#11 – Expand our minds.. of what is possible.

I started this blog nearly a year ago with reflections and a few predictions on the incredibly turbulent times ahead (this was before Donald Trump and Brexit, see blog #1). As I have been reading and I have been taking an incredibly insightful class on Political Risk, featuring some of the brightest minds at the Eurasia Group, I thought it would be worth the time to summarize and paraphrase some of the more astute comments. The bottom line is we have to expand our notion of what is possible. Increasing nationalism and weak leadership across the globe is increasing the range of potential outcomes. Buckle up, we all need to be prepared!

1^st story – Donald Trump. No surprise here, but we need to go deeper.

There is not a lot of global leadership in the world. We have more wildfires than we used to have. No Global Leader want’s to accept the cost and risks of putting them out. When we talk about the #1 Geopolitical risk we need to start with Donald Trump. We have to be able to talk about Donald Trump in an analytical way. Some people think of him as a savior, or as a man-child. We need to go beyond that.

Why is Donald Trump different? He is the first person to serve as US president without serving in the Gov’t or in the Military. Most of the time you have a track-record, a voting record. With Donald Trump we are still trying to piece what types of decisions he will make, and what drives him; and he is probably trying to piece it together it himself.

He is the first president since the 1930’s that does not think that Global Leadership means US leadership. Go back to the Marshall Plan – was it the smartest move in the US politics / or was it a bail-out for Europe? He doesn’t believe the US has to be playing that leadership role. He believes that the US guarantees the security of Japan and Germany. These are the two of the world’s richest countries, why is the US still doing that? The counter argument is that there are advantages to the US playing that role.

Would Donald Trump start something if China went after Taiwan? Will the US support NATO? What about Mexico? Mexico is still thinking this guy is building a wall. Does he have to build the wall? He can’t take that back?

We haven’t had to ask these questions in some time! They are moving markets, adding risk! Whether you think he is an agent of change, or a tyrant… he is moving markets, he is opening up possibilities of change.
2^nd story – all of our assumptions on oil are changing.

July of 2008, – Oil was selling for $170 a barrel. Folks were writing articles about how this was going to 500. With India, China etc., demand is only going higher. Are we going to run out of oil? Nope. We used to think that we would run out of oil, now many experts believe this may never happen!

Here is what happened: Fracking and technology has now allowed for oil to be pulled from the earth, that no one was thought was possible. Electric and renewable energy is adding energy sources that are not dependent on oil. If you go all the way back to 1980, the only thing that Regan and Carter could agree on was to end foreign oil dependence. If you compare the known reserves of 1980 to today (2 and half more times oil today). We can find new oil, we can produce it, and we can produce it a lower cost.

There are a lot more US oil companies in the market that are able to compete, drill and sell when price goes up. These companies also are able to bounce back quickly, when the price drops they go into bankruptcy. When the price rises, they re-enter the market and add rigs to drill more oil. It’s not just the big oil companies that are adding to the over-supply it is these nimble smaller companies that are adding to the pressure of over-supply (given the technology advances, and the costs of producing oil have dropped).

We are now back in the low 50’s with the price of Oil. Countries that export oil, that really need the money, are in really bad trouble in the long term. When OPEC cuts production they are just trying to establish a floor. When American companies see price going up, companies pop up… We are stuck in this range of 45-65 on oil prices…

If you are Saudi Arabia and Russia they won’t have a problem in 2017, or 2018… but maybe 2019. Venezuela has a problem right now. Venezuela, is in real trouble. Venezuela used to rely pretty heavily on the US given the crude they were producing required a significant refining capability. Their natural partner was the United States.

When does Russia really get in trouble? When does Saudi Arabia really get in trouble?

Saudi’s solution is vision 2030. A project that is trying to modernize the Saudi economy. How much of the human capacity can you use is the question most countries will face? How much talent can you use? Most graduates of university of Saudi are women, yet only 22% of women are employed. Iran is not under any sanctions anymore. There is intense competition between Iran and Saudi on influence and leverage. Saudi’s are losing oil share and losing influence (Syria will stay in power – Iran will not win Yemen conflict). UAE and Oman, allies of Saudi, don’t really want to stir up conflict they want to make money. Saudi doesn’t really have the same friend on the US that it did with GW Bush (given our lack of independence).

Putin has an approval rating of 82%. Putin hovers above the government and finds people that are to blame. 90% of people get their news from state media. Central bank has some independence and credibility. So there are a two rainy day funds: the reserve fund which is almost gone, and the national welfare fund (a lot of that money is liquid). The state of these funds are the leading indicators to judge whether Russia has a problem. After Putin wins the election in 2017 they will need to start talking about cuts… then you want to look at the price of oil, to see if Russia is in much greater trouble.

3^rd story – ISIS may be losing territory, but don’t forget about them.

ISIS is going down. ISIS is losing Mosul. If you define ISIS by territory, then they are going down. That’s not the only way to define ISIS, however. It is a brand. People are around the world may look up on the internet and claim they are ISIS.

Once the territory goes away, the ISIS fighters will be dispersed along in the world, and will not quite go away. Who is vulnerable? Europe, Southeast Asia, Middle East countries close by. We can expect that there will be another ISIS (just like ISIS popped after Al Qaeda).

4^th story – Europe – It just takes one

Europe has 47 challenges. Not just one 1. There are so many risks that you can make the argument that they will likely manage them, but just one of them has to go badly for things to turn ugly quickly.

• Brexit. Article 50 next week. Britain wants to discuss divorce and future agreements. Europe wants to discuss just discuss divorce. This will play out over 2 years. Can end ugly.
• Le Pen (far right) is running for election in France. Macron likely to win (centrist party). The story here is neither center-left nor center-right will win. Risk is likely overrated.
• Merkel not inspirational. Formidable leader. Close election in Geramny. Bottom line is the next government will be pro-European.
• Early elections in Italy, Five Star making populist moves in Italy.  Italy dealing with significant economic challenges.
• Early Elections in Greece, and overall state of Greece bail-out, Grexit still possible?
• Europe has a delicate relationship with Russia- Delicate relationship with Turkey. Erdogan – referendum in Turkey (desires power similar to Russia). Germany and Turkey at odds, tension in media. Turkey and Netherlands tension as well (Netherlands refused to provide Erdogan with airport access). The leverage and deal that is in focus, is teal on migrants that the EU struck with Turkey. Turkey is holding a substantial amount of migrants in Turkey that would have traveled to the EU, and getting paid by the EU to do so. Only 10% of the flow that occurred in 2015 has occurred in 2016 because of this deal.

 5^th story – and China?

So much is going on in the world that we forget how big of a year it is for China. 19^th election, they will replace 5 out of the 7 people of the politburo committee. They make all the decisions. The stakes are enormous. It moves markets. The bottom line: 7 people make all the decisions, decisions that we can’t see. This has never happened before where we cannot see the decision making process! For a country that moves the markets tremendously, to not be able to understand this process will increase volatility for world markets.

 

#2 – An uncertain way forward, Brexit and what’s next

As I wrote in my first post in May of 2016, I predicted a major transformative economic/political event was on the horizon for Europe; whether it was Grexit, Brexit or some other crisis – the foundation of the European Union would be tested in the near future. While Brexit surprised many – it was only a matter of time for one of these make or break moments to actually occur. For those that are in shock or still mired in a state of disbelief, are still likely underestimating the rising swell of discontent amongst the “have nots” and those that are not participating in the new economy. Political parties and citizens are becoming increasingly polarized and extreme.  This is the start and not the end,  the fear of immigration and outsiders is on the rise. The Trump vote is a real global phenomenon that should not be underestimated.

While analysts and scholars debate what’s the most likely outcome for the UK (e.g., whether the UK will pursue a Norway/Swiss solution to working with the EU – or be treated as a third party country), and as such the damage and next steps will becoming clearer; I think we should be a lot more focused on what’s happening in Italy. As I think the EU actually is worse off as a result of this than the UK, and the underlying question of the EU will survive – is going to come into focus a lot sooner than people think. The UK will eventually sort through the mess they made, and although London will be diminished in it’s standing as a business friendly financial hub, it will survive.

The Financial Times reported on Sunday July 3^rd, that Italy was prepared to unilaterally pump billions of euros into its troubled banking system if it comes under severe systematic distress. As we discussed in the first blog post, many of the factors for the previous Euro zone crisis have not been addressed; namely the feedback loop between sovereign risk and bank risk. Further exacerbating the situation in Italy is:

• Low growth Eurozone wide (many countries still not back to GDP levels seen pre-crisis), impacting bank’s growth prospects
• Negative interest rates, compressing bank return’s on core banking products
• Total of 400 billion euros of Non-Performing Loans across large Italian banks
• Rising political instability – due to referendum on constitutional reform (if Renzi – the current PM loses the vote and resigns- significant instability will introduce )
• Confidence in the Italian banking system is wavering, and the capitalization levels lag large US and EU peers
• Brexit only hurts these banks further

Let’s look at what’s developed – this is as of July 1^st (source: Yahoo Finance / Bloomberg)

Large Italian banks are getting hammered, when we take a closer look at what’s changed from April to July. Stock prices are on average across the top 5 Italian banks are down 32%, and CDS has risen 13%. Take a closer look at Unicredit, which is the only Italian large globally systemically important banks (G-SIBs). Down more than 42% (at a price of 1.92 a share).

While the news cycle will be focused on next steps of Brexit. Look deeper at some of the other dark clouds on the horizon..