Seven year itch

On December 16 2008, the Federal Reserve established a target range for the Fed Funds rate of 0-0.25%. It said then that it expected to maintain low interest rates for an extended period of time. Not even they would have expected that target range to still be in place in 2015.

Seven years on to the day, on December 16 2015, following clear hints from several FOMC members, the Federal Reserve is widely expected to bring to an end the era of zero interest rates in the US. It is certainly the case that the FOMC have been strongly hinting all year of a rate rise in 2015, but events, a weak US economy in  H1, and generalised market weakness in Q3, following the decline in the renminbi, have delayed them to date. Now there is just one opportunity remaining.

It may be sheer coincidence but, biblically, seven is a number that indicates completeness. More prosaically, seven years is widely held to be the time at which many marriages start to struggle, and those involved think of change! Whether for reasons of completeness or boredom, the Fed seems keen to move!

The seven years of zero interest rates have been lucrative for investors in US financial markets, though not of course for those who prefer to keep their savings in cash. Many savers have been forced out of their preferred cash holdings and now hold investments in the bond and equity markets in order to seek some sort of return. As interest rates on cash savings are once again visible, the flows into financial market assets are likely to reverse. The tailwind of liquidity from US savers which has boosted market returns and taken valuations in all markets to historic highs, will become a headwind to returns and valuations will decline.

At the same time as this reversal of liquidity, there is also a reversal of another key source of global market liquidity. Since 2000, the rise of sovereign wealth funds from Asian trade surpluses and oil exporting nations has been a key source of liquidity for financial markets as China and OPEC in particular have recycled their trade surpluses into the export of capital, most particularly into US government bills and bonds, but also more widely into global bond and equity markets.

In recent times, China’s desire to maintain a strong currency, or at least avoid being seen to have a weak currency, has meant that they have been reducing their holdings of US Government securities, quite probably in order to invest in gold, given recent disclosures of rising bullion holdings. As the Chinese economy has deteriorated there are increasing reports of entrepreneurs seeking to move capital abroad and out of renminbi, which have probably meant that to maintain a stable exchange rate, the state must have been buying renminbi and selling other currency holdings.

The collapse in the oil price over the last 18 months has seen dramatic effects on the fiscal positions of many Arab oil producing countries – for many years the Saudi government assumed $100 oil for its budget planning!  At a time of febrile regional politics, Arab governments cannot afford to bear down too heavily on the traditional government largesse to their own people. So, with revenues in freefall and expenditure steady, they have plugged the gap by drawing down from their sovereign wealth funds. The apocryphal rainy day has arrived! The leading investment management groups have been reporting significant mandate losses from the Middle East over the last twelve months as they drawdown on the rainy day savings.

Some have dubbed this reversal of flows from sovereign wealth funds as Quantitative Tightening – it certainly has a similar effect as the reversal of central bank QE would have. With this, as well as rising US interest rates, the liquidity available for investment in financial markets is now falling after seven years moving higher. This is not a good backdrop for the performance of markets in 2016.

Syria – Assad situation

Syria is a secular state, but the religious breakdown of the Syrian population is approximately 74% Sunni Muslims, 16% Shia Muslims, 10% Christian (source – CIA World Factbook).  However, the al-Assad family which has ruled Syria since 1971 are Alawites (one of the branches of Shia Islam), and government positions are mainly held by Alawites.  The Arab Spring – the movement across the Middle East which sought to overthrow long-established autocratic leaders – saw an uprising in Syria against the Assad government; this began in March 2011 and the ensuing civil war continues today, with the Assad regime determined to stay in power.  It has become a war between Shia and Sunni Muslims.  Both share many of the same beliefs, but the Sunni Muslims, who represent about two-thirds of Muslims in the Middle East region, believe in the authority of the Koran and the sayings and actions of the prophet Mohammed as the source of truth and wisdom, whilst Shia Muslims believe that Allah has appointed certain people from Mohammed’s descendants and that they possess special spiritual and political authority over their community.

The key allies of the Syrian government are Iran and Russia.  Iran is the largest Shia Muslim state and a neighbour, and is thus determined to ensure that Syria remains controlled by Shia Muslims.  Iran and Syria have been strategic allies since the Iran-Iraq War when Syria sided with Iran, sharing a common hostility to Saddam Hussein, as well as to the US and Israel.  For Russia, Syria is of geo-strategic importance as an ally, since the Syrian port of Tartus is Russia’s only Mediterranean naval base.  In the UN Security Council, Russia has consistently supported Syria against the imposition of UN sanctions and in providing arms to the government.

Saudi Arabia has been the biggest supporter of the Syrian rebels, providing finance and arms. Saudi is predominantly Sunni Muslim and its official form is Wahhabism, often described by critics as being “puritanical” or “intolerant”.  Both Iran and Saudi have aspirations to be seen as the leaders of Islam, and Saudi interests would be served by the rebels overthrowing the Assad government and installing a Sunni regime, thus gaining a new major ally and depriving Iran of the same.

Al-Qaeda is a terrorist Islamic organisation, which sees its targets as both any non-Muslim influence on Muslim countries (hence its attacks on the US and the UK), and any non-Sunni branches of Islam. They are widely believed to be very active in supporting the Syrian rebels with finance, troops and weapons.

Qatar is another Sunni-dominated Muslim country which has given heavy support to the rebels.  Qatar is a tiny country with huge gas reserves and is very keen to build a gas pipeline into Europe via Turkey. To get to Turkey, it must pass through either Saudi Arabia or Syria, and Saudi is currently blocking the proposals.  A more reliable and Qatar-friendly government in Syria would make a huge difference to its ability to supply gas to the European market.

Israel has little direct interest in the Syrian civil war other than to be very aware that should the US engage in military action, then it poses a very convenient and close target for retaliation by Syria.  It would though be more wary of a religious-led government in Syria than the current secular government.

In the initial stages of the Syrian civil war, the three Western permanent members of the UN Security Council, the US, the UK and France were generally sympathetic to the Syrian rebels, on the grounds that a minority grouping ran the country against the wishes of the majority grouping, which would not occur in a properly-functioning democracy.   However as time has gone on, the active support of Al-Qaeda to the rebels has limited the Western desire to take sides actively in the civil war, and instead seek to broker opportunities for peace.

About a year ago, President Obama warned Assad that he would regard any use of chemical weapons in the dispute as breaching a “red-line” for him, and would be unacceptable.  Last week the US announced that they were convinced such weapons had been used by Assad.

The US faces a set of very poor choices: (i) if it decides upon military intervention and this leads to the overthrow of the Assad regime, they are likely to find that Syria’s next rulers hate the US with just as much passion as Assad, and indeed Al-Qaeda supporters may well find themselves in power; (ii) if it decides upon military intervention and this does not lead to a change in the regime, then it will look weak and Assad will become a bigger hero in the eyes of many Arabs; or (iii) if it decides against military intervention, then Obama will have allowed Assad to cross one of his “red-lines” without incurring any serious consequences.  This will be noted and seen as weakness by Iran and North Korea where Obama has also set out “red-lines” over their development of nuclear weapons.

From its beginnings as an internal uprising during the Arab Spring to its evolution as a sectarian Muslim civil war, markets have taken little notice of Syria.  It is only now, as it nears turning into a proxy war between superpowers that the gold and oil prices have started to rise, and markets have begun to be wary.  The lack of public support in the US for military intervention is however likely to mean that Obama will not wish to get heavily involved in Syria beyond a round of air strikes at key Syrian targets.

We are not recommending any changes to portfolios in the light of the Syrian crisis – we expect tensions over the next few weeks, but in the end we believe that the US will not seek a deep involvement in Syria, as it has no major national interest in the outcome of the civil war and no clear objectives and strategy that would inform any deeper involvement.  However, should there be a clear escalation of US involvement in the conflict, the risks to the oil price and the world economy would become much larger.

The Falling Oil Price – mirror on China, geopolitical football or beacon of hope?

The oil price has fallen from $128 on March 1 to below $90 in recent days, but this sharp decline has received little news coverage.  There are good reasons from both supply and demand perspectives why this 30% fall has occurred:

On the demand side

  • Economic data since March have disappointed expectations, following a burst of optimism in January and February on the back of the ECB’s dramatic action to offer a trillion Euros of extra 3-year liquidity at the start of the year. However none of this liquidity made it into the real Eurozone economy – it went into the banking system and the banks used it to support the government bond markets in Spain and Italy as many other investors used the opportunity to exit from their Euro assets.
  • Austerity continues to drive the peripheral countries deeper into recession and the German economy has seen its export engine struggle as the rest of the world slows down.
  • In the US, the improvement in the labour markets that appeared to be taking place at the start of the year has stalled as austerity from the individual states, which are forced to run balanced budgets, has reduced domestic demand. Growth expectations for 2012 have been steadily reduced over the course of this year.
  • It is however the Chinese economy which is the key driver of oil demand, and although not clearly reflected in the official statistics, which are aggregated from local regions all keen to show themselves in a good light to the centre, there is increasing anecdotal evidence of a major slowdown in demand from manufacturing companies for raw materials with the appearance of large inventories of coal and copper within China, together with continued weakness in demand for electricity.

On the supply side:

  • Saudi Arabia has pumping record amounts of oil over the last three months and shown no sign of reducing this rate of production as the oil price has fallen  close to levels (generally assumed to be $80-90 per barrel), which make it difficult for them to balance their budget. They have declared this to be part of a policy aimed at helping the Western economies – closer to the truth might be that the American authorities have requested a much lower oil price, which would boost consumer disposable income and confidence and thus give more room for the Federal Reserve to ease policy and for Obama to win the election in November.
  • Oil production and exports from both Iraq and Libya have been expanding rapidly this year as calm has returned to these countries and with it a focus on rebuilding export earnings.

So weaker demand and increased supply have occurred together and prices have fallen sharply. For Western economies trying to deal with the after–effects of a major banking crisis, this is positive news.  Lower petrol prices leaves more money in consumer pockets to spend in other areas of the economy, at a time when consumer incomes are otherwise under pressure, and allows the Central Banks to be more relaxed about any inflationary pressures. Should Europe be able to find a way through its problems in the next few weeks, there may be scope for an equity market rally.

In the longer term, it should be noted that the USA is moving aggressively towards being energy self-sufficient). The new fracking technologies are significantly increasing the productive potential of its own gas reserves, which will, over the long term, ensure that it will not be dependent upon the Middle East for its energy requirements. Structurally this bodes well for the US relative to Europe and Japan, which will remain more beholden to political developments in those regions, and therefore for the dollar relative to the euro and the yen.