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.

Georgia: an emerging economy in the heart of the Caucasus, a player of the new Silk Road

I have recently answered the call of a friend of mine that asked me to take a closer look at country system that could benefit some of my existing and new clients: Georgia.

I therefore took the time to study the macroeconomic data available via secondary sources prior of the trip and planned to visit the country first hand to match the data sourced with first hand experience.

Following is a high level summary of findings that I would like to share with the audience of my blog.

KEY COUNTRY DATA ABOUT GEORGIA

Located in the hart of the Caucasus, Georgia is a country with 4.6M people and a size of 70,000 Km2, comparable to the state of South Carolina in the USA. Mostly known to neighbors for its wine production, fine mountains and beautiful seaside, for the past 7 years this country has been undergoing profound legislative and economic changes that de facto make it the most liberal and less corrupted country in the Caucasus.

Georgia borders with Russia to its North side, the Black sea to the West, Turkey and Armenia to the South and Azerbaijan to the South East.

Since 2004 after the victory of the so called Rose Revolution, Georgia was able to jump start the economy by virtue of drastically reduce the red tapes necessary to build infrastructure, start businesses and favor foreign direct investment.

Taxes were reduced, tax law simplified and a strong movement against corruption, including in the judiciary system, initiated.

While the methods adopted by the government led by President Saakashvili have been the object of criticism by a fragmented opposition the results have been very encouraging.

Till the conflict with Russia in 2008 the GDP was growing at an average of 9%. The conflict with Russia: Georgia?s main trading partner and the global economic crises stopped growth and in 2009 Georgia has posted a net decline in its GDP by 4% according to the IMF.

Still at the end of 2009 the same IMF officially declared that Georgian economy was on the verge of restarting its growth: a remarkable result given the circumstances.

Of the same opinion was the report published by the Economist Intelligence Unit of March 2010 and in the same year Standard & Poor's has raised from B to B+ the sovereign debt of the country with an outlook rated "stable" due to its particularly friendly business environment (29th rank globally).

Further, according to surveys promoted by the World Bank, the level of perceived corruption has been reduced to only 1/4 as compared to 2002: 11% of the companies declares to resort to corruption practices as compared to 44% in 2002.

"Business Freedom" Graph in comparison to Italy and Russia:

The country's leadership is maintaining a clever political balance with all partners and neighbors. The visa regime is very liberal and favorable, for example both Europeans and Iranians receive free visa on arrival.

In spite of recent signal of ease the most difficult relationship remains the one with Russia. After the war of 2008 the situation has recently improved: reopening of the of the border pass of Kazbegi-Lari and the reactivation of the Moscow-Tbilisi flights. The government has deployed a new strategy for what are defined as the Occupied Territories of Abkhazia and Ossetia and it includes the re-establishment contacts with individuals and the re-connection of economic ties although at certain determined conditions.

Worth noting is the "Economic Freedom Act" that includes a series of constitutional reforms aimed at:

• containing public expenses and manage the debt to GPD ratio (debt not to exceed 30% of GDP);
• regulating the activities of government authorities
• and try to impede the participation of the state in the banking system.

It is important to note that some foreign institutions, such as the EU, have expressed some doubts with regards to the content and extent of deregulation envisaged.  It is my personal opinion that such foreign organization already suffer of over regulating everything and the results are far from encouraging, I personally hope that the Georgian government will resist these attempts and find its own Georgian way of developing keeping the balance among the so many different parties at play.

ON THE GROUND EXPERIENCE

The renowned Georgian hospitality and the beautiful landscape made it easy to match business with pleasure.

During my time in Georgia I was able to connect with the country leaders in the political, economic and art fields. 

Spending time on the ground is not only essential to develop workable professional relationships but also to experience first hand what any investor would experience when trying to establish a business or simply live and explore the country: the ease of communicating with taxi drivers to go from location to location, ability to open a business without any institutional help or recommendation, opening of a bank account, ability to feel safe when walking in the streets, access to primary goods, pharmacies, etc.

Since the Rose Revolution the government leadership has been focused on enacting legislative changes to liberalize the economy and reduce ex Soviet style corruption. The end result has been a sweeping generational change that has propelled to power a new generation of young, generally Western educated, politicians and business people.

One of the significant and consistent feelings that I experienced across my entire set of meetings has been the significant desire for progress that animated all parties I came into contact with. 

Walking the streets of Tbilisi felt safe at every time of the day. I walked by myself the entire center city in the morning, afternoon and evening.

While English is still not widely known most of the young generation has a working knowledge of English and it is easy to get by for all basic operations including banking.

Taxi drivers or people over 45 find it easier to communicate in Russian and a basic knowledge of this language is useful to get by in the country.

Over various conversations with government officials and representatives of the economic world I narrowed down the sectors of most interest for foreign investors to:

Energy: hydro electric

In 2005 Georgia exported 122,000 KWh of electricity valued at only $3M USD; in 2010 1B kWh were exported valued at $37M. Hydro electric power supplies 85% of the country?s needs and the ministry has identified approximately 300 rivers around the country powerful enough to generate 15,000 Megawatts. The entire sector has been privatized including the distribution system. In 2007 18% of the total FDI in the country was dedicated to the energy sector.

Note: further opportunities exist in the oil & gas related activities such as logistics and pipelines.

Agriculture

While it employs 50% of the labor force it only contributes to 10% of the country GDP. The ownership is particularly fragmented preventing access to credit and economies of scale. Technology is antiquated and needs additional investment. During Soviet Union time as recently as the 80s agriculture was a sector growing at 10% a year. Foreign direct investment in this sector would benefit from a ready made local market that is currently more and more dependent on expensive goods coming from abroad. While a new strategy by the Minister of Agriculture is about to be drafted there is an untapped resource that looks interesting: 150,000 hectares of state owned agricultural land that is available to investors. Please note that Italian Ferrero S.p.A has already acquired land to grow hazelnut for its Nutella product.

Tourism

Although Georgia is a relatively small country it has been blessed with access to pristine nature suitable for 5 star tourists: beautiful mountains and seaside. Both represents untapped opportunities to cater to tourists in the region and outside. The combination of nature and the rich history of the country: remember the memorable tales of the Silk Road and the numerous historical sites sprinkled all over the country are able to provide tourists with "smart" vacations where relaxation meets art and history. Particularly worth noting is the focus to develop ski resorts in Mestia and Khulo in the Adjara district. Further, numerous sites on the Black Sea are available to resorts. To favor the development of tourism the private sector and the government have partnered to create the necessary supporting logistics infrastructure: the airports of Mestia and Batumi are fully functioning and able to cater to both national and international traffic.

Foreign investment in these key areas comes with government exemption from taxes for a number of years. And the usage of Georgia as a logistic platform to reach out to other countries can be done using free trade zones that also reduce taxes to zero for foreign investors (1 free zone is available right now, 2 other free zones will be created shortly).

Last but not least the art scene is vibrant and diverse. The theater and the opera have rich programs and the quality of the performers is very high. It is not by chance that many Georgian performers are sought after internationally: they offer high quality at a cheaper price point than Europe and North America.

In consideration of the generational change it is also clear that Tbilisi and Georgia in general are becoming a point of reference in the Caucasus art world with performers and talent from the neighboring countries reaching out to Tbilisi to take advantage of the "scene" and the network that the city is developing internationally.

It is worth noting how the private sector is starting to integrate seamlessly with the arts creating an important example for the neighboring countries.

WHAT DOES IT ALL MEAN?

It means that while the consumer product market is relatively small in consideration of the population and the average income level, this country offers great opportunities for what concerns infrastructure, energy,  logistics, art and agricultural projects.

Further, its location in the heart of the Caucasus in connection with its liberal laws makes it the ideal place to set up a base to reach out to other countries part of the new Silk Road. 

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Lastly, please note that detailed reports are available from our company for each of the sector and opportunitie that have been noted in this summary. Don't hesitate to contact me directly if you would like to know more.

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A particular thanks goes to ALL that welcomed me to Georgia and went the extra mile to make me feel at home and comfortable, especially:

• David Sakvarelidze, General Director of Tbilisi State Opera and Ballet Theater;
• Gianluca Marciano', Director of Orchestra, Tbilisi Opera;
• Franco Impala', DHoM, Ambasciata d'Italia a Tbilisi;

Emerging markets - SME confidence higher than in developed economies

Emerging markets have been making headlines in all publications globally. The global recovery is led by emerging economies and this is a fundamental fact bound to stay long term.


I receive an average of 3-4 business delegations a month here in Ras Al Khaimah. Delegations come from all corner of the worlds since our free zone has investors from 120 different countries. While meeting businessmen part of a delegation may not be a statistically viable sample to determine the trends in a specific country, it is nonetheless a good viewpoint to develop a perspective about so many different economies. Over time, over many delegations, consistent trends tend to set in.


I was therefore very happy when on February 2nd, HSBC has published the results of the its most recent research on SME Confidence (20 markets were surveyed). The primary data was gathered last October and November 2009.
I have now the statistical confirmation of the trends I have been collecting over the past year: not only emerging markets are leading the economic recovery but SMEs are going to play a leading role in the recovery.

The report also confirmed a wide differential in confidence levels between the so called highly industrialized economies (G7++) and the emerging markets.
Emerging markets are significantly more confident than developed markets. With an index of 100 as neutral emerging markets have scored an aggregate of 121 and developed markets an aggregate of 106 (France registers below 100 at 96).


Nicholas Levitt, Regional Head of Business Banking at HSBC said: "Confidence levels appear to be back to pre-financial crisis level. The Middle East outlook correlates strongly to the global emerging market outlook, and as a major international trading hub, the region is well-placed for future growth."


From the survey we learn that the Middle East is the second most optimistic area after India.
I can related personally to this finding since every month I receive one or two business delegations from India. During my presentation on emerging markets with them I always ask: "How is business during these challenging times?", invariably I receive feedback about how the impact goes from mild to negligible.


In the Middle East the SME survey confirms:

• 47% plans to increase capital expenditures;
• 41% commits to current levels of capital expense;
• 11% are planning capital expense reductions;
• 36% is committed to increase staffing;
• 58% will keep the same staffing levels;

SMEs were also asked about their propensity to engage more in international business and the survey has confirmed the role of the Middle East as an international trading hub.

• 72% of the SMEs in Qatar planned to grow their business internationally within the next 2 years;
• 28% in Egypt;
• 19% in Saudi Arabia;

The top international locations for business for the Middle East are China, South East Asia and Europe.

While this research presents gaps[1] in its approach to define the geographical footprint, it highlights something that is at the core of the economic global shift currently underway. 

In order to validate the aspirations for internationalization of many SMEs both in the Middle East and other emerging markets it is necessary for local governments to support the development of a solid and more sophisticated banking system specifically tailored to support trade and investment.
As Dr. Butcha, vice president and managing director at A.T. Kearney Middle East, said in a recent article “A.T. Kearney has worked with governments across the world to improve the SME sector. SMEs are the backbone of any successful and sustainable economy, they are the blood cells behind successfully diversified economies and large corporations. Successful long term economic growth plans for the GCC can only succeed with strong support to SMEs...”. A.T. Kearney research in emerging markets shows that successful SMEs create jobs at a rate which is four times faster than the rate of larger corporations and create revenues and GDP at a rate which is six times faster than large corporations. This is largely due to the fact that successful SMEs tend to grow more exponentially than large blue chip and established business (more at: http://www.eyeofdubai.com/v1/news/newsdetail-38845.htm)

It is because of the essential role of SMEs in the global economy that we at Ras Al Khaimah Free Trade Zone have created a business environment specically designed to facilitate SME business. Especially the newly created "valued added services" for RAK FTZ clients are focused on reducing the "incubation" period of new companies and to put them in the condition to generate successful business in the region in the fastest and most cost effective way.

[1] the survey did not include the United Arab Emirates in the emerging markets, developed markets surveyed included only US, Canada, UK & France, results in confidence in the developed economies would have been slightly different if Spain, Greece, Italy would be included.

Dubai & its sustainable advantages

It is during the times of difficulties that companies tend to retrench and focus on their core competencies and missions. The same applies to countries.

Recently I have been reading a lot of negative press with regards to our most famous neighbor: Dubai. The same journalists that just a little more than a year ago where writing long articles about the outstanding vision of HH Sheikh Mohammed ruler of Dubai are now writing articles about the shortcomings of Dubai strategy, the issues related to the hyperinflated real estate market and so on.

I am sure that foreign readers no longer know who to believe. Or at least they find it hard to set on a credible bearing. Caution and analysis are required to better understand complex economic systems.

Dubai like most economies in the world has been hit by the economic downturn due to its reliance on financing. When considering Dubai please note that the emirate is not blessed by the same natural resources as the capital of the country Abu Dhabi: Dubai has no oil.
Its development has been based upon trade and all its infrastructure development has been financed, like most of the businesses, by the international banking community.
In a country where there are no taxes (neither income, nor corporate taxes, nor property taxes) the mechanisms for development tend to be relatively simple: the government has created holding groups and companies that have been operating like a normal private organization. The majority ownership goes back to the government and the ruling family and that explaines the "semi governmental" etiquette that these companies have been receiving. The profits of these operations have been reinvested in the development of the country.

Detractors of Dubai at times forget what was the Emirate only 20 years ago. In addition, sometimes they forget the reality of where they write from. I recently saw an article from a Detroit newspaper criticizing Dubai urban development. For the people familiar with the abandoned downtown Detroit area, like I am, I am sure the critic sounded a bit out of place. In Italy, where I come from, there are dozens of governement funded infrastructure projects that have been financed that have been "IN PROGRESS" for decades: hospitals, highways, acquedots and more.

I will leave the critics to their job while I would like instead to focus my attention on the infrastructure that Dubai has developed and that is here to stay because it represents a clear competitive advantage given the current economic trends:
- Jebel Ali port;
- Dubai Airport;

Such infrastructure in combination with the well developed concept of the Free Trade Zones has created employment and sustainable development.

Jebel Ali Port is the 6th largest container port in the World (2008 data - Containerisation International) and handled around 12 million TEUs in 2008. It is the largest container port outside of Asia and has won the Award for best Middle East seaport for 15 consecutive year.

The 365-metre long Daniela (nominal capacity of 13,800 TEUs) being handled by the port's largest tandem lift gantries, the biggest of their kind in the world. (Image courtesy of DP World corporate presentation).

In tandem with the growth of the sea operations Dubai has been growing steadily its air traffic in spite of the global economic challenges.
As of June 2009, there over 5,600 weekly flights operated by nearly 100 airlines to over 200 destinations across all six continents.
In 2009, the airport was the 17th busiest airport in the world by passenger traffic and 11th busiest by cargo traffic handling 1.927 million tonnes of cargo in 2008.
With the opening of Terminal 3 on October 14 2008 the capacity of the airport has been increased by 43M passengers for a total of an estimated 60M passengers annually.

To understand the progress taking place:

• in 1998 Dubai airport handled 9.73 million passengers, 431,777 tons of freight, had 110 city links and 2,300 weekly flights.
• In 2009: 40.9 million passengers, 1.92 million tons of freight, 210 city links, 4,900 weekly flights.

Dubai has de facto become the gateway connecting Europe to the Middle East and Asia, more importantly it has become the gateway into many African countries by air & sea.
The logistics infrastructure combined with the favorable tax free environment has created important synergies for all companies interested in operating within emerging market economies.
These are facts not bound to be reversed by the current challenges. While emerging markets are leading the way out in economic development Dubai is a reality that is here to stay and its infrastructure is going to facilitate trade across this New Silk Road.