|By Matein Khalid| Geopolitics is now another source of risk for the Turkish lira, government debt and Istanbul equities. The Turkish air force is bombing Daish in Syria and the secessionist Kurdish PKK party in northern Iraq. Suicide bombings have killed Turkish citizens in eastern Anatolian cities on the Syrian border. Ankara has given the US a green light to launch military airstrikes from the Incerlik air base, once a base for Cold War surveillance flights over the Soviet Union. President Erdogan did not win an absolute parliamentary democracy in the June elections, has not forged a new grand coalition and cannot ally with Kurdish nationalist parties now that the ceasefire with the PKK has ended. A new snap election adds to political risk.
The Turkish lira has been in virtual free fall since July 2014, falling from 2.10 to 2.82 now against the US dollar even before the Federal Reserve has made its first interest rate move. Istanbul shares, dominated by banks and conglomerates, fell 18% in 2015, double the MSCI emerging markets indices. Economic growth has plummeted to 3%. Inflation, modern Turkey’s financial Achilles heel, is 8% and the Ankara central bank is often impotent to tighten monetary policy due to political interference from President Erdogan.
The free fall in the Turkish lira makes chronic stagflation the new “Turkish malaise”. Even though Brent crude has fallen from $115 in June 2014 to below $48 now, the Turkish current account deficit is still a staggering $50 billion, making it vulnerable to an exodus of offshore hot money when US dollar rates rise. There is zero prospect that the Turkish central bank will achieve its 5% inflation target in 2015 and this means yields on the ten year lira bonds will remain well above 10%. It is still far too dangerous to invest in Turkish bonds now, even though Turkish banks have fallen 35% since I outlined the bearish case to short them in late 2014. 2015 will go down in Turkish history as an “annus horribilis” on the Bosphorus. The Yellen Fed will only increase the risk premium in Turkish banking.
The collapse of the Turkish Lira since the 2008 credit crisis is a disaster for Turkish banks and conglomerates, since $180 billion in unhedged corporate debt is denominated in foreign exchange. Turkey’s unemployment rate is far too high at 11.3% and recession in 2016 could trigger social unrest similar to Istanbul’s Gezi Park protests in the past. Turkey faces its worst currency and banking crisis since the failure of Lehman Brothers, HSBC and Citigroup’s exit is a vote of no confidence in Turkish banking (Wall Street and the City of London CEO’s cringe at Erdogan’s “international interest rate lobby” tirades), the risk of a sovereign debt downgrade and external debt crisis is all too real.
The Turkish lira can well fall below 3 to the US dollar in the next interest rate cycle. Sadly, this means Gulf and Arab investors with billions of dollars in Turkish financial exposure face crippling losses as economic, geopolitical, sovereign, banking, inflation and funding risk will only escalate this autumn. The lira has fallen 35% against the US dollar in the last two years. As Turkish inflation soars, the lira could fall another 20% in the next twelve months.
This summer’s petrocurrency short (other than the loonie) was the Russian rouble, which fell against the US dollar for eight successive weeks as Brent/West Texas crude oil prices were in free fall. While Russia is the world’s largest oil and gas exporter and the Kremlin is still the target of US/European sanctions after Putin’s Duma annexed the Crimea, a diplomatic thaw with Washington and Berlin over Ukraine could enable the Russia to end its blackball in the Eurobond new issue market. The Russia rouble has fallen 46% since Putin’s Spetsnaz commandos occupied Crimea and now trades below 70 against the U.S. dollar. Ruble volatility is 22% and Russian energy/mine exporters are reluctant to switch into roubles as long as King Dollar is on a rampage against petrocurrencies. However, the Kremlin will force the exporters to sell their US dollars for roubles. When that happens, the Russian rouble will rise to 58 – 60 against the US dollar. I have been bearish the rouble and Russian equities ever since Putin’s Crimean Anchluss in early 2014. At 70, my strategy call is to go long Russian roubles against the US dollar and Swiss francs.
Stock Pick – Standard Chartered Bank shares have still not bottomed!
Standard Chartered Bank, the world’s emerging markets bank whose pedigree goes back to colonial South Africa and the Victorian Raj in India, is in deep distress. The shares have plummeted more than 50% from a peak of 1800 pence in early 2013 to 870 pence as I write. Former CEO Peter Sands, a McKinsey consultant, was forced out by the board (and reportedly Temasek, Singapore’s sovereign wealth fund and the bank’s largest shareholder) after successive profit warnings, a spike in bad loans, a failed post Lehman foray into investment banking and a politically devastating US sanctions violations fine. Stan Chart was a classic value trap for me as long as Sands was CEO, the reason my strategy ideas focused on Citigroup, UBS, Goldman Sachs, Barclays PLC, even ADCB and UNB in Abu Dhabi. However, Bill Winters, once rumoured Dauphin to Jamie Dimon at J.P. Morgan, is the new CEO. A bottom for the shares? Not yet, but at least I see potential catalysts for a trend change.
The first half 2015 earnings was a disaster. Protax profits plunged to a mere £2.1 billion, down from £3.3 billion in 1H 2014. Loan impairments rose a staggering 69% in 1H 2015. Though Winters claimed this was due to deteriorating credit condition in the bank’s core banking markets, I disagree. If loan impairments rise 69% in an emerging markets bank, it can only mean there is something deeply wrong with the credit underwriting/loan origination corporate culture.
Bill Winters slashed the interim dividend to a mere 14 pence and will cut the full year dividend too. This will obviate the need for a global capital raise since it saves $1 billion and adds 30 basis points to the bank’s Basel Tier One ratio, a low 11.5% in June. The Bank of England will “stress test” Stan Chart’s vast Asian and African exposure. This could put a capital raise back on the agenda, even though I notice the bank shrank its balance sheet and risk weighted assets dropped by 5% in 1H 2015.
Stan Chart now trades at an optically attractive valuation of 9.4 times earnings and 0.8 times book value. However, since the earnings outlook in the emerging markets is awful now that China has blown up and bearish commodities devastate ASEAN/Africa/Gulf banking. After all, profits slumped 44% in 1H 2015. Winters faces a trilemma of bad debt, iffy capital adequacy and awful profits. This is the reason I would not be surprised if the bank’s shares fall to 780 pence in London. I learnt the hard way not to catch falling knives in global banking.
Stan Chart has at least $65 billion exposure in commodities loans and I am shocked by Southeast Asia/South Korea’s export slump and consumer banking NPL ratios. As Asian, African and Arab trade finance shrinks, the earnings outlook will continue to deteriorate. We could be on the eve of the most protracted, most severe bear market in oil and metals since the Asian flu/Russian rouble default in 1998. This is the worst possible macro scenario for an emerging markets bank, especially if King Dollar soars, China tanks and Brent falls below my target of $40. Brent was $60 in June and $48 now.
Winters needs to reinvent the bank’s business model and corporate culture. It did not surprise me that the bank exited equity capital markets and cash brokerage. Amazingly, Peter Sands was hailed as Euromoney’s banker of the year and the toast of Davos for strategic mistakes that gutted shareholder value.
Bill Winters must cut costs, boost capital, restore morale, stabilize profits and reassure shareholders. He targets a 10% return on equity, now a dismal 5.4%. His success in this Herculean task will determine the fate of the shares, a process I will track and chronicle in these KT columns! For now, I avoid most emerging markets debt, equity and currency markets like the plague, as I have done since 2012.
Market View – German Automakers and the China yuan shock
I had mused about the catastrophic impact of Chinese financial turmoil on Daimler AG shares in a column I published last Monday. I had calculated that the shares had 10-12% downside risk to 74 Euros. So imagine my shock when the PBOC devalued the yuan and Daimler AG fell 10% in two sessions to 76 euros. As anyone who has visited Shanghai or Beijing knows, Mercedes Benz SUV’s are a status symbol in the Middle Kingdom. Daimler AG is exposed to China macro risk as the yuan could well depreciate to 6.8 against the US dollar by early 2016 and hit Chinese consumer demand for luxury German automobiles. However, the investment case for Daimler AG rests on its fabulous cash flow generation, strong US truck (Freightliner) market, the 5% dividend. At 76 Euros, Daimler AG now trades at below 8 times forward earnings and 3.4 times enterprise value/EBITDA, 1.3 times forward price/book value metrics that I feel incorporate “China risk” in the shares.
While Daimler AG produces 190,000 Mercedez Benz units in China, Volkswagen produces more than 3.34 million units and BMW exposure on imported/locally manufactured sedans and coupes is 450,000 units. This does not mean Daimler AG will be unscathed from the yuan shock. Last week’s share price plunge was entirely rational and justified. With Daimler AG shares now 25% below recent highs, my valuation paradigm tries to guesstimate a credible trading range where the risk/reward is skewed in my favour. I believe Daimler AG could well trade in a 65-85 Euro range as China angst will continue to pressure the shares.
I did not explain my bearishness on BMW last week. I was disappointed by BMW’s earning risk and the Street grapevine suggests management will be forced to lower 2015 earnings guidance. There is no doubt that BMW sales growth is decelerating and not just in China. BMW’s China imports business is in structural decline and this will have a baleful impact on operating profits, EPS growth and margins. The valuations or dividend yield/free cash flow generation potential is nowhere near as attractive as at Daimler AG. Unlike Mercedes Benz, then no new product launch cycle to goose the shares until 2017. There is no credible case for a valuation rerating on BMW. This was my thinking behind the idea of a potential trade “long Daimler AG/short BMW”, a sunrise-sunset spread.
It is impossible for me to justify an investment case for Porsche, as its governance model is not transparent, its share are a proxy for its Volkswagen stake, its holding company structure argues for a valuation discount and German court rulings are, by their very nature, unquantifiable.
Volkswagen has also de fact reduced unit sales volume guidance. The China joint ventures profit contribution just got slammed by the yuan shock. In any case, the China joint venture profits were down 17% even before the yuan devaluation. This means there is significant EPS disappointment risk in Volkswagen shares. The “cheap” valuation metrics are actually a value trap for investors. The significant “China risk” alone makes a valuation rerating impossible. Volkswagen shares have underperformed in Frankfurt and I see no reason for this scenario to change. I will not be surprised to see Volkswagen shares trade down to 150 Euros. After all, Volkswagen is the largest auto brand in China, with GM, Nissan, Hyundai and Toyota also vulnerable.
There is no doubt that China is a source of fundamental, even existential risk to global autos/component suppliers. This is the reason for my unwillingness to buy Ford and General Motors at their (superficially) attractive valuations. Note that General Motors shares have fallen 12% in 2015 and trade at 52 week lows below 30. Ain’t no sunshine when she’s gone – to testify before Congress!
China yuan shock is a disaster for Thailand, Asia’s auto hub, whose capital Bangkok is the Asian Detroit. Asian markets has hugely dependent on Chinese exports, as the woes of the Korean won, Taiwan dollar, Sing dollar, Indonesian rupiah, Thai bhat and the Malaysian ringgit (4.0 now, down 19% against the dollar despite Bank Negara intervention). Hyundai Motors sales in China fell 8% in 2014-2015 even before the yuan shock. Note that Nisan is also hostage to China risk since its strategic partner Dongfeng Motors also reported falling sales. It is a testament to China’s grim auto sector realities that Nissan sales fell 14% in the PRC despite the Abenomics linked epic devaluation of the Japanese yen.
