Addendum: oil prices, short term - variables at play

This is an addition to the previous post in which we have analysed oil prices based upon fundamentals estimates based on supply & demand. As anticipated in the same post we have warned against large changes in prices due to other variables such as geopolitics.
Since our last post the price of OIL has continued its down spiral and as of today we are sitting at a 5 ½ years low.

We would therefore like to shed some light on the current variables at play and also advise on the non sustainability of such pricing in the long run. These are exceptional times and they should be treated as such.

Variables currently pushing the OIL price down:

• Policy of containment towards Iran, Syria, Islamic State and Russia adopted by OPEC Gulf States;
• OPEC members interest in slashing fracking projects profits and delay or contain their production;
• Weaker than expected Chinese economic performance although we believe that the current statistics with regards to economic performance are not justifying the current price drop;
• Weaker demand demand than expected from the US side. 

In spite of the large reserves of some OPEC suppliers trapped into their Sovereign Funds, many of these countries have set up their countries expenditures and development against a higher price per barrel. Please be reminded that these countries are tax free regimes and their economic performance and development plans are affected directly by the price of OIL.

Further, a low OIL price and a strong dollar combination is going to hurt significantly all development projects in the Oil & Gas industry that are financed in USD, something clearly undesirable for many powerful US lobbies.

Lastly, while the mainstream media in the USA are hailing the low OIL price as a welcome stimulus to the economy this will not turn into reality. The US is facing a lethargic demand that is not supporting the recovery picture portrayed on the media. Please note that statistically any time that there was an energy tax cut in the US there has been no subsequent sign of positive stimulus afterwards.

Because of the above listed reasons we believe that the current significant price drop is temporary and far exceed the drop potentially justified by a weak US and partial restatement of Chinese growth.

We would only expect OIL at current price for a protracted period of time in the face of a recession 2009 which could be fought once again by the Feds with a new and improved set of QE cycle.

Oil prices - short term considerations & long term perspective

As recent oil news make headlines we have decided to take a closer look at the OIL price and provide a perspective in considerations of few significant industry and geopolitical trends.

Fossil oil is and will play a significant role in satisfying global energy demand. The medium to long-term trend is determined by multiple factors such as among others: the status of the global economy, geopolitical events, technological advances as well as consumer choices. The two main variables impacting supply and demand have been on the one hand a significant increase in the energy demands of developing countries, and on the other hand the emerging of a wider variety of energy supply typologies (i.e. oil sands, fracking technology) altering the traditional energy supply routes and therefore also geopolitical choices.

1.     OVERVIEW OF THE OIL SUPPLY AND DEMAND

In 2013 crude oil global consumption grew around 1.3 million b/d (+1.4%), with an average of 90.4 million for year. The Energy Information Administration forecasts an increase of 1.1 million b/d in 2014 and 1.4 million b/d in 2015.

In the medium-term period (2012-2018) Reference Case Demand could increase by an annual average of 0.9 mb/d, reaching 94.4 million b/d in 2018. Europe, Asia and Russian demands are rising very slowly, as illustrated in Table 1 while developing countries demand rise faster, with an increase of 1.1 mb/d every year.

The outlook for the second half of 2014 shows that the oil demand of non OECD countries will be higher compared to the OECD countries.

Table 1 Medium-term oil demand outlook in the Reference Case[1]

Source: World Oil Outlook 2013

In the long-term period (2012-2035) Reference Case Demand could reach an increment of 20 mb/d each year, this value could rise up to 180,5 mb/d in 2035. The biggest share of this forecasted increase should come from developing countries.

Table 2 World oil demand outlook in the Reference Case

Source: World Oil Outlook 2013

Oil and other liquid combustibles global supply is estimated to grow 1.5 mb/d in 2014 and will decrease to 0.9 mb/d in 2015. Nevertheless, Non-Opec countries supply presents an estimated upward trend, with forecasts assessed at around 1.8 mb/d in 2014 and 1.1 mb/d in 2015.

Figure 1 Change in non-OPEC supply, 2012–2018

Source: World Oil Outlook 2013

In the medium-term 2012-2018, as illustrated in Figure 1, total non-Opec supply is expected to constantly rise by 5.7 mb/d. The two main variables impacting these estimates are the supply of “tight oil” and “oil sands”.

These could create additional supply, in particular in Latin America (Brazil and Colombia), in Middle East and Africa, even if in those countries supply may be negatively affected by political instability.

EIA’s data show that crude oil Opec production had an average of 29.9 mb/d in 2013, with a decrease of 1 million with the respect to the year before, due to the oil production outage in Libya, Nigeria and Iraq. This decrease is partially mitigated by a strong growth in non-OPEC country supply.

The EIA outlook indicates that Opec production should decrease of 0.3 mb/d in 2014 and by other 0.2 mb/d in 2015.

In fact, 8 of 12 Opec members, present a negative production in 2013, such as Libya. The other 4 countries try to maintain a stable production, furthermore, Iraq increase its production from 1.75 mb/d to 3.25 mb/d starting from 2005 to 2013. OPEC conservative production allowed to preserve oil price around 100-110 dollars per barrel during the last few years.

The graphic below, reported by Kent Moors, Phd, in Money Morning, shows that demand will continue to grow until 2025, while supply instead is expected to decline. Based upon these estimates it is possible to experience  a shortfall between demand and supply.

Figure 2 World oil demand and supply

Source: Money Morning 2014

2.     FORECASTING OIL PRICES

Lately crude oil forecasts depend heavily on the oil exporters geopolitical uncertainty. The reduced risk to Iraqi oil exports and the news regarding increasing Libyan oil exports contributed to a drop in the Brent crude oil spot price to an average of $107 per barrel in July2014, $5/bbl lower than the June average, as reported in EIA outlook of August 2014.

The Saudi active intervention in price setting over the past few weeks, coupled with further signs of a weakening of the Chinese economy have both contributed to driving the price to a 4 years low ($80 USD/bbl). Some add that there may be geopolitical interests at play to further weaken Russia by virtue of keeping the price of oil particularly low. Regardless of the geo-political reasons behind this short term oil price low, it is reasonable to expect a medium term increase to a more reasonable price level, especially if the US economy confirms its acceleration as indicated by the latest indicators released by the Federal Reserve.

Based upon recent events oil price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecasted levels. Implied volatility averaged 16 %, establishing the lower and upper limits of the 95% confidence interval for the market's expectations of monthly average WTI prices in November 2014 at $84/bbl and $111/bbl, respectively. Last year at this time, WTI for November 2013 delivery averaged $103/bbl and implied volatility averaged 21%. The corresponding lower and upper limits of the 95%confidence interval were $85/bbl and $125/bbl.

Figure 3 Uncertain oil prices are expected to fall

Source: IMF 2014

According to World Oil Outlook (2013), the nominal OPEC Reference Basket price[2] will be remain on an average of $110/bbl until 2020, and then it will increase in both real and nominal terms.

In nominal terms, we suppose that the nominal price will reach $160/bbl within 2035, whereas in real terms it will reach $100/bbl. It represents a slight shift upward than WOO 2012 expected.

Table 3 OPEC Reference Basket price assumptions in the Reference Case

Source: World Oil Outlook 2013

3.     CONCLUSIONS

Eventually, oil price is set to rise, influenced by fear and uncertainty from Middle Eastern and North African countries. The new geopolitical instability of the late 2014, continued nowadays in Iraq and in all Middle East, causes oil production shortages that could take oil price back up to $110-120/bbl.

We judge the existing low price as temporary and due to the following conjunction of few geopolitical and economic events: a slow down in Chinese manufacturing output, Saudi oil discounting IS heavily discounted although limited supply. We acknowledge the above as short-term temporary factors.

Although we expect oil prices to rise in the long-term (2014-2035) we forecast that any sustained price above $150 USD maintained for a long period of time is going to accelerate the oil for gas substitution trend. We therefore believe that the probability of high OIL prices for a sustained period of time is be quite low.

Oil price is closely connected to the futures market, that forecasts an increase oil price and it is minor influenced by the production.

As political instability grows in key oil producing areas and extraction technology progresses, oil companies have more incentives to explore and extract oil in international waters away from conflict areas. Thanks to new technologies these new offshore areas are now within reach.

REFERENCES

EIA, Short-Term Energy Outlook August 2014, Energy Information Administration, U.S. Department of Energy: Washington, DC.

Kent Moors, Money Morning, August 2014

IMF (2014), Regional Economic Outlook. Update: Middle East and Central Asia Department, International Monetary Fund: Washington, DC.           

OPEC (2013), World Oil Outlook, Organization of the Petroleum Exporting Countries, Publications: Vienna.

Authors: Marta Pezzoni & Luca Gorlero

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[1]The Reference Case scenario in the World Oil Outlook 2013 indicates that demand for energy is expected to increase by 52% over the projection period 2010–2035. As for oil, its demand increases by around 20 million barrels a day (mb/d) in the years to 2035, representing the first upward revision in oil demand growth since the WOO was first published.

[2]Introduced on 16 June 2005 from World Oil Outlook, is currently made up of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

Caution must be the word of the day

Recent events in Ukraine as well as the long term unresolved situation in Syria have been adding to a complex geopolitical environment that seems to set us back to Cold War times during which the "Western coalition" challenged the influence of the Soviet Union, nowadays Russia. Old memories but truly a completely new scenario thanks to the very assertive political role played by China in the far east.

Further, such events come at the back of a very unusual economic environment whereby we are witnessing the effects of unorthodox (!!!) fiscal policy making: Japan’s monetary policy, Fed’s claimed unwinding of their fiscal stimulus, the Euro ever present crisis and a US bullish stock market that seems to no longer relate to the REAL economy.

Therefore, regardless of our own personal opinions we ought to analyse these events and reconcile their potential effects with the economic decisions that we make today or that we plan to make tomorrow.

CAUTION is the word that comes to my mind when I reconcile geopolitical events in progress with economic indicators coming out of several G7 economies. And therefore CAUTION applies to smaller size economies like the UAE or the GULF that are much dependent on both commodities prices and transit of goods. The recent over-supscription of the Dubai IPO of Marka is a sign that ought to be evaluated carefully.

I would like to therefore motivate my CAUTION advice by pointing out some key facts from around the globe as it is often difficult to cut through the clout of main stream media and the hype generated by the new Dow Jones records. 

Following are therefore some of the sobering or better yet warning signs I collected and that I would like to share:

• Japan: Abenomics shock economic therapy is generating concerning effects: the plunging yen has crushed the Japenese purchasing power in spite of the growth in the stock market may have given the illusion for someone to get richer. The recent 15% correction may make the illusion disappear, especially if the USD/JPY breaks below 102. At the end all that will be left for the Japanese people is a soaring energy bill and ever increasing food prices. Japanese wages have been falling for 22 straight months with a fall of 0.4% in March only. In the latest news, sony slashes profit outlook by 70% thanks to Abenomics.
• China: the official Chinese PMI index misses expectations. As a correlated ripple effect: Australian PMI (greatly correlated to China) declined by more than 3 percentage points to its lowest point in nine months (6 consequent months of contraction);
• USD: while the Dow Jones seems to continue its rally some of the fundamentals of the US economy don’t seem very rosy, signalling once again a strong decoupling between the stock market and the “real” economy. The below data doesn’t give us much confidence in US consumer spending and overall US demand.
• Consumer spending for durable goods in the USA has dropped 3.23% since last November 2013. 
• 20% of US families don’t have at least a family member employed;
• While the US population has kept growing since 2007 there are approximately 1.3 million jobs less (http://economyincrisis.org/content/all-sign-point-to-a-servant-economy)
• During the “recovery” period 2010-14 employment gains have taken place only in low-wage industries while during the recession employment losses took place mostly in high to mid wage industries (http://www.nelp.org/page/content/lowwagerecovery2014/) 
• Lower-wage industries constituted 22 percent of recession losses, but 44 percent of recovery growth.
• Mid-wage industries constituted 37 percent of recession losses, but only 26 percent of recovery growth.
• Higher-wage industries constituted 41 percent of recession losses, and 30 percent of recovery growth.


• As of today 56% of US citizen own subprime credit (http://time.com/2742/nearly-half-of-america-lives-paycheck-to-paycheck/)


• 90% of the jobs in the USA pay an average of less than 35,000 USD per year (http://www.bls.gov/news.release/ocwage.nr0.htm?_ga=1.73666065.22471688.1396473081)
• Ukraine: the instability is bound to generate a more rigid contraposition between Russia on one side and the USD & Europe on the other. While sanctions so far have been more formal than substantial the rhetoric is increasing on both sides and there may be instability pass onto the economic system increasing its volatility and impacting energy prices.
• EU parliamentary elections: while the EU periphery keeps on evidencing clear signs of weakness (Italy, Greece, Spain, Portugal) new elections are looming. Word from the street is that parties against the EURO are gaining significant strength and are bound to acquire a sizeable stake in the new European parliament. If that turns into reality there may be some hard questions put on the plate of the European Union leadership and whether fundamental union regulations are to be readdressed.

Therefore, CAUTION must be the word of the day. In the post 2008 world we have accepted as systemic a much higher volatility index which makes it a bit more difficult to evaluate wider base economic and stock market swings. We just need to analyse the speeches of the heads of the Central Banks to realise that they are leaving for themselves wide arrays of options sometimes at odds with each other. Economic indicators are more difficult to read. In such an environment positions should be short, optimism measured and cash an invaluable asset to give investors the ability to ride with profits both the “bull" and perhaps the “bear" coming our way.  

Country review: the most cost effective access into the Schengen Zone and its vast market - Invest in Latvia

When we read economic news we are bombarded by events from the usual suspects: US, China, Russia, EU. The truth of the matter is that there are key geographical areas in the world that, although sometimes made up by small economies, offer instead very good attractive environments for investors that aspire to access a large markets in a very cost effective way.

One of these key countries is Latvia. Very interesting location among the Baltic countries I will provide a series of key competitive advantages that position this country as the natural gateway into Europe on one side and into Russia on the other side.

ACCESSIBILITY TO LARGE MARKETS: EU & Russia (and CIS Countries)

Latvia is uniquely positions in Norther Europe with equally good access to Europe as well as Russia and CIS countries.

Latvia in spite of his moderate dimensions has 3 large ice-free international ports: Riga, Leipaja and Ventspils. All the ports are closely linked to the country transportation infrastructure including: railway, pipeline system & highways.

Since Latvia is part of the European Union and a Schengen Zone member all custom regulation are based on free trade principles and are uniformed with the rest of Europe, although custom procedures have been standardised and simplified to make the movement of goods and cargo as effective as possible.

Further Latvian railway uses the same standards as Russia and CIS countries making it very easy to transport goods into Russia and Central Asia. As an example: NATO used Latvian ports to transport non-military goods to Afghanistan using the Russian railway systems. 

DEVELOPED INFRASTRUCTURE

Transportation & Logistics

All the global logistics and shipping companies are present and operate in Latvia (Schenker, BTL, Kuehne and Nagel, Maersk, etc.) and make wide use of the available intermodal infrastructure.

• Roads: Latvia is one of the only three EU countries with direct access to Russia making quite easy to move goods along an east-west route. The Russian highway M9 also known as the Baltic Highway connects Moscow directly with Riga (Capital of Latvia), this highway also crosses another important traffic artery for goods and people which is the Via Baltica highway which runs north to south and connects seamlessly Helsinki with Prague.
• Ports: Latvia is famous for its maritime routes and infrastructure, it features three international ice-free ports: Riga, Leipaja and Ventspils. All ports feature intermodal connections and Ventspils also features a free trade zone.
• Rail: the rail system is well developed and quite reliable with standards matching the typical one of Northern European countries. One important aspect of this system is that it matches the Russian rail track standards and therefore it is very suitable to move goods into Russia and other ex CIS countries adhering to the same technical standard. The system has been used by NATO for example to move non-military goods from the Latvian ports into Afghanistan to support the military effort in the country.
• Air: Riga airport (RIX) is the largest airport in the Baltic and offers direct flight to 80+ destinations and it is conveniently situated at the cross road between Via Baltica and the Baltic Highway.

Information & communication technologies

Latvia has one of the fasted telecommunication network in the world and this has favoured the development of the information system industry as well as contributed to one of the highest Internet literacy in Europe and the World.

• Latvia is 5th globally for the average measured internet connection speed (7 Mbps)
• 7th globally for broadband connectivity above 5 Mbps.

Source: State of the Internet 2011 Q4 Report, Akamai.

MACROECONOMIC STABILITY

Latvia is a member of major economic and political global organisations including but not limited to: WTO (World Trade Organization), NATO and the European Union (Schengen Zone).

As opposed to many European countries Latvia upon the 2008 economic crises has significantly reduced government expenses and immediately put in place a series of investor friendly laws that accelerated the quick economic recovery that is currently still in place.

Data shows that post crisis a healthy de-leveraging process truly took place in Latvia, as opposed to many countries in Europe such as Spain, Greece and Italy for example, and while painful at that very moment it gave way to the recovery and a new cycle of economic expansion.

Latvia has bilateral trade and tax agreements with more than 40 countries for the promotion and mutual respect of investments.

The country joined the EURO area on January 2014.

Intellectual Property Laws are well developed in full compliance with EU standards and the country is not part of the Special 301 Report maintained by Office of the United States Trade Representatives including all countries without adequate IP protection laws and IP enforcement. 

Heritage Foundation Survey 2013 results - Index Economic Freedom: Latvia 

COST EFFECTIVENESS

Latvia is one European country that allows for high productivity at low resource cost, especially what concerns human resources.

The main parameters that make Latvia a very investor friendly country are:

• very competitive and skilled workforce at low price;

• competitive tax rate.

Riga, the capital of Latvia, was ranked 7th best European City for Cost Effectiveness by FDI Magazine (European Cities and Regions of the Future 2012/2013), while Jelgava and Ventspils were ranked 6th and 9th respectively as Best Micro European Cities for Cost Effectiveness.

Latvian Labor productivity

Please note that Latvian workforce in addition to be very productive is also very versatile as the average Latvian speaks at least 2 languages and for the new generation it is common to speak 3 languages: Latvian, English and Russian making it an ideal place from which to conduct international business.

Labor expenses are also very reasonable as compared to the rest of Europe and the employment laws exceptionally liberal for a European country.

For example: Germany’s labor costs are approximately 4-5 times higher than Latvia.

Eurostat data available HERE

Latvian Tax rates

Latvia has one of the lowest corporate rates in Europe and one of the lowest in the world: flat rate 15%.

Personal income tax is also at a low flat rate of 25% according to a government decision such rate will be reduced by 5% in 2015. Dividends to EU citizen are not taxed.

Further note though that for re-export companies or manufacturing companies operating in the designated free zones there are significant tax benefits in place.

Latvia has 4 free economic zones (quite an anomaly in the European Union and something that the existing government negotiated hard to keep in spite of the entrance in the EURO zone this Jan 2014): Ventspils which has been ranked as 7th best free zone of the Future by fDi Intelligence. Riga and Rezekne - 49th and 50th respectively. Please note that Ventspils has also been named second best world port zone in the world.

Residence Program for Investors

Further to the various advantages above the country like few others countries in Europe has set up a residence program for investors with the exception that the entry costs are quite lower than respective programs in Cyprus, Spain or Greece for example.

Investors these days are choosing to buy a real estate property in Latvia that they can easily rent if necessary to be able to acquire a Schengen Area residency and unlock several privileges: unrestricted travel across the EU, access to resident only educational program at the European level, be eligible for European grants for business projects and so forth.

Many Russian and Chinese nationals have availed themselves of this program although recently we started noticing an increasing interest from Arab nationals, especially from the Arabian/Persian Gulf area. 

For additional information about the Schengen residence program please visit HERE.

Please inquire with me if you require additional data about Latvia, for reason of conciseness we avoided entering data about:

• Labor related incentives granted by the government to investors hiring Latvian personnel;

• Macroeconomic data about the different industrial sectors;

• List of investment opportunities in renewable energy and high value added sectors

• Quality of life data

All topics above are bound to be material for additional postings on this blog to further uncover opportunities in Latvia and neighbouring countries.

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.