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.

Taxes: UK - Swiss tax agreement, what it means for UK Citizen and Europe (includes advice for UK non-doms)

Continuing news coming from the Euro zone keep us alert that the shocks that we have forecasted coming over the next few months are going to be on time.

As countries, especially European one are coming to terms with their mounting debts, the same are focusing more and more resources into uncovering and taxing financial resources that their citizen have traditionally kept in “safe” places such as Switzerland, Lichtenstein and Luxemburg.

It is therefore not surprising the latest news with regards to the UK/Swiss tax deal that was initialed on August 24, 2011. Please note that this deal follows a similar deal again between Switzerland and Germany initialed on August 10.

The concept is simple: both deals impose a withholding tax; the UK deal includes a withholding tax just below its top marginal tax rates of income, dividends and capital gains. The German deal includes a withholding tax rate of 26.375%, corresponding to its flat tax rate for income and capital. Both of these agreements include a one-off taxation between 19% and 35% depending on the value of the account at a specific point in time.

In essence: the Swiss authorities have agreed to tax the “illicit” funds held by UK and German citizen and share the proceeds while not divulgating the identity of account holders. In other words Swiss authorities will collect the taxes and remit them to the UK and German authorities. Please note that under the UK agreement there is a “one off” fee for UK citizen that want to retain their privacy.

Further note that according to these agreements the UK revenue service can request the details of up to 500 accounts per year versus the German agreement allows for up to 999 account requests per year.

For whoever is not familiar with this matter please note that the European’s Union Savings Directive (EUSD) in place since 2005 already includes provisions for a withholding tax. The latest unilateral moves by the UK and the German government with Switzerland are obviously moving away from the perspective of a concerted European Union effort, putting into question whether a EUSD is going to see revisions added very soon or whether given the current economic climate each country is going to move forward by itself in regulating its tax relationships with Switzerland. A recent comment by senior of officials of the HM Revenue & Customs (HMRC) to Accountancy Age

With regards to the UK: this latest agreement takes precedence over the EUSD. What does it mean for the investors? Well, savings will be taxed at 48%, but the agreement covers more than liquid assets and it includes: shares, commodities, interest, dividends or capital gains (27%) that are generated in Switzerland.

The commitment on sharing records by the number per year is also an important signal to keep in mind. Further, I am unclear on how the accounting system is going to be managed between the Swiss authorities that collect the information but don’t share them and the HMRC or German authorities that receive them.

The US approach

The US government has stepped up the pressure "on" the Swiss authorities but followed a separate path which is consistent with its quest for full disclosure.

The US made it clear that it has no interest in a deal including a withholding tax with Switzerland, it wants full disclosure of US citizen’s accounts instead.

The US Foreign Account Tax Compliance Act (FATCA) requires all banks to disclose information about accounts held by US citizen of businesses. Such Compliance Act is going to be unilaterally imposed on July 1, 2013. Foreign banks that don’t comply with the Act will face sanctions, including large financial liabilities that will affect their operations in the US (see USD denominated transactions). This follows the famous UBS inquiry by US government authorities, the investigation has been ongoing since 2007 and that forced UBS to disclose more than 4,500 customer names and received a settlement of $780M USD.

The US government puts pressure on foreign banks and its citizen alike. Recently a Federal appeal last week ruled out that the Fifth Amendment doesn’t apply to non-disclosure of offshore accounts. Please note that the Fifth Amendment gives US citizen the right to remain silent on issues that incriminate themselves.

Although there are serious doubts over the legality of FATCA, given its extraterritorial nature, it is clear that the USA have the necessary “might” to force the situation since banks, Swiss or not, have the necessity to operate in the US. Small boutique banks will have more latitude in their operation if they succeed in carving out niche markets for themselves.

Options for the UK non residents/domiciled or better called “Non Doms”

Many of the non-doms in the UK are American and their status is perhaps the most intriguing. Unlike UK domiciled individuals, non-doms are not necessarily taxed on their whole worldwide income. Therefore, if they wish to maintain the secrecy of the account, the one-off charge might not be appropriate, as it would be taxing income that is not subject to UK tax.

Because of this, the agreement makes specific provisions for them. They have the option to fully disclose or retain their privacy and pay the one-off fee, the same as all taxpayers. However, non-doms have two more options. First, they can self-assess their UK taxable funds in the account as of 31 December 2010 on which they will be charged 34%. The benefit of this is that they will not have 19% to 34% of their whole funds taken out. Second, they can also opt out of this part of the agreement. This is, of course, not without controversy. The Telegraph quotes one expert who says: "It's no secret that Switzerland houses non-doms' cash and this immunity looks very unfair for everyone else."

HMRC has been keen to stress that non-doms who opt out of the agreement or self-assess and are later found to have had undeclared UK taxable funds will be treated with severe penalties, including criminal prosecution.

There is no opting out on the withholding tax. Non-doms on the remittance basis will face a withholding tax on their UK-sourced income and remitted income. Of course, they would have to remove their privacy so that the taxman knows they are on the remittance basis. However, unlike UK-domiciled individuals, when non-doms remove their privacy, they will only be charged the withholding tax rates and not the UK top rate of tax – for example, 48% on income as opposed to 50%.

Having said all this, non-doms are in a better position than UK-domiciled individuals as they have more choice available. But, contrary to some reports, this does not represent a complete immunity. Perhaps to hammer this point home, we can expect to see HMRC focusing on non-doms who have self-assessed or opted out. More than anything, a prosecution along these lines would be a public relations coup and would dampen down the understandable criticisms of non-doms getting an easy ride.

Advice to applicable UK taxpayers
Although there is choice available to non-doms, the overwhelming advice from tax professionals to all taxpayers is to fully disclose through Liechtenstein. The Liechtenstein Disclosure Facility (LDF) allows taxpayers to become fully compliant with a fixed penalty of 10% plus interest on all past liabilities since 1999 and, importantly, immunity from prosecution.

Conclusions

Switzerland banking secret and its role as a tax heaven is obviously becoming part of the past, as so it is for Liechtenstein.  The recent UK and German agreements seem to me more a transitory step towards the type of full transparency that European countries and the USA require given the necessity to recovery as much funds as possible to manage the growing debt related concerns.

As always in life, I am sure that other jurisdictions will take leading roles in filling the void. It is also clear though that the same pressure coming down to Switzerland will be asserted against other obvious traditional tax heavens like BVI (British Virgin Islands, Cayman Islands, etc.), although the effectiveness of such pressure is yet to be measured.

Current trends highlight the strategic role of jurisdictions such as the United Arab Emirates that rather than a tax heaven is a country with a solid economy and thriving trade but still retain a tax-free regime. I expect to see more and more investors and retiree to opt for residency in the Emirates to take advantage of the friendly lifestyle, tax-free regime and the advantageous bilateral trade agreements. Further note that the UAE is neither a signatory to the relevant directory, nor agreeing to cooperate with the Organization of Economic Cooperation and Development (OECD).

Don't hesitate to contact me directly if you are interested in any further information about this topic or you would like to discuss any related problem or strategy.

UAE: traditional banking and venture capital in a knowledge based economy

I have been doing some reflecting lately on the economic development choices available to the UAE as a country and further at the emirate level. The necessity for diversification from oil driven economy has been stated multiple times and while it may be true for most of the countries in the GCC including the Abu Dhabi emirate for others like Dubai and all of the Northern Emirates the name of the game has always been trading. Needless to say, diversification remains a fundamental aspect for these economies in spite of the fact that the driver is different.

As recently pointed out in an interview Dr. Fabio Scacciavillani, director of Macroeconomics and Statistics at the Dubai International Financial Centre: “Advanced sectors in the twenty-first century will be based less on the combination of labor and machinery and more on the values of ideas and the business acumen required to translate them into commercially viable operations”.

The UAE has therefore embarked in the development of high value add industries which are knowledge driven other than heavy industries that are driven by availability of raw materials and cheap labor. In the global economy it has become almost impossible to compete with Chinese and Indian manufacturing costs. Some might argue that some of the external costs associated with bureaucracy, language barriers and relatively unfavorable foreign investment laws in these countries create a more even playing field still the ground to cover from cost-structure perspective remains significant.

The development of a knowledge based economy relies on few key ingredients, the most important of which is obviously “knowledge” both created throughout a solid educational system as well as imported via hiring of a highly specialized work force. Further, the legal system needs to provide the necessary framework and certainties to encourage risk taking and entrepreneurship as well as protect the ownership of intellectual property: probably the single most important asset in a typical knowledge based economy.

While “intellectual property” management and the educational systems would certainly deserve their own article and analysis, for this posting I would like to focus my attention on the type of banking system required to support the knowledge based economy of the future. Access to start up capital is a vital component for the development of a strong economy, but traditional lending seems ill equipped to provide the right valuation to knowledge-based start up. In fact traditional lending is still based on the valuation of tangible assets, in fact often times entrepreneurs need to provide collateral unrelated to their business venture to be able to get its appropriate financing. In other words, visionary entrepreneurial attitude doesn’t score high with loan officers and credit committees. The latter focus mainly on calculating risks privileging residual equity in case of bankruptcy instead than calculating project risk based upon a market based analysis and business potential.
In a high risk entrepreneurial environment the rules of traditional lending just don’t match market needs. And that is where government bodies with their regulatory powers, banks and equity funds will need to step in to fill the gap by growing a more sophisticated and structure venture capital industry. Venture capital firms provide much needed equity for innovative start ups, not loans. VC firms compensate for the higher risks by taking an ownership stake in the enterprise and dividing equity rounds based upon project milestones often taking a tangible role in the direction or development of the project.

If GCC banks want to meet the demands of a growing and more specialized knowledge based economy they must outfit themselves with experts with the capabilities and experience to analyze, evaluate and rate business plans in order to maximize returns for the bank and in turn provide entrepreneurs with much needed startup capital. As part of this model financial institutions playing in this field must also formulate clear exit strategies that would allow start ups to transition to traditional, and less onerous, debt upon reaching of their maturity stage and in turn allow the equity providers to cash in after the initial and more risky incubation process is over.

So, while banks and lending institutions face the challenge to modernize and meet the challenges brought about by knowledge based economy, regulatory and government bodies on the other have the difficult task to create the transparency laws and mechanisms required for the markets to operates and flourish, and that includes among others: adoption of shared accounting rules, enforcement of penalties for any wrong doing, creation or enhancement of investor friendly procedures.

The UAE government both at the federal and emirate level has taken significant steps already to meet the challenges on hand. It would be great for many entrepreneurs and visionaries in a variety of industries if the banking systems would quickly follow suit providing the equity partnership that is required by them. Any delay would turn into an opportunity for the many venture capital firms in the US and Europe that could step in matching knowledge and processes with capital existing in the GCC. That would be a lost opportunity for lenders already operating in this region.