Investment Themes and Considerations for 2019


“Every man is the smith of his own fortune.” – Iranian proverb

“Time is like a sword: if you don’t cut it, it cuts you.” – Arabic proverb


  • Global Liquidity
    • Enhancers
    • Depressants
  • Investment Themes
    • Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?
    • US Dollar: What Will the US Treasury Do?
    • China: Incrementally Better, Not Worse
    • Emerging Markets: Relief Not Reprieve
    • Semiconductors: Led On the Way Down, To Lead On the Way Up?
    • Saudi Arabia: Emerging Market Indices Inclusion
  • Outsiders for Outsized Returns
    • Triunfo Albicelestes
    • Data Driven Dystopia: “The monetization of every move you make”
  • Books
    • Five We Have Read and Recommend
    • Five from Our 2019 Reading List

Note: Our comparable piece from 2018 can be found here.

This post runs quite long, if you prefer you can click here to download the PDF.


Global Liquidity


As we reflect back on 2018, the year, in a capital markets context, was defined, in our view, by the charging and retarding forces acting upon global liquidity. On the one hand we had the tax reform driven liquidity enhancers, on the other a host of liquidity depressants, including monetary policy driven tightening, pseudo-capital controls under the guise of anti-graft measures, rising interest rates and high oil prices.

In the words of Thomas Joplin, the nineteenth century British banker and merchant,  “A demand for money in ordinary times, and demand for it in periods of panic, are diametrically different. The one demand is for money to put into circulation; the other for money to be taken out of it”.

Last January, with global stock markets off to their best start in more than three decades, the world was in the midst of demand for money to be put into circulation far outstripping demand for it to be taken out of circulation. From October through to the end of the year, as markets witnessed a sharp sell-off, demand to take money out far outweighed the demand to put it back. While in the intervening months between January and October, dominance waxed and waned between the two opposing forces.



One of the leading sources of liquidity in 2018 was US companies’ accelerated contributions to their respective defined-benefit pension schemes. The Republican Party’s tax reforms gave American corporations till mid-September of last year to benefit from the higher 35 per cent corporate tax rate when deducting their pension plan contributions from their tax bill. US Companies making contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference last year was that the value of the deduction fell to 21 per cent following the mid-September deadline.

Pension plan contributions by companies in the Russell 3000 Index are estimated to have topped US dollars 90 billion through mid-September last year – more than 10 times the contributions made the year before.

The other major source of liquidity was also motivated by US tax reforms. The reforms, by subjecting US corporations’ offshore profits to a one-time tax of 15.5 per cent on cash and 8 per cent on non-cash or illiquid assets, eliminated the incentive to keep money offshore. In response, US multinationals are estimated to have repatriated more than US dollars 500 billion last year, a significant portion of which went toward share buybacks. The flow of money was not evenly spread throughout the year, however. Corporations repatriated the vast majority of the funds in first half of the year with the amount of cash being brought back dropping off sharply in the second half of the year.



There were many forces working to suck liquidity out of and impede the flow of capital through the global monetary system.

1. Oil and US Interest Rates

Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global monetary system and the other fuels everything else. Barring a toppling of the US dollar hegemony or till such time when the dominance of oil as the world’s primary energy resource diminishes meaningfully, the global economy is unlikely to enjoy prolonged and synchronised economic growth in an environment in which US interest rates are rising and oil prices are high.

In the more than 30 years between end of May 1988 through December 2018, the US 10-year treasury yield and the oil price have simultaneously been above their respective 48-month moving averages for less than a fifth of the time. And only on six occasions have the two prices remained above their respective 48-month moving averages for 5 or more consecutive months. (The periods when both prices are about their respective 48-month moving averages are highlighted in grey in the two charts below.)

US 10-year Treasury Yield 10YSource: Bloomberg

West Texas Intermediate Crude Price per BarrelOilSource: Bloomberg

2. Policy Driven Tightening

The two dominant liquidity centres of the world, the US and China, moved in 2018 to rein in animal spirits and tighten monetary conditions.

In China, the Communist Party’s, in a bid to bridle systemic risks, clamped down on shadow finance. The tightening of credit conditions, however, has thrown up an interesting twist: interest rates, as opposed to increasing as would be expected, have declined.

China Shadow Financing Growth Year-over-YearChina Shadow FinanceSource: Bloomberg

In the US, the Treasury upped issuance of short-term debt to replace maturing long-term bonds just as long-term issues were being worked off the Fed’s balance sheet through quantitative tightening.

The potential ramifications of quantitative tightening and increased Treasury bill issuance bubbling under the surface are difficult to assess. In a monetary system governed by the hitherto untested Basel III framework and the many policy tweaks enacted by the Fed, such as money market fund reform and setting the interest on excess reserves below the upper band of the feds fund rate, following the Global Financial Crisis, it is difficult to grasp what, if any, hiccups there will be in the transmission of monetary policy as the Fed continues to drain reserves from the banking sector.

Nonetheless, the tightening policies employed by the Fed and the People’s Bank of China, have squeezed global liquidity. Using year-over-year growth in money supply (M2) across the US, China and Europe, as a proxy, we can see global liquidity growth fell to multi-decade lows in 2018.

Global Money Supply Growth vs. MSCI ACWI and EM Indices Money SupplySources: Bloomberg, European Central Bank

3. Anti-Graft

A number of governments across the world have, in recent years, taken drastic measures to crackdown on corruption and the outflow of illicit funds from within their borders. We share a few examples below.


In 2016, in a bid to curtail corruption and weaken its shadow economy, the Indian government announced the demonetisation of all Indian rupees 500 and 1,000 banknotes. It also announced the issuance of new Indian rupees 500 and 2,000 banknotes in exchange for the demonetised banknotes. What transpired following the announcement was as, if not more, surprising than the government’s demonetisation scheme: an estimated 93 per cent of the old notes made into the banking system.

With most of the notes flowing into the banking system, they were now unsullied, legal tender. And little need for capital to flow out of India illegally through the hawala system to be held out of reach of the government remains.

Saudi Arabia

In November 2017, the Saudi government famously rounded up, amongst others, wealthy Saudi businessmen, government officials and members of the royal family in the glitzy Ritz Carlton hotel in Riyadh as part of its anti-corruption campaign. Little of what transpired within the boundaries of the five-star hotel has been confirmed by official reports. We do, however, know that billions of dollars of assets moved from private asset pools to the Saudi government’s coffers.


China, under the leadership of President Xi Jinping, has been pursuing a far-reaching campaign against corruption. Since the campaign started in 2012, Chinese authorities have investigated more than 2.7 million officials and punished more than 1.5 million people, including seven national-level leaders and two dozen high-ranking generals.

As governments across the world have cracked down on corruption and elicited the support of regulators across global financial centres, price insensitive bids for real estate across New York City, London, Sydney and Vancouver have started to dry up. The best gauge of the liquidity impact of the anti-graft measures described above, we think, is Dubai. Long a magnet for Russian, Chinese, Indian, Saudi and Iranian capital, amongst others, Dubai had one of worst performing equity markets globally in 2018.

Dubai Financial Market General Index DFMSource: Bloomberg

In summary, as the forces propelling global liquidity petered out over the course of last year, the squeezes on liquidity overwhelmed global financial markets taking down one market after the other, culminating with the dramatic end to the long-running US equity bull market in December.


Investment Themes


Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?

 One time series that has intrigued us over recent weeks and months is that of the ratio of MSCI All Cap World Ex-US Index (RoWI) to the S&P 500 Index (SPX). The chart below is a plot of the month-end ratio of the two indices from December 1987 through December 2018. (A rising line indicates the RoWI is outperforming the SPX while a falling line indicates the SPX is outperforming the RoWI.)

Superimposed on the chart are the Fibonacci projection levels based on the relative high of the RoWI, occurring in July 1988, and cyclical low of the ratio recorded in October 1992. (You can learn more about Fibonacci projections here.)

Ratio of the MSCI All Cap World Index Ex-US to the S&P 500 IndexROWUSSource: Bloomberg

From a long-term perspective, the drastic under performance of equity markets in the rest-of-the-world relative to the US equity market is obvious. Looking at the above chart, however, we cannot help but feel that a cyclical upturn for the rest-of-the-world is due.

The question then is: What would prompt a correction in the secular trend? We think the answer is a ramp up in global infrastructure investment led by infrastructure diplomacy programmes.

The most marketed, and some might say most notorious, infrastructure diplomacy programme is China’s Belt and Road Initiative. The initiative encompasses the construction of two broad networks spanning four continents:

  • The “Silk Road Economic Belt”: A land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and
  • The “Maritime Silk Road”: A network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

The Belt and Road Initiative, however, is not the only global infrastructure investment program in existence today. In 2015, worried by China’s growing influence in Asia, Japan first unveiled its “Partnership for Quality Infrastructure” initiative as a US dollar 110 billion investment programme targeting Asian infrastructure projects. In 2016, the initiative was expanded to US dollars 200 billion and to include Africa and the South Pacific.

In October 2018, the US Senate joined the US House of Representatives in passing the Better Utilization of Investment Leading to Development bill (or Build Act), a bipartisan bill creating a new US development agency –  the US International Development Finance Corporation (USIDFC). The passing of the Build Act is being hailed by many as the most important piece of US soft power legislation in more than a decade.

The USIDFC has been created with the goal of “crowding in” vitally needed private sector investment in low and lower-middle income countries. The agency, endowed with US dollars 60 billion in funding, is being positioned as an alternative to China’s Belt and Road Initiative, which has at times been described as nothing more than “debt trap diplomacy”.

We think if the three distinct initiatives propel infrastructure investment across the developing economies and help them integrate into the global economy, create jobs and gain access to much needed hard currency, the rest-of-the-world can once again enjoy a prolonged period of out performance.

Investors, particularly those with an investment horizon of at least three years, should gradually reduce exposure to the US and reallocate it to the rest-of-the-world.


US Dollar: What Will the US Treasury Do?

When the US Treasury issues bills and increases its cash balances in the Treasury General Account at the Federal Reserve Bank of New York, it inadvertently tightens monetary conditions in the global banking system.

For the period starting September 2017 through April 2018, the US Treasury did just that. It increased cash balances with the Fed from under US dollars 67 billion at the end of August 2017 to US dollars 403 billion by end of April 2018. (At the end of last year, cash balances with the Fed stood at US dollars 368 billion.)

The increase in the US Treasury’s cash balances was offset by the loss of an equivalent amount of reserves and / or deposits by the US banking system.  Thereby tightening monetary conditions and reducing the availability of US dollars.

The last time the US government faced the prospect of a shutdown, the US Treasury started drawing funds from its cash balances with the Fed to pay for entitlements and other government expenditures. The US Treasury’s Cash balances held with the Fed went from US dollars 422 billion at the end of the October 2016 down to US dollars 63 billion by the end of March 2017. The release of US dollars into the global banking system provided much needed relief, stimulated global risk appetite and weakened the greenback.


US Treasury General Account vs. US Dollar Index $DXY TGASources: Bloomberg, Federal Reserve


With the US government shutdown triggered by President Trump entering its third week and with little sign of progress in talks between the Democrats and the Republicans, the US Treasury may once again have to draw down on its cash balances with the Fed. If this does transpire and is similar in scale to the previous draw down, it could again stimulate risk appetite and weaken the US dollar.

We are bearish on the near-term (six to nine month) prospects of the US dollar.


China: Incrementally Better, Not Worse

 The year has barely started and the People’s Bank of China has already announced the first reserve ratio (RRR) cut of the year, a full percentage point reduction. Unlike previous RRR cuts in 2018, the latest move is a two-step reduction, effective on January 15 and January 25.

This RRR cut will release approximately Chinese yuan 1.5 trillion in liquidity, part of which will replace maturing medium-term lending facilities during the first quarter. On a net basis, the cut is equivalent to Chinese yuan 800 billion in easing.

On the fiscal stimulus side, the government has already approved new rail projects amounting to US dollars 125 billion over the course of the last month. Beijing refrained from stepping up fiscal spending in 2018. With a slowing economy and the on-going trade dispute with the US, however, the government appears to have greater willingness to loosen the purse strings in 2019.

Beijing, in a bid to shore up credit creation, is even allowing local governments to bring forward debt issuance.

Manufacturing data coming out of China is likely to get worse before it gets better – a hangover from US companies’ accelerated orders to build inventories ahead of the initial 1 January deadline for tariff increases. Nonetheless, given that the official policy stance has now tilted towards easing, we expect Chinese economic activity to improve, not worsen over the course of 2019.

Throw in the prospect of MSCI quadrupling the inclusion factor of Chinese A-shares in its emerging markets index and there is a strong possibility Chinese A-Shares break out of their bear market in 2019.


Emerging Markets: Relief Not Reprieve

A sharp drop in oil prices, a pause in the US dollar rally, signs of increasing fiscal stimulus in China and retreating long-term Treasury yields are providing emerging markets much needed relief. While the structural challenges, particularly on the funding side, faced by many of the emerging economies are unlikely to be resolved soon, the welcome liquidity relief can certainly provide tradable opportunities for investors.

Moreover, as we noted in December, emerging markets have been outperforming US markets since early October, which may well provide further impetus for asset allocators to re-consider exposures and potentially exchange some of their US exposure in favour of emerging markets.

Ratio of the MSCI Emerging Markets Index to the S&P 500 IndexEMSPXSources: Bloomberg

The simple play is to be long the iShares MSCI Emerging Markets ETF $EEM. And in times of either euphoria or despair, it can prove to be the right choice as there can often be little to distinguish between constituent level returns. Nonetheless, with the rise of China’s tech giant, we think $EEM has become both too tech and too top heavy.

For broad-based exposure we prefer being long dedicated emerging market asset manager Ashmore Group $ASHM.LN. In terms of country selection we prefer being long Russia $ERUS and Indonesia $EIDO. We would also like to be long Hungary, opportunities for direct exposure to the country are, however, limited and is instead better played with some exposure to Austria $EWO.


Semiconductors: Led On the Way Down, To Lead On the Way Up?

 We were bearish on the prospects of semiconductor stocks for the better part of 2018. With technology at the centre of China’s trade conflict with the US, and no technology more critical than semiconductors, our thinking was that production capacities, led by China, would rise faster than the market was pricing in.

While China has made headway in gaining market share in the more commoditised segments of the semiconductor market, it has failed to catch up with the leading chip companies in the world. The top-end of the semiconductors market remains tightly controlled by a handful of players.

The Trump Administration’s security hawks and a slowing China, however, have, we think, had a far greater impact on the sharp drop in chip prices than the increases in production capacities.

With valuations for the constituents of the Philadelphia Stock Exchange Semiconductor Index $SOX having corrected significantly and a lot of doom-and-gloom reflected after Apple’s guidance cut, we think semiconductors are well-placed to surprise to the upside in 2019.


Philadelphia Stock Exchange Semiconductor Index Trailing 12 Month P/E RatioSOXPESource: Bloomberg

Moreover, if there is to be a favourable outcome to the trade related negotiations between the US and China, we suspect China will pony up to reduce its trade surplus with the US by offering to buy more chips.


Saudi Arabia: Emerging Market Indices Inclusion

Ignoring the human rights grievances, the fallout from the murder of Washington Post columnist Jamal Khashoggi, and the sharp drop in the price of oil, we weigh the opportunity of investing in Saudi Arabia based purely on a technicality. That technicality being the inclusion of Saudi Arabia into the FTSE and MSCI emerging market indices in 2019.

Based on broker estimates, passively managed assets of greater than US dollars 15 billion are expected to flow into the Saudi equity market on the back of the inclusions. The vast majority of these passive flows are set to materialise during the first half of 2019. Given the size of flows relative to average daily traded values of less than US dollars 1 billion, the passive flows can move the needle in a market with few other positive catalysts.

We remain long the iShares MSCI Saudi Arabia ETF $KSA.

Outsiders for Outsized Returns


Here we discuss investment ideas that we think have an outside chance of generating outsized returns during 2019. We see these opportunities as cheaply priced out-of-the-money call options that may warrant a small allocation for those with a more opportunistic disposition.

Triunfo Albicelestes

Argentina, to put it mildly, has a chequered history when it comes to repaying its creditors. It has defaulted on its external debt at least seven times and domestic debt five times in the 202 years since its independence.

Argentina first defaulted on its sovereign debt in 1827, only eleven years after gaining independence from Spain. It took three decades to resume payments on the defaulted bonds.

The Baring Crisis, the most famous of the sovereign debt crises of the nineteenth century, originated in Argentina – at a time when Argentina was a rich nation and its credibility as a borrower had been restored. Argentina had borrowed heavily during the boom years of the 1880s and Britain was the dominant source of those funds. The flow of funds from Britain was so great that when Argentina defaulted on its obligations in 1890, the then world’s largest merchant bank, Baring Brothers & Co., almost went bankrupt. Had it not been for intervention by the Bank of England, the British lender would have been long gone before Nick Leeson came along a century later.

In 1982, Argentina once again failed to honour its external debt obligations and remained in default for almost a decade. Its emergence from default was made possible by the creation of Brady bonds – a solution proposed by then US Treasury Secretary Nicholas Brady as a means for debt-reduction by developing nations.

In the 1990’s Argentina kept piling on debt until it finally defaulted on around US dollars 80 billion of obligations in 2001, which at the time was the largest sovereign default ever. The government managed to restructure 93 per cent of the defaulted debt by 2010; however, Paul Singer’s Elliot Management famously held out and kept Argentina exiled from international debt markets for a further six years. Argentina returned to the bond market in 2016 after settling with the hedge fund and bringing to an end a long-running saga, which saw Paul Singer take extreme measures such as convincing Ghanaian courts to seize an Argentinian navy vessel so it could collects on its debt.

The lessons from Argentina’s history of defaults, however, were quickly unlearned by capital markets. In little more than a year after its return to the bond markets, Argentina successfully pulled-off the sale of a 100-year bond in 2017. The good times did not last very long, however. In August 2018, Argentina was heading to the IMF cap-in-hand requesting the early release of a US dollars 50 billion loan. By end of September the IMF had increased the debt-package to US dollars 57.1 billion – making it the biggest bailout package ever offered by the IMF.

After running through Argentina’s history of debt defaults and at a time when it may appear that its future is bleak, we are here to tell you that Argentina has the foundations in place to surprise to the upside.

The days of “Kirchnerismo”, the legacy of Cristina Fernández de Kirchner’s and her late husband Néstor’s  twelve years in power, defined by the concentration of power, unsustainable welfare programmes and fiscal profligacy shrouded under the guise of nationalism, are gone. President Mauricio Macri’s willingness to chart a new course, armed with a robust IMF bailout package, we think, can help revive the Argentinian economy.

What is transpiring in neighbouring Brazil, too, has potential spill over effects on Argentina. If newly elected president Mr Jair Bolsonaro remains true to his word, Brazil is likely to pursue a reformist economic agenda that liberalises the economy from the statist policies that were the mainstay of the Workers’ Party’s rule. If the economic reforms spur growth in Brazil, Argentina should benefit – Brazil is, after all, Argentina’s largest trading partner.

President Bolsonaro’s external agenda is also likely to diverge from that of his predecessors. He has openly criticised China – Brazil’s largest trading partner – and expressed a desire to forge closer ties with the US. If Brazil pivots towards the US, Argentina, as South America’s second largest economy, is likely to be wooed aggressively by China. China’s ambition to dilute the US’s influence in Latina America is an open secret. In China’s bid to acquire influence, Argentina is well placed to attract investments from Beijing.

There are many ways to play this theme be it through the bond market, the currency or the equity market. For the average equity market investor the easiest way to gain exposure is probably through the Global X MSCI Argentina ETF $ ARGT.

Data Driven Dystopia: “The monetization of every move you make

From The New Yorker’s article “How the Artificial-Intelligence Program AlphaZero Mastered Its Games”:

“David Silver, the head of research at DeepMind, has pointed out a seeming paradox at the heart of his company’s recent work with games: the simpler its programs got—from AlphaGo to AlphaGo Zero to AlphaZero—the better they performed. “Maybe one of the principles that we’re after,” he said, in a talk in December of 2017, “is this idea that by doing less, by removing complexity from the algorithm, it enables us to become more general.” By removing the Go knowledge from their Go engine, they made a better Go engine—and, at the same time, an engine that could play shogi and chess.”

As the leading tech companies have ramped up investments in developing their artificial intelligence – or machine learning, if you prefer – capabilities, what has started to become apparent is that data not algorithms hold the keys to success. The companies that collect the most and best data, not the ones that develop the most sophisticated algorithms, are likely to reap the greatest rewards from investing in artificial intelligence.

One, much maligned, ‘wearables’ company that has been tracking and collecting data on its users’ movements for many years, with little to show for it, is Fitbit Inc. $FIT. The company has fallen out of favour amongst investors ever since the launch of the Apple Watch – particularly after Apple’s health and fitness pivot following the launch of Series 2.

We think $FIT is a viable acquisition target for Amazon.

Amazon, through the Echo, is already collecting data at home and could close the data loop with an acquisition of $FIT. $FIT’s wrist bands and watches can be integrated with Alexa and with a little investment be upgraded to better compete with the Apple Watch. Moreover, Amazon could feature $FIT’s products front and centre on the most valuable retail real estate in the world – Amazon’s homepage.



Five We Have Read and Recommend

  1. Monetary Regimes and Inflation: History, Economics and Political Relationships by Peter Bernholz
  2. Time to Start Thinking: America in the Age of Descent by Edward Luce
  3. Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts by Annie Duke
  4. The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor
  5. Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Five from Our 2019 Reading List

  1. Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze
  2. The Volatility Machine: Emerging Economies and the Threat of Financial Collapse by Michael Pettis
  3. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
  4. The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox
  5. These Truths: A History of the United States by Jill Lepore


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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Saudi Arabia: Excited by the Market not Transformation

“All change is not growth, as all movement is not forward.” – Ellen Glasgow

“The stock market is just too important to leave to the vagaries of an actual market now.” Babar Rafique, CFA of Setter Capital

“Successful offense brings victory. Successful defence can now only lessen defeat.”  – General Curtis Lemay

Gabriel:  Have you ever heard of Harry Houdini? Well he wasn’t like today’s magicians who are only interested in television ratings. He was an artist. He could make an elephant disappear in the middle of a theatre filled with people, and do you know how he did that? Misdirection.

Stanley: What the f*** are you talking about?

Gabriel: Misdirection. What the eyes see and the ears hear, the mind believes.

Swordfish (2001)


Failures and negative outcomes are often followed by a call to action. College football teams regularly fire successful coaches after a poor season, companies replace senior executives following a series of public relations mishaps, and rarely does an administration overseeing a recession survive the electorate.

The Great Recession gave us the Obama presidency. Coca-Cola losing market share to its rivals gave us the “New Coke” debacle. A spate of bad press and multiple revelations of past misconduct ultimately cost Travis Kalanick his job as chief executive of Uber. After failing to win a grand slam for three years in a row, Roger Federer parted ways with Stefan Edberg and started training with Ivan Ljubicic. The examples are countless. The results mixed.

One such recent call to action, with its own wrinkles, has been the national transformation plan announced by Saudi Arabia. The kingdom has come under severe economic pressure since the collapse in the price of oil. A monarchy has little appetite for political change. Any change therefore has to be either economic or social in nature with a view towards prolonging the political status quo. Prolonging the political status quo remains paramount.

Central to Saudi Arabia’s transformation plans are a more equitable participation by the private sector in the economy, enhancing downstream petrochemical capabilities and a reduced reliance on oil revenues. To reinforce the message of transformation, Mohammed Bin Salman (MBS), the driving force behind the plans and favoured son of King Salman, announced plans to publicly list Saudi Aramco, the state oil company.

The headlines have come thick and fast since MBS unveiled the kingdom’s Vision 2030 in April 2016: a USD 3.5 billion investment in Uber; a USD 17 billion international bond offering – the largest ever by an emerging market nation; a USD 20 billion commitment to a Blackstone infrastructure fund; an anchor investment into Softbank’s Vision Fund; King Salman’s dismissal of Mohammed bin Nayef – dubbed as the “the prince of counter-terrorism” in Washington – as Crown Prince and the ascension of MBS as successor to the throne; Saudi Arabia along with the UAE, Bahrain and Egypt placing economic sanctions on Qatar; and MSCI placing the Saudi equity market on its Emerging Markets Index inclusion watch list.

These are the headlines, the real change, however, is happening on the ground. Nowhere is change more visible than in the socioeconomic framework that has been the staple of the Al Saud dynasty. To understand these changes, let’s take a step back and understand Saudi Arabia’s economic model.

The Saudi Arabian economic model is straightforward and not too dissimilar to the economic model of other emerging markets generously endowed with natural resources. It is a model of government largesse in return for compliance and forsaking political freedom. It is a model where the lion’s share of profits in the economy is provided by the government.

Some of the ways the government provides profits include:

  • Transferring natural resources to the private sector at below market prices
  • Infrastructure spending
  • Being the largest employer in the country – even excluding the large government controlled private sector entities

The private sector is largely organised to exploit the profit making opportunities provided by the government. Refiners and converters acquire natural resources at subsidised rates and convert them to mid-stream and downstream products to capture the difference between subsidised prices and market prices plus a refining / converting margin. Energy intensive industries take advantage of subsidised energy prices. Contractors and construction companies bring in low cost labour from countries such as Egypt, Pakistan and the Philippines and bid for lucrative infrastructure contracts. Traders and retailers cater to the bulk of remaining local demand through imports.

The banking sector remains steeped in traditional lending practices with an almost non-existent shadow banking sector. There is limited participation by international creditors beyond lending to government and government related entities subsequent to the Al-Gosaibi / Saad Group scandal that rocked the Saudi financial sector in 2009. Topping it off, the Saudi Arabian Monetary Agency (SAMA) has adopted a tough and conservative regulatory framework requiring banks to remain well capitalised and adhere to prudent lending practices.

The Saudi Arabian economic model is unsustainable and true to Herbert Stein’s Law – “if something cannot go on forever, it will stop” – in 2016, it came to a stop. The government signalled that it was not willing, nor able to be the source of ever increasing private sector profits. It admonished the private sector for not doing its fair share in supporting the economy and addressing the challenges of youth unemployment.

Gasoline and diesel prices were increased. Feedstock subsidies for petrochemical producers restructured. Electricity and water tariffs revised. Municipal fees introduced for commercial activities. Airport taxes increased. Cigarette prices doubled with the introduction of “selective” taxation. Roll-out of a value added tax proposed.

These were some of the fiscal reforms. Austerity followed.

The government stopped awarding contracts for a large number of projects, vaguely classified as projects where the “scale of spending was not compatible with the economic and development returns hoped for them.” Contractors stopped receiving payments, which coupled with public sector borrowing crowding out private sector credit snowballed into an epic liquidity squeeze. With pressure mounting, the government, towards the end of 2016, pledged to settle its dues to the private sector.  Despite the pledge, around 70% of outstanding dues to contractors of public projects in Saudi Arabia remain unpaid, according to local broadsheet Okaz.

The Saudi Riyal Interbank Average Offered Rate – 3 Months Source: Bloomberg

Perks and financial benefits for public sector employees were also cut – based on our discussion with locals, we found that Saudis from all classes unanimously had the a priori belief that public sector pay was sacrosanct. By cutting public sector pay, the government crossed the proverbial line in the sand and we are not surprised that decision has since been reversed.

After fiscal reforms and austerity came protectionism.

According to McKinsey Global Institute, 4.4 million jobs were created in the kingdom from 2003 through 2013 – a decade of booming oil prices – about 1.7 million were taken by Saudis with the remaining being taken by foreign workers.

Much to its chagrin, the government remains the employer of choice for Saudis.

The public sector is bloated. Salaries and allowances accounted for 45% of government spending in 2015. Efforts to rein in spending will be in vain unless the private sector hires more Saudis. Half the population is under the age of 25. Attitudes of and towards the private sector must change. The government appears unwilling to take any chances and has, much to the private sector’s displeasure, opted not for the carrot but the stick.

Starting July 2017, the government implemented a “dependant fee” on all expatriate employees. This levy entails an expatriate employee paying SAR 100 (USD 27) per month for each of his or her dependants holding a residence permit. The fee will be increased annually till 2020. An expatriate employee with a wife and two children living in Saudi Arabia will be out of pocket SAR 14,400 (USD 3,840) annually from 2020 onward. Expatriates, holding work or residence permits, require exit and re-entry visas to travel in and out of Saudi Arabia. The cost of obtaining exit and re-entry visas was also increased starting July 2017. Predictably, we are receiving anecdotal evidence that expatriate employees are starting to relocate their dependants back to their home countries or leaving the kingdom all together.

During 2012, the government doubled the cost of expatriate employee work permits from SAR 100 (USD 27) per month to SAR 200 (USD 53) per month. It also introduced a fee to penalise companies that employed more expatriate staff than Saudi staff. Companies with 50% or more of the workforce comprised of Saudis did not incur any additional direct costs. Companies that failed to meet the 50% “Saudisation” threshold were required to pay a monthly fee of SAR 200 (USD 53) multiplied by the number of expatriate staff in excess of Saudi staff. For example, a company with 100 employees, 60 expatriates and 40 Saudis, would be required to make a monthly payment of SAR 4,000 (USD 1,067) to the government. These payments were to be utilised to support the training and development of the existing and prospective Saudi workforce. Starting January 2018, the monthly fee will be increased and will be applied to every expatriate employed and not just the number in excess of the total number of Saudi staff. The fees will be increased annually till 2020. In 2018, a company with 100 employees, 60 expatriates and 40 Saudis, will be required to make a monthly payment of SAR 14,000 (USD 3,733).

The introduction of the “expat levy” in 2012 created demand for Saudi staff. Predictably salaries for Saudis went up, an intended consequence of policy. However, given the challenging economic environment and based on a number of discussions we have had on the ground, this time companies are more likely to shed expatriate staff over hiring additional Saudi staff.

Cost of doing business is going up. Capital investments are shrinking. The consumer is retrenching and the expatriate population maybe declining. All factors contributing to declining private sector profitability.

New Letters of Credit Opened – Six Month Moving Average (SAR in million)Source: SAMA

Where will the growth in profits come from to drag the economy out of its doldrums? Government plans highlight seven industries that will receive concentrated government support; chief amongst them is the petrochemical sector.

The petrochemical sector is at the core of Saudi Arabia’s non-oil economy. In 2015, petrochemical products accounted for USD 30 billion in exports, representing almost two thirds of total non-oil exports. Olefins – ethane and LPG derivative products – account for three quarters of total petrochemical capacity. While aromatics – naphtha derivative products – contribute 13% of capacity.

Local production is skewed towards commoditised chemicals – unsurprising given the generous subsidy regime, which incentivised management teams to capture the spread relative to market prices as opposed to venturing further downstream. A lower price of oil and expectations of further subsidy reform places the onus on producers to increase value creation by focusing increasingly on specialty chemicals. This is not without risks. Producing specialty chemicals requires technical expertise that is in limited supply both locally and regionally. Developing technical expertise requires time and investment. There also needs to be a cultural shift towards innovation and research & development – no mean feat given the government’s majority ownership of and influence over a number of the major producers.

Shale, not for the first time, may scupper Saudi ambitions. As a major new source of natural gas, shale has revived the US petrochemical industry. With the Permian Basin’s level of natural gas production expected to increase by 5.5 million cubic feet per day between 2016 and 2020, the revival is only getting started. Majors such as Dow Chemical and ExxonMobil have already announced major investment plans to expand their production capacities in the US. Even Saudi petrochemical giant SABIC is looking at investment opportunities in the US.

Economic reform is one aspect of the transformation. Privatisation (read: selling state assets to shore up finances) is another. Everything is up for sale.

The success of the government’s privatisation efforts hinges not only on the quality and price of assets but also the robustness of the legal and regulatory framework governing those assets. With a judicial system steeped in bureaucracy and a reputation for arbitrary interpretations, the system is in real need for change. Yet, signs of legal and regulatory transformation remain largely absent. As a case in point, the kingdom still does not have a bankruptcy law. The absence of which has long discouraged failure and by extension curtailed innovation.

Saudi Arabia is only at the very beginning of a long and arduous journey towards sustainability.  Rational thinking dictates that Saudi Arabia must remain committed to transformation. Political will to stay the course, however, remains untested with signs already emerging that it is waning. Ultimately, all decisions in a monarchy come down to one person and their desire to do the right thing weighed against their need to be celebrated. In Saudi Arabia, that one person happens to be a thirty-something prince who has designs on becoming king. In a world where Donald Trump is President, we now know popularity tops all.


Investment Perspective

The Saudi Riyal is the primary determinant of the cyclical direction of the equity market. At first glance, that may appear to be a strange statement given the currency is pegged to the USD. The peg, however, is precisely why asset prices must adjust to reflect the value of the currency. As the currency moves from being undervalued – real effective exchange rate (REER) below 100 – towards fair value, equity market performance deteriorates, as witnessed late 2014 onwards. While cyclical upturns in the equity market are witnessed as the currency moves from being overvalued – REER above 100 – towards fair value, as witnessed near the start of the millennium.

Tadawul All Share Index vs. Saudi Riyal REER (Inverted)Sources: Bank for International Settlements, Bloomberg

The Saudi Riyal is the most overvalued it has been in over fifteen years. The question, therefore, for those weighing up the opportunity of investing in the Saudi market, is whether they believe the currency can become even more overvalued. The answer to which lies in whether you (i) are an oil bull or bear; (ii) believe the Saudi government can reduce its budget deficit; and (iii) are in the Saudi Riyal devaluation camp or not.

Whilst all three points require a discussion, in and of themselves, to summarise our views on the first two, we are of the opinions that (i) oil price risk lies to the upside; and (ii) the Saudi government has undertaken a number of initiatives that will enable it to reduce its budget deficit. For these reasons, we are of the opinion that the Saudi market may be at the beginning of a cyclical upturn.

With respect to the USD peg, we contend that the peg is inextricably linked to political stability and maintain that prolonging the political status quo remains paramount. In a country where local demand is almost entirely met through imports while exports are largely commoditised goods priced in USD, the political concerns relating to a de-peg or devaluation outweigh the potential for economic gains. We think, the powers that be will maintain the peg till the point of maximum absorbable pain. And the willingness of the government to sell its assets only confirms our thinking.

To some our scepticism over the transformation plans and concerns around shrinking private sector profitability may appear contradictory to our view of a potential cyclical upturn in the equity market. To that we would counter that markets are made at the margin. We are seeing evidence of economic activity picking up; improving money supply metrics; and we expect the government to move from a heavy- to even-handed approach to reform. That being said we do have a number of concerns that we highlight below.

Saudi Arabia Money Supply M2 YoYSource: Bloomberg

A quote from Babar Rafique of Setter Capital best captures our major concern around the Saudi equity market: “The stock market is just too important to leave to the vagaries of an actual market now.” In a country bereft of social activities, the equity market is embedded in the social fabric – making it ripe for policymaker intervention. Our discussions with brokers and asset managers lead us to believe that is indeed what has happened.

Take for instance, the performance of the equity market on 25 April 2016, the day MBS’s interview unveiling plans for the country’s transformation was aired. It is important to note that the interview was pre-recorded and most of the facts had already been drip fed to the public or revealed in a Bloomberg article published on 21 April 2016.

Tadawul All Share Index (19 to 26 April 2016)Source: Bloomberg

We leave it to you to guess at what time the interview started airing.

As a second case in point, we consider the best performing stock across the Saudi market since Salman bin Abdulaziz Al Saud became king. The stock happens to be Saudi Research and Marketing Group (SRMG). The performance of this stock is staggering. So much so that its return is more than 2.5 times the return of the second best performing stock over the period. When we consider that the company has failed to turn a profit since 2012, the performance is even more remarkable.

Why has this company caught our attention? We quote from the company’s profile on Wikipedia:

From 1989 to his death in 2002, Ahmed bin Salman was the chairman of the company. Then, his younger brother Faisal bin Salman became the chairman of the company. On 9 February 2013, Turki bin Salman succeeded Prince Faisal as chairman of the SRMG when the latter was appointed governor of the Madinah province. Prince Turki’s term as chairman ended in April 2014 when he resigned from the post.

From 1989 to April 2014, each appointed chairman happened to be a son of King Salman.

While we have found other instances of curious market action coinciding with government announcements, we do not want to belabour the point any further.

Another concern we have is valuation. The market is not cheap at around 18 times trailing twelve months’ earnings as compared to the MSCI Emerging Markets Index which trades around 16 times trailing twelve months’ earnings.

Lastly, any discussion related to Saudi Arabia is incomplete without considering geopolitics. We are not political analysts and therefore will limit the discussion to matters that we consider important to investing in Saudi Arabia. To that end, we find it important to highlight concerns around the Qatar Crisis. Saudi Arabia traditionally opted for a defensive stance and used backchannels and its wealth to achieve its geopolitical ambitions. The current leadership, however, has opted for offense. We believe the change in stance has been caused by insecurities that arose out of Obama’s Asian pivot and US disengagement in the Middle East region. As an added benefit, geopolitical tensions redirect the population’s attention away from economic hardship and foment nationalism. Irrespective of the motivations behind the move, we believe that Saudi Arabia’s and its partners’ move to isolate Qatar damages the investment case for the GCC region as a whole. Further, if Saudi Arabia continues to take the more aggressive approach it only increases the political risk premium that should be attached to investments in the region.

We are long the iShares Saudi Arabia Capped ETF $KSA.