionEstimates2050.pdf)

As part of this challenge water and food are going to be essential commodities to sustain our development. It is because of this challenge that few strategic areas in the world are becoming the destination of investment in agriculture.
One of such global areas is the Caspian Sea and the countries in its region. The environment, the latitude and water access makes it a perfect candidate for the agriculture revival currently underway. Georgia especially given its very welcoming business environment and unique geography is becoming one of the preferred destinations for agriculture investment.
Below we take a closer look at bio farming, a sector that we expect to present great opportunities for investors.

Agriculture in Georgia

The fact that Georgia is one of the oldest agricultural countries is already proven by the archaeological findings. Such status is first of all determined by the diverse climate, which creates the possibility to grow and later harvest different crops any time of the year. Georgia shares the same latitude with Italy for example.
However, despite the farming is one of the oldest professions for Georgians and nowadays more than the half of the population (54%-58%) is involved in agricultural business this sector of the economy is  contributing only 11% of the national GDP. The fractioning of the land in small family plots and the lack of an effective pro-agricultural policy post Soviet union break up have both contributed to chronic lack of resources to invest in the industry.
Investment in up-to-date technologies is necessary to reap the benefits of a rich soil and that is in fact where many opportunities for investors lie.

Bio farming in Georgia

During the recent years, the world trend, namely the organic farming also entered the Georgian agriculture business. However this field is nowadays in the initial stage and still the importance of bio farming isn’t well understood in the local market both from the point of healthy nutrition as well as from its economics point of view.

We interviewed Georgian bio technologist David Chachanidze who is actively involved in organic farming in Georgia and who tries to develop the bio agriculture sector in the country. He explains how so far the overall lack of information has been the main culprit of the low interest of Georgian farmers towards bio agriculture.
“Unfortunately most of the domestic farmers do not have any information and even minimum education about the bio methodology and its advantages and still use chemical fertilizers in agriculture”, explains Chachanidze.

During our conversation he also emphasized that based upon soil resources that Georgia has the country could satisfy the existing agriculture demand of its own citizens, and also it could export its products and successfully enter international markets, where the importance of ecologically clean products is already mature and where the demand for such products increases from year to year.

bio method: putting hay for ground fertilization

Why to invest in Georgian emerging organic farming

There are several uniquely favorable parameters critical for bio farming development Georgia:

1. Lands giving plentiful harvest
2. Diverse climate zones
3. Labor force
4. Bio technologies

These four major parameters are already accessible in Georgia and that’s very important from business point of view, they are available for significantly lower prices than in countries where organic agriculture is already embraced and developed. 

Currently, two companies already operate in this field in Georgia; the first one is “Bio Organic Georgia”, producing organic fertilizers and the second one, its affiliated company- “Organica”, producing bio pesticides. 

Both companies’ products ingredients are taken entirely from nature, multiplied in the laboratory and later the concentrate output is used in the fields.

Mr. Chachanidze declares that these organic products are cheaper than the similar products produced in foreign countries and are competitive as with the price, also from the quality point of view. 

It’s noteworthy that these companies have all the necessary documentations and international certificates for all the fertilizers and pesticides, that means that if the farmer/company will use these products in the process of farming, it will be easier to export the final goods to international markets and be able to mark the product as “organic”. These documentation is essential to help exporters to spend less time at each border crossing and therefore reduce costs. 

At this moment in time only few farmers are involved in bio farming in Georgia and are exporting to international markets. Most of them became interested in this niche of the agricultural industry after visiting foreign countries where they gathered basic information and witnessed first hand the benefits of an increasing demand for organic products. 

As of today though the Georgian government hasn’t yet created essential policy necessary to support and develop organic farming, it is therefore auspicable that renewed attention will be given to this matter soon since all developed countries have already assessed the importance of ecologically clean products and have established the appropriate policies and legislation necessary to ensure the differentiation process between organic and non organic products. 

Such policies have increased the motivation and investment behind bio farming by creating rules and traceability processes protecting producers and consumers alike against fraud and falsification of products.

Appropriate legislation favoring organic products helps developing the necessary niche for them, ensures premium pricing against conventional products (premium currently stands at 40-50 percent), and therefore Georgian bio farmers could became increasingly stimulated to export their products to foreign markets. 

Below is given comparison between the prices for organic and conventional fresh products in USA market according to www.abcnews.go.com. 

Food	Organic Price	Conventional
Asparagus	$4.99	$2.99
Avocado	$2.99	$1.99
Sweet Peas	$1.59	$1.59
Grapefruit	$2.49	$0.89
Onions (Y)	$1.29	$0.99
Sweet Corn	$2.89	$1.69
Pineapple	$5.99	$3.99
Fuji Apple x4	$4.89	$3.89
Bell Pepper	$4.99/lb.	$1.99
Carrots	$1.99/bag	$0.89
Celery	$3.99	$3.49
Lettuce	$2.99	$1.99
Potato	$1.49/lb.	0.99
Strawberries	5.99	4.99

In case of exporting organic products out of Georgia, it will be more profitable in case of such products as: Georgian Bio wheat, potato, carrot, cabbage, herbs, spices, wine, dried fruit and other goods, which are easy to keep and transport.

However another way also exists, which is linked with secondary production, like: canning or drying the products.

Also the way to freeze the fresh products exists. The 21st century offers technologies makes available to use shock-freezing method. Fresh foods frozen in such way maintain the initial visual appeal, as well as the original taste after defrost and it’s almost impossible to feel the difference between the real fresh food and the defrosted one.

The potential markets where Georgia based organic products can be exported

Demand for bio products increase almost on everyday basis, as developed countries’ population have already realized the importance of healthy food and understood that despite the relatively high price, in the long term they save money, that could be spent in the future due of health or weight related problems.

For example the table below displays the yearly sales figures in the USA, prepared according to the Industry Snapshot performed by the Center for Economic Vitality, Western Washington University.

These data clearly shows how in the USA that total organic food sales increased about 307% (during 2000-2009 year), while during the same period of time the “traditional” food industry as a whole experienced only 34% growth. 

Almost the relatively same situation is present in Europe and also in other developed countries. There are also the numbers of agricultural countries such as: Romania, Poland, Turkey and etc. which proclaimed organic farming as a national priority and there also exists the other countries, which have poor amount of land, from which absolute majority is already used and where the labor force is very expensive and so the prime cost for organic products are high.

Bio peach plant

Georgia’s competitive advantages

On the other hand such country as Georgia exists, where labor force is much cheaper, as for example the salary for a person to hire varies from 500-700 Gels, It’s also very important that  bio farming business is on its initial stage and so there’re still lots of opportunities. 

Climate zones are also very diverse, and more than half of the agricultural lands (52%) remains still raw and unprocessed. And according to the general parameters if the soil is unprocessed for several years, it’s richer than already used one. 

Bio technologies are also much more cheaper in Georgia, than in countries with developed organic production. We can say that in case of general, farming one hectar of land using the traditional method requires at least 500 GEL ($302 USD) pesticides and necessary inputs for initial stage, while in case of bio farming it varies from 200-250 GEL ($120 USD). 

In many cases in Georgia agricultural soil hasn’t been harvested for many years in Georgia due to political and social reasons. Agriculture related investors are bound to invest in soil which is rich in minerals and can yield, with proper preparation and know-how, above average crops.

Water availability factor also turns out to be very important factor in farming process; According to Georgian National Investment Agency, the Georgia ranks as a “Top Country” globally in Water Resources per Capital. There are 26,000 rivers on the territory of the country, and their total length is approximately 60, 000 km. 

Cucumber greenhouse

Fresh water supply of Georgia, which is made up of ice, lakes and water reservoirs and so that is very crucial for farming, Georgian water turns out to be rich with different minerals. 

Last but not least: logistics favor Georgia as it represents the natural gateway of goods into Europe and Central Asia alike. Georgia’s location combined with its simplified custom procedures makes this country a future player both in terms of export and re-export.

Due to the above reasons many businessmen have already realized Georgia’s potential and foreign direct investment in agriculture has started to rise. Given Georgia’s overall size and relative land availability we expect bio farming to be a significant part of the Georgian agricultural mix. 

“We know already that foreign investors have bought large amounts of land in Georgia, in order to start bio farming business”, declared David Chachanidze, who due to his business is greatly involved in almost every project linked with organic farming, since his companies (“Bio Organic Georgia” and “Bio Agro”) turns out to be one of the very few service providers so far in this field.

Since the cost of bio production in Georgia is lower than in countries where this direction of agriculture is already developed, the companies and farmers operating in Georgia have possibility to carry out the production of competitive organic products.

Georgia is at this point in time just an emerging market in the bio farming industry although if foreign direct investment in this area will persist at this rate we expect Georgia to be an important player in the region in just a few years; a player able to produce high quality appealing products that will find their lucrative niches in Europe and the Middle East and neighboring developing countries where a more affluent segment of the population demands for organic products.

Organic mushroom

Bio technologies, already well developed in Georgia and the climate conditions ensuring the quality (delicious, flavored, full of vitamins) of the products, together with lower costs, will guarantee that Georgia based organic products will honorably compete with its rivals on the international market in just a few years. 

Organic mushroom green house

We at Affinitas remain available to provide additional details with regards to bio-farming in the Caucasus and in Georgia especially. Please direct any further query to info@affinitasconsulting.ae or join our Facebook page to keep updated on the latest news: www.facebook.com/Affinitas 

bio salad in greenhouse

Article by: Kate Lekishvili & Luca Gorlero. All rights are reserved. Total reproduction or partial reproduction of the information above is forbidden unless authorized in writing by Affinitas Consulting.

From BRIC to BIC? Is Russia worth the emerging market status?

It took me a while to get back behind my desk and write for this blog. Too many projects have diverted some of my attention elsewhere although the topics over which to share my humble views are a lot.

Numerous times over the past few weeks I had the opportunity to share with clients, investors and friends alike my negative opinion about Russia's future economic outlook.

I went back to substantiate some of my qualitative comments with data gathered from the recent World Economic Forum report.

The data from the report is not encouraging, following is a summary that I have provided in an earlier post:

Russia: 63th position, same as last year. After the significant slide of the previous year, Russia maintains its position. While infrastructure, health, education and technology improves significantly other components of the index suffer. The major area of concern highlighted in the report are market competitiveness and efficiency of the goods markets. Competition is hindered by inefficient anti monopoly laws and restrictions on trade and foreign ownership. One of the main issue highlighted further in the report remains the weak institutions that translate in weak property rights (126th rank) and weak corporate governance standards (119th rank).

In spite of the large amount of natural resources available for development the country doesn't seem to be able to attract large amount of foreign capital due to poor market efficiency and regulatory frameworks able to give proper guarantees to foreign investors. 

Further to the contingent stagnant situation I believe there are some more fundamental weaknesses of the system that is worth outlining:

• very negative demographic trends;
• limited communication skills in the international arena as most of the business people tend not to be able to speak basic English.
• weak and non competitive SME sector

The first is the most worrisome of the trends. It has been recognized by the local government as a serious problem and some measures have been taken to stimulate the natality rate.

Low birth rates and abnormally high death rates caused Russia's population to decline at a 0.5% annual rate, or about 750,000 to 800,000 people per year from the mid 90s to the mid 00s.

The population peaked in 1991 with 148,689,000 and it is now at 141,927,000 as of January 1, 2010.

The language aspect is more difficult to quantify in its impact but in my opinion remains an important one. While the Indian subcontinent for example presents clear difficulties in regulatory frameworks and infrastructure among others remains a lot more dynamic and integrated with the global economy due to the pervasive use of the English language among the average business person.

On the other hand Russia remains insulated as most of the business people, even of young age, are barely able to speak basic business English.

Russians have developed their own set of social network website separate from the rest of the world: Vkontakte (www.vkontakte.ru) and they are trying to develop their own set of domain names in cyrillic: Russian domain names. 

In a world where being connected and communication is the underlying basis for all business it is hard to imagine how big is the cost of this type of "isolation".

The SME sector is undersized for this nation as the entrepreneurial class has only a very brief history. During the entire Soviet Union time there was a systematic dismantling of the entrepreneurial spirit and only after the break up and the savage deregulation following SMEs have found a reason to exist. 

In both emerging markets and developed countries SMEs often tend to be the most resilient during an economic downturn as well as a consistent source of innovation. Without such developed strata of companies combined with some of the difficulties outlined above the Russia economy appears lacking a necessary component to long term prosperity. Please note that to support the claim above according to the latest World Bank's survey (Doing Business, 2009) Russia ranks 120 out of 181 economies in 'ease of doing business'.

Overall, my position remains that given the existing economic issues and moreover due to the long term demographic trends currently in place Russia no longer belongs to the emerging market economies in spite of the large natural resources available on the territory.

Too many changes are to be applied at the same time to reverse the situation. It would be at least necessary to create a more favorable set of predictable rules to favor and regulate foreign investment in the country such to develop and modernize further the natural resources industries.

Swift and deep additional efforts are to be made to integrate additional foreign workers in the country to be able to reverse some of the underlying demographic trends and more importantly collect the related taxes.

As many friends and clients come from this beautiful country I hope to assist to a swift reversal of such trends.