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What next for interest rates?

|By Matein Khalid|

Janet Yellen confirmed the Wall Street consensus that the Federal Reserve will raise its overnight borrowing (Fed Funds) rate at the March FOMC. Wage growth, inflation, crude oil, asset prices, economic data momentum and Trump’s fiscal stimulus all reinforce the dual mandate logic of a rate hike. Only a really awful February non-farm payroll shock (consensus is 200,000 jobs) will avert a rate hike on March 14.
Trump’s election led to a historic sell off in the US Treasury bond market as the yield on the ten year note rose from 1.75% in October to 2.6% in mid-December though yields have since softened to 2.51% now. Is the $3 trillion bear market in global bonds over as the financial markets brace for political (French elections, North Korea) and economic (the US deficit spending spree time lag on tax cuts) shocks? No. I expect volatility on the US Treasury bond market to rise in 2017.
If Marine Le Pen becomes France’s next President and threatens to pull her country out of the Eurozone, all bets are off. The world financial markets would panic. The US dollar index could well soar 20%. The US Treasury bond market will become the world’s safe haven and the yield on Uncle Sam’s ten-year note could plunge to 1.5% or even lower while the yields on French, Greek, Spanish and Portuguese debt would soar as investors dump Club Med debt. Gold Could soar to $1500 an ounce but crude oil could plunge to $35 a barrel, despite the Saudi/Russian output cuts, as the world economy slips into recession.
The smart money in Europe does not discount the awful Madame Le Pen win scenario, though my contacts in Paris assure me she will never live in the Élysée Palace. This is the reason the yield on the German two year government bond (Bund) fell to minus 0.95%. This is what visceral fear in the capital markets means (or “flight to quality” in the sanitized language of asset management!).
The macroeconomic case for higher US Treasury bond yields in the US becomes more compelling if the French election does not lead to a win for the National Front. Fiscal stimulus at a time of full employment is a formula for inflation risk, as Yellen has warned the Trump White House ad infinitum. Her forecast for three rate hikes in 2017 and 2018 becomes certain if wage growth exceeds 2.5%, the jobless rate falls below 4.5% and US economic growth accelerates to 3%. The rise in crude oil has led to an uptick in inflation risk across emerging markets. In this scenario, the ten year US Treasury bond yield moves to 2.9% or higher, bank shares begin to soar again and King Dollar becomes King of Kings Dollar!
Real estate investment trusts (REITs) are a classic hedge against inflation risk when global growth and interest rates creep higher. REIT’s were a license to print money in the Fed easy money era, generating a total return (dividends plus capital gains) higher than the S&P 500 index. The REIT sector was slammed after Trump’s win as interest rates rose. Yet, unlike Treasury notes or Eurobonds, REIT’s provide inflation protection as rents rise when economic growth accelerates and the CPI rises. True, aggressive Fed rate hikes in 2017 will lead to panic selling in REIT’s. Yet stronger economic growth invariably correlates with higher rental growth, higher tenant quality, higher capital values in selected property segments. Please, no shopping malls or department stores!). This is the reason I would accumulate shares of industrial REIT colossus Prologis and prime New York office REIT SL Green Reality (steeper yield curve, global growth and Trump’s pledge to “do a number” on Dodd Frank is nirvana for New York money center banks). The world is still in the early stages of the E-commerce/digital revolution and demand for distribution centers will explode.
I have zero interest in REIT’s listed in Dubai as office fundamentals are poor (46% vacancy rate) sponsors charge excessive fees (upto 400 basis points) and yields are hostage to high bank leverage. It is far better to invest in the Vanguard REIT index fund symbol (VNQ), with $34 billion in assets, 0.1% in fees (40 time less than illiquid Dubai REIT’s!) and offer a 5% dividend yield for those who can design option strategies on the Chicago Board Option Exchange. This is a must own product for any investor who needs liquid real estate as an inflation hedge. Once Fed rate hikes happen the Vanguard index fund becomes a must own inflation hedge!
Macro Ideas – Frontier market nightmares and frontier fairy tales!
Nigeria has been a frontier market nightmare since President Buhari finally devalued the naira, with the MSCI Global X index fund (symbol NGE) down from $10 to below $4 in the past two years. In the past twelve months one, the Nigerian country index fund (NGE) is down 35%. Yet the reasons that make Nigeria a profitable macro short idea – the oil crash, epic corruption in the Goodluck Jonathan era, Boko Haram terrorist attacks, a banking crisis, recession, capital flight – have now reached their endgame. Saudi Arabia has stabilized the world oil market. President Buhari, the elected ex military dictator whose economic policies proved so disastrous for the naira, is hospitalized in London. Baba Goslow has handed defacto power to Vice President Yemi Osibanjo, an ex Lagos attorney general with strong links to the southern state Ibo business elite and the powerbrokers of the Niger Delta oil producing region.
If Osibanjo succeeds Buhari as head of state, the NGE could well have at least 40% upside. Fairy tales seldom happen in real life but they do happen in frontier market stock exchanges. Remember my call on Pakistan? Up 400% in five years and up 45% in 2016, when Karachi was Asia’s best performing stock exchange. Nigeria could well be the next Pakistan if the financial markets, the Lagos elite, the military, the Hausa Fulani emirs of the northern states, the World Bank/IMF and Washington embrace Osibanjo as Nigeria’s most credible de jure political and economic helmsman. Nigeria is no Mickey Mouse oil or cocoa satrapy but Africa’s most populous and most powerful state.
Buhari’s anti-corruption crackdown and refusal to devalue the naira facilitated epic capital flight in 2015-16. Yet since Nigeria’s economy plunged into recession after the oil crash, imports demand vanished and the current account deficit is a mere 0.4% of GDP even as Nigerian exports are finally competitive again due to the devaluation of the naira. Nigeria has suffered its worst economic recession since the early 1990’s slump under military dictators Ibrahim Babangida and Sani Abacha. Inflation has surged to 18%, a ten year high. Despite Buhari’s pledge to float the currency, the central bank is still forced to defend the naira at the 320 level to the US dollar. The black market rate is closer to 500 naira, a symbol of the chronic foreign exchange shortage that has devastated Nigeria’s traders. If Osibanjo outlines a credible plan to boost the economy, vanquish Boko Haram, stabilize the naira and clinch an IMF deal, Nigerian equities could just, maybe just, be the next frontier market fairy tale. Stay tuned!
My favourite frontier markets since last summer are Vietnam and Saudi Arabia. After Saudi Arabia received $63 billion in bids for the kingdom’s inaugural $17.5 billion sovereign Eurobond new issue, I recommended buying the Saudi Tadawul index at 5600 as I was certain that the Eurobond new issue would ease its money market/cash crunch. This was the precise moment to bottom fish in Saudi corporate/retail banks notably SAMBA and Al Rajhi. The Tadawul index is now above 7000.
Vietnam’s Communist Party was disappointed by President Trump’s withdrawal of the US from the Trans Pacific Partnership and assault on global free trade. If Trump reduces the US naval presence in the South China Sea, Vietnam could be exposed to the Chinese armed buildup – and China has been the traditional enemy of Vietnam for two millennia. The TPP debacle and Trump’s protectionist tirades will hit Vietnamese exports to the US, up 17% in the past year. It is significant that Vietnam has a $31 billion trade deficit with the US and is thus in Trump’s target sights. The State Bank of Vietnam intends to use mergers to create bigger banking national champions and boost private sector lending. The GDP growth target is 6.7% and Vietnam is a $160 billion export colossus. The doi moi reform policy is still alive. This could make the Vietnam country fund (symbol VNM) a buy at 12 for a 15 target in 2017.
True, I believe the easy money in Pakistan has now been made in this spectacular frontier bull market. Karachi is not expensive at 12 times earnings and a 4.8% dividend yield on the eve of the MSCI emerging market upgrade. The wave of recent bloody terrorist attacks in Pakistan demonstrate political risk is still a sword of Damocles. Yet the Karachi index was 34000 when I recommended it in this column last April and is 48000 now. Wicked!
Stock Pick – BNP Paribas and the black swans of France in 2017!
Springtime in Paris is a cliché but the spring of 2017 is a game changer because France goes to the polls in April and May to elect a new President to replace the hapless François Hollande. With the Volatility Index (VIX) at 11, I am certain that the stock market’s fabled risk and fear pendulum does not remotely capture the risk embedded in global equities. True, the yield curve in the US Treasury and German Bund/French OAT market has steepened as global growth accelerates, inflation risks rise and Eurozone PMI moves into the 55-56 range. If Macron wins the French election, French equities will soar in value.
What if the global populist wave, or a sordid scandal in the center-right’s Presidential campaign and the “clash of civilizations” in the bidonvilles of Paris, Bordeaux, Lyons etc. lead to a landslide win for the xenophobic, anti-capitalist, anti-EU, anti-Euro National Front candidate? A Marine Le Pen win will spell disaster for French equities and the global stock markets. In this scenario, I can easily envisage a 2200 point or 25% drop in CAC-Quarante index in Paris. A Le Pen win would trigger a stock market crash, another spike in Club Med sovereign bond yields and a free fall in the Euro to 0.85 cents. The global safe haven bid in the US dollar will plunge the world into recession. In this sense, Marine Le Pen could well be to 2017 what Lehman was to 2008, what the sterling – ERM crisis was to 1992, what the invasion of Kuwait was to 1990. A black swan event that triggers global panic. Bonjour tristesse!
Reveries aside, I have to trade and invest in the real world. I believe Le Pen will not win. So I accumulate French shares on any pre-election examples. BNP Paribas is France’s “bank for a changing world”, arguably the most undervalued corporate, private and trade finance bank in the Old World. I had last recommended BNP Paribas as a core holding in Europe back in the summer of 2012, when angst about Greek sovereign debt and the existential (Camus? Satre?) crisis of the single currency slammed the shares down to 29 Euros. BNP Paribas doubled in the next five years before its recent mini-swoon in the stock market. My ideal buy level for the bank is 54 Euros or a valuation of 9.5 times forward earnings and a dividend yield of 4.9%, which would move the risk calculus so overwhelmingly in my favor as to constitute another asymmetric winner trade.
The investment rationale for BNP Paribas is compelling. BNP Paribas has deleveraged its balance sheet, derisked its funding profile, slashed its cost base, boosted its Basel Tier One capital adequacy ratios, increased its returns on equity and accelerated its dividend payouts/share buybacks. Even in the ooh la la world of French haute finance, shareholders understand the alchemy of le operating leverage (a concept as near and dear to the Gallic soul as le weekend!) all too well. The gnomes of La Defense at the “banque rouge-noir” alone see 2.7 billion Euros in operating cost cuts by 2020.
True, fourth quarter profit estimates disappointed the markets. Retail banking in France is a mature, low return, low growth, thankless (thousands of 35 hour workweek functionaries from Cherbourg to Cannes, Calais to Carcassonne… quelle horreur!). I also cannot grasp why BNP Paribas has not sold Bank of the West, let alone Banca Nazionale del Lavoro. Yet it is surely significant that BNP Paribas managed to increase net income by 15% and reduce the cost of risk by a stellar 46 basis points or 14%. BNP Paribas also accomplished the holy grail of global banking, organic capital generation. For instance, the Common Equity Tier One capital ratio for Western Europe’s most valuable bank is now 11.5%, an amazing metrics in a low interest rate, revenue growth malaise milieu. I was impressed that BNP Paribas reduced its cost of risk despite Italy’s banking woes, a testament to the risk controls in its loan underwriting/origination. In addition, the liquidity reserve for the bank is 305 billion Euros, prima facie evident of low wholesale funding risk. Book value is 73.9€, my target for the bank in 2018!