|By Matein Khalid| The world’s emerging markets have been savaged by multiple economic, banking, currency and political shocks since 2011. Global emerging markets are far too diverse and nuanced to be analyzed as a single asset class but now trade at a 24% valuation discount to developed markets. The financial markets now price draconian scenarios for earnings, exports, sovereign credit, industrial production and economic growth. The shortage of US dollar liquidity due to unhedged foreign debt overwhelms countries like Brazil, Turkey and Indonesia. There has been capitulation in dedicated Western funds as retail investors redeem in panic. Commodities as diverse as crude oil, Dr. Copper, iron ore, aluminium, nickel and lead face 20 – 25% downside risk. Standard & Poor’s sovereign credit downgrade of Brazil to speculative junk (BB+) debt means Russian, Turkish, South African and Colombian debt is at grave risk.
I believe investors should focus on countries with a current account surplus, stable banking systems, undervalued currencies, technological excellence and cheap valuations. This leads me to the People’s Republic’s Renegade Province. Taiwan has a 10% to GDP current account surplus, the stablest banking system in the Pacific Basin, minimal inflation, low corporate leverage, world class technology exporters leveraged to Silicon Valley (TSMC, Acer, Hon Hai, Ao Optronics etc). Taiwan is not expensive at 12 times forward earnings.
I believe the Sensex/Nifty are still overvalued at 16.4 times forward earnings, a colossal and unjustified 45% premium to the Morgan Stanley Asia ex Japan index. Dalal Street is also vulnerable to capital outflows since India is a 500 basis point crowded overweight for global EM fund managers. The only other emerging market I like is Poland, a proxy for German industrial growth. In the Arab world, the UAE is cheap after its 30% correction at 12 times earnings. I have no interest in either the Bovespa or the Brazil Real, which I predict will fall to 28000 and 4.35. This means the Brazil Index Fund, symbol EWZ, could easily fall from its 74 peak to 10 as Ursa Maximus guts the “samba trade”.
I was stunned to see Jeff Currie, Goldman Sachs’s legendary commodities king, predict the tail risk of $20 crude oil in his forecasts. I remember arguing in 2007 with a (then) star member of Mr. Currie’s team who called for $250 crude amid an energy super-cycle. Peak Oil was a cruel illusion and has morphed into a 3MBD oil glut. Oil market volatility has soared to 52% and spot Brent is $47 as I write so, yes, $20 Brent is no six sigma event (which despite their one in ten billion probability occur all too often on Wall Street, from LTCM’s failure to Black Monday!). The oil market has been savaged by a supply shock (US shale, Iraq, offshore West Africa, post sanction Iran), demand shock (China, Brazil recession etc) and Saudi Arabia’s refusal to play the role of OPEC “swing producer”. Arab oil importers like Morocco, Jordan, Lebanon and Egypt do not benefit from lower oil prices since they are dependent on petrodollar aid from the Gulf. Taiwan is a far more relevant “oil windfall” investment theme, as it is one of the most industrialized economies in Asia, with IT almost 57% of the Taipei Index.
MSCI China has now derated to 8 times forward earnings. This proves that Premier Li Keqiang’s claim at WEF Dalian that China will achieve the Politburo’s 7% target is just not credible. My abacus take from iron ore prices, freight/power generation, an August PMI below 50 and 8% slump in July export tells me that the Middle Kingdom’s growth rate is 2-3%, nowhere near President Xi’s target. So is it time to hold one’s nose and buy Chinese equities on the eve of the mother of all fiscal and monetary stimuli? Yes, if value is defined as Hong Kong H shares, not Shenzhen’s phony, inflated companies like Tiger Balm Number One Tatoo Parlors Inc. Macau and Chinese E-commerce/search used to be my twin themes in the PRC. Macau is kaput for now but Alibaba at 60 is half is post IPO peak. Could Alibaba’s cyclical bottom be 52-54 or 16 times earnings once the 1.6 billion insider share lockups expire?
Wall Street – What next for Wall Street bank shares?
US bank shares were outperformers in the first six months of 2015 as Wall Street assumed the Federal Reserve rate hikes would lead to a steeper US Treasury yield curve and higher net interest rate margins (fatter profits) for banks. Yet the Peoples Bank of China (PBOC) killed the rally in bank stock when it devalued the yuan. The Chicago Volatility Index more than doubled to 28. Global equities markets tanked in unison. Corporate/high yield bond spreads, already under pressure from the crude oil shock, widened sharply. US Treasury note yields fell as global capital flows fled in panic to the largest, most liquid bond market in the world. Emerging markets from Brazil to India, Russia to Saudi Arabia, crashed. The shares of international banks Citigroup, J.P. Morgan, HSBC, Bank of America, Goldman Sachs, Barclays and Standard Chartered Bank all fell 12-20%. August and early September 2015 saw a swift, savage bear market in the Western world’s money center bank shares.
China, the Uncle Sam debt yield curve, recession risk in Russia and Brazil, the shrinkage in world trade, trading losses in volatile assets and loan exposure to distressed oil/metal producers all have the potential to hit bank earnings. China could well trigger a slowdown in global growth, if not outright recession. Investors yanked $300 million from the S&P Bank ETF in August, its worst outflow since the June 2013 “taper tantrum”. Wall Street has downgraded its outlook for Fed monetary tightening, loan growth and bank profits.
There is no reason to believe the US economy, 25% of global GDP, will fall victim to a “Made in China” recession. Second quarter GDP growth was 3.7%, the unemployment rate has fallen to 5.1%, the plunge in gasoline is a de facto tax cut for the US consumer, US vehicle sales are even higher than pre-Lehman credit bubble era levels at 17 million units and housing starts are a robust 1.1 million. The American consumer, 70% of US GDP, is in extremely good shape.
The Federal Reserve’s dual mandate means the “data dependent” US central bank cannot ignore the rise in US economic data momentum and wage growth in excess of its 2% inflation target. So the flattening of the US Treasury note market yield curve is only temporary. Moreover, Chinese state reserves are still $3.4 trillion and Beijing’s central bank has intervened after August 11 to prevent a steep yuan sell off.
The US money center banks litigation cycle has peaked (Bank of America alone paid $70 billion in more than Citi, Wells Fargo and J.P. Morgan combines), though further fines related to the LIBOR, credit derivatives or foreign exchange rate rigging scandals are possible. While loan growth in the US is a solid 6% and all the New York money center banks passed the Federal Reserve’s “stress tests”, they could face rising losses on syndicated loans to US shale oil producers and Asian/emerging markets corporate borrowers.
With such great systemic uncertainty, it is no longer possible for bank stock valuations to rerate on Wall Street – for now. The KBW Bank Index has fallen even more than the fall in the S&P 500 index since the Chinese yuan shock on August 11. This will continue even if the Fed leaves rates unchanged on September 17.
Even if there is no rate hike in September, US economic data will continue to strengthen, making the case for a winter Fed rate hike irrefutable. I am certain – yes, certain that Dr. Draghi will announce a “shock and awe” ECB rate cut in October, as the Bank of Japan did last October. A “shock and awe” ECB QE means the Euro could well fall below 1.02 or even parity by Christmas. (King Dollar should then be called King of Kings Dollar!). Yet, a ECB move will also be a steroid shot for interest rate sensitive and emerging markets exposed money center banks. This means Bank of America, Citigroup, J.P. Morgan and Goldman Sachs could surge and make me relive la vida loca. There are two key ECB conclaves this autumn. It is time to drill for real gold (not that Auric trash that is a phony store of value, down 40% since its $1930 peak) in bank calls and puts on the Chicago Board Options Exchange now that implied vols have tripled.
Stock Pick – Emaar Properties is a compelling buy at 6 AED!
The oil shock and the Chinese yuan devaluation has led to a 30% fall in the UAE stock market indices. A 20% rise in the US Dollar Index is a macro double whammy for GCC equities, since the logic of the regional currency pegs mean that the burden of adjustment invariably falls on local asset markets.
King Dollar has coincided with a 45% fall in the price of Emaar Property from its 12 AED peak to its 6.25 AED price as I write. Emaar is the most liquid, most widely held index megacap on the Dubai Financial Market (DFM), 25% of the index weight. In times of stress, fund managers sell what they can, not what they must.
The UAE is the second largest yet most diversified, most globally integrated, most resilient economy in the Arab world. So the fall in the UAE stock markets in 2015 seems excessive, given that it is only exceeded by the bear markets in Russia, Brazil, Turkey, Egypt and Indonesia. At 12.6 times forward earnings, the UAE even trades at a discount to Saudi Arabia and Qatar despite a lower exposure to oil price risk. After all, the UAE faces no funding, banking, sovereign or geopolitical risk, unlike the Fragile Five emerging markets. The UAE is also cheap relative to India at 16.5 times, South Africa at 16 times or Mexico at 20 times earnings. The UAE GDP is $400 billion, its sovereign wealth funds have $2.6 trillion in assets and Dubai is the financial hub of the Gulf.
Emaar Properties now trades at 12 times forward earnings and 1.2 times forward book value after its epic bear market. Since its 12 AED peak. Emaar traded at above 8 AED is late July. So why on earth should a 2% fall in the Chinese yuan derate the best managed, most successful property conglomerate in the Middle East by 20%? In fact, Emaar should have risen, not fallen, on China’s “currency war” salvo since it reduces the risk of aggressive Federal Reserve monetary tightening and will lead to Chinese/Asian capital inflows into Dubai.
Property prices have softened in Dubai and transactions volumes fallen on both the property market and the DFM since spring 2014. UAE bank loan growth has decelerated since 2014 and liquidity/world trade has shrunk in both the Gulf and Southeast Asia. Yet Emaar is a proxy for the most networked, most cosmopolitan, most globalized city in the Arab world. Dubai is a magnet for global capital, brains, ideas, tourism and entrepreneurial talent. Dubai is not a one trick pony boom bust prone oil town like Houston, Aberdeen, Port Harcourt or Caracas. Oil is only 4% of the Dubai GDP.
Dubai rental yields are 6%, more than double those in Mumbai, Sydney, Hong Kong and Singapore. This tells me downside risk in property is 15-20%, nothing like the 50 – 60% slump we witnessed in 2008-10. The high end expat market is on a roll. Bentley sales, reservations in Nobu and Zuma, 20% rise in new DIFC licenses, high enrolments in elite English private schools. Every metric of expat affluence I track tell me that high end Dubai property will preserve value despite high prices, like the prime London, garden squares of Chelsea, Knightsbridge or Belgravia. This means investors should focus on Downtown, Palm Jumeirah and Burj Khalifa as avenues for wealth preservation. This is not 2009. There is no systemic global banking stress and UAE banks are among the best capitalized in the world. Liquidity squeeze, yes. Credit crunch, no.
I still hear friends in London refer to Emaar as a “property developer”. True enough in 2007. No longer. Almost 35% of Emaar net profit comes from leasing/hospitality, providing a recurrent, diversified revenue model. Emaar’s gross margins have surged from 35% in 2007 to 60% now while net debt/EBITDA has fallen. There is nothing speculative about a developer that pre-sells 95% of its delivery schedule.
Fast forward five years. Expo 2020 boosts Dubai’s GDP above $120 billion. 25 million people visit Dubai, thanks to new Emirates global routes. A record 100 million visitor footfall in Dubai Mall. Who is best positioned for Dubai’s future? Emaar, the crown jewel of the DFM.
