Audio Transcript of the Geo Political Risk session of the Euromoney Kuwait Conference, 2014
Moderator: Richard Banks, Euromoney
Speakers: M.R. Raghu, Head of Research, Markaz; Thomas McManus, Managing Director, Lazard Asset Management
Richard Banks (Euromoney): I am joined by two distinguished speakers their biographies are in your work book.
Richard: Tom is from Lazard investment management who has a very good global view on the markets and impacts of geopolitical risk on the market. Raghu is head of research at Markaz aka Kuwait financial center a man who is based in and has a extensive experience of this part of the world. so both market professionals interacting with investors on a daily basis with slightly different perspective and I sit in the middle. What we want to do with this session, is to pickup on some of the things that I said in my opening remarks and I thank you Ralph, for that slide in your presentation that said political risk and it’s a good place to start I can chart the event of things in Syria, Iraq, ISIS, Palestine and of course Russia-Ukraine.
You see it on the television, it’s on the internet and it’s on the newspapers if you still read the newspapers and yet the markets have done a little bit of a wobble but nothing more than that and everyone seems pretty relaxed about it whereas if you believe the media this is the end of the world. So, is this geopolitical risk, is this impacting the market? We are going to start with that then we are going into ways in which geopolitical risk can impact market and finally we could try to talk about what that means to Kuwait and then I take some questions and trying to get some sort of debate. So Raghu we will start with you in terms of the Markaz view and in terms of your viewWhy do you think that we have seen geopolitical events of significant magnitude according to the media this year and yet in terms of market and investment it doesn’t seem to have any sort of difference?
Raghu: Thanks Richard and happy to see lot of friends here. Obviously geopolitics is not the space that Markaz operates in. So whatever I am going is strictly going to be my personal view we are an asset manager far removed from geopolitics.
You know it fascinates me as an analyst to know about we have so many geopolitical hotspots today intersped all over the world I mean its just not restricted to Middle East. We are based here we read the local newspapers and we have very close view about things happening in Iraq, Syria, Lebanon and other places but then geopolitical risk is a very global phenomena but I have never seen it impact the financial markets that seriously. We need to probably debate during this discourse to why that is and are we missing something here, is it going to take us by surprise and will we have enough time to react. It will be even interesting to understand, how do you define geopolitical risks. In my view, the very simple definition of geopolitical risk is a low probability high impact event. This is the very simplest of the definition. It is low probability, you don’t expect it to happen every year but if it happens it’s a very very high impact event and the best example of that would be the 9/11 attack. It was a very low probability but it created a huge impact. Having said that geopolitical risk comes in various flavors. You can generally bucket them in four categories.
There is this natural resources based geopolitical risk, whether it is countries that are trying to get those natural resources and countries that are trying to guard those natural resources. Obviously the GCC countries are guarding their natural resources which is oil and Chinese are trying to grab natural resources where ever they can including Africa. And then you have this geopolitical risk that surrounds ambitions, national ambitions. For example, Iran wants to be a nuclear power. It’s the risk that is driven by ambition. And then you have geopolitical risk surrounded by ideologies. ISIS is a great example; all of a sudden it sprang up with an ideology and just swept half of Iraq. And then finally we have geopolitical risk that comes through income inequality which is the very serious risk and which is a serious source of geopolitical risk but not often discussed. So, if you bucket the risks into these four, some of them are unknowns. Famous saying goes how many of that are known unknowns and how many of them are unknown unknowns. For example, terrorism is obviously an unknown unknown. We just don’t know when the next terrorism attack is going to happen and where it is going to happen. It’s completely a blind spot, whereas risks emanating from say income in inequality is a fairly predictable. So the question is how do we assess the geopolitical risk as it exists today and how as a portfolio manager or an investment analyst you can prepare yourself and hedge those risks. For example if terrorism a good risk to hedge? if you look at statistics you would say no.
Richard: So lets us follow your model for a minute we don’t have time to particularly granmular on it but it’s very internally coherent. Arguably Ukraine, ISIS is a low probability but it is not a high impact. What you think is really going on. what you think is driving this increase in what we would normally call geopolitical risk in 2014 do you think there is going on here that we are not seeing because of the smoke and the noise.
Raghu: You used a perfect word Richard. Everything starts with a noise, it starts with skirmish it starts with a noise and then it develops into a crisis if mismanaged and mishandled completely. If politically, diplomatically it is handled well at a noise level then probably it is contained and localized in terms of its impact. You let it go out of your hand then you have a global impact. That’s why I said it is not very much synchronized in terms of how you can understand them. They are very region specific if you analyze Korea it’s a different ball game if you analyze Pakistan and India it is a different ball game and if you come to Middle East it is a different ball game.
Richard: I am going to turn to you now, Tom. Do you in terms of the way you look at your business, do you mirror what Raghu says and do you consider geopolitical risk per se from a positive investment decision making or it is something that is remote, generally from the mainstream market even the emerging markets.
Tom: Well it is something that we consider and I would agree to a low probability event but I would say that traditionally it is been a higher impact. I would explain that the transmission mechanism for geopolitical risk has traditionally been the oil price. You go back to 1980 and think about Rasboro, his company and his people in Tehran and other Americans that were kidnapped and held hostage there. That kind of risk has a direct impact. The risks that companies are taking in order to drive growth around the world. I guess the oil price got about 30 dollars a barrel in 1980 and then they came down to about 10 in the mid-1980s. By the time of the first Gulf war in 1990 there was a spike up to 40 dollars and that spike had a direct impact on people’s expectations. Personal consumption expenditure was directly impacted by it. Likewise we have seen other events that has sparked over the recent time, the second invasion of Iraq in 2003. I think that oil prices at that time were in the high teens and moving into the twenties continued all the way up to 150 dollars a barrel. So they had a clear direct impact. Now, I think that this particular time because of Russia is threatening to cutoff the energy supply to Eastern Europe and importantly to Germany. But Russia is so dependent on exporting oil that they are going to find some place to sell it. So they are turning to the Chinese to try and do deals with Chinese but then if the Chinese buy the Russian oil and they are going to need to buy less oil from somewhere else. So ultimately, the people realize that there is circularity here. I think that the ISIS has indicated that they have great demand for or need for funds and that if they were somehow to take control of those oil fields in Iraq that they probably wouldn’t set the wells on fire. So, my guess is that this supply isn’t necessarily going to be reduced by these events.
Richard: Let me just come back towards the end we have been an audience on the sort of bringing together a scenario. But let us stick with the transmission mechanism and I know it is new. Raghu talked about how to find them he said how they can manifest itself through resource guarding, acquisition, ideology, terrorism and all those sort of things. You mentioned that the first transmission mechanism going in to investment market which is the oil price. what are the other transmission mechanism can you see, because it is not directly observable like event A happens and Dow Jones falls unless event A is something cataclysmic. But I would argue that there are big, there are effects. What mechanism do you feel is transferring those events to the market?
Tom: Well it’s a very simplistic view; I see there are three parts. Number one it affects corporate decision making; where companies are willing to invest and put their assets and people at risk around the world. Secondly I think it can affect markets through interest rates and military buildup could cause some crowding out in public financing markets, causing interest rates to rise, inflation expectation to rise, credit risks to rise etc. and that is obviously not good for financial asset pricing. And then lastly I think that it affects investors directly and that just by creating volatility, it doesn’t necessarily mean that the future price of something which is going to be changed but if you tell me it is more volatile path from here to there I am going to need a lower price today to compensate me for the volatility over that life.
Richard: So it affects prices oil prices in particular, the flow of corporate investments, wider rates and volatility. We are all focused on ISIS on Iraq and the military buildup. Coming from the UK were in UK today well may not be the UK in ten days’ time (referring to the Scottish referendum). You know and that’s political risk. I mean in terms of the investments, is that perceived as a political risk? Should we all be shorting gilts?
Tom: Well this has been reflected already and the price of the pound sterling is obviously weak since that last poll came out. I have seen some research which says that the real victim would be the Scottish economy that will go into a deep depression. Well I think there are risks for both sides because obviously you got these two very similar but somewhat different cultures that have over the years have decided to have a mutually beneficial relationship. And now one side has realized that they are not getting as much as they want from that relationship.
Richard: So, which is why we decided to let the Scotts go? (interrupting Tom)
Tom: Yes well but ultimately it will increase the costs for both sides and therefore investors have to be compensated for the additional risk.
Richard: You mentioned another transmission mechanism which is currency. The headline effect was of all this is declining value of the pound which the Scottish government would happy to see in a way.
Raghu: That’s a very good question that you asked now what a political risk is. To me everything is a political risk but what are the risks that you should be worried. There are two scenarios in which you should get worried. One is if that political risk results in damage to a vital infrastructure or if it results in affecting your trade, capital and labor flows. If one of these two things happen then it will have percolating effect on markets across the spectrum. Otherwise it will tend to be a localized risk to be managed at a local level. The risk not going to go away, there are ignored risks today for example, the US midterm election is an ignored risk, if democrats are going to come back it’s going to make life which are already difficult for Obama more difficult is not going to push anything which is going to stop global recovery. Chinese going after corruption these are ignored risks but then as I said they are all noises. If the answer for the Scottish referendum is yes which we will come to know by 18th. It is going to cast a big spell on the pound structure itself. Or the Chinese going after the corruption. When do they manifest themselves into a crisis when you have a serious destruction to a vital infrastructure. For example, somebody bombs the Ghawar fields in the GCC or if your trade capital and labor flows are affected because of what is happening in your country then you have a serious problem on hand.
Richard: And as always with these panels, I always make as we go along and what I wanted to in a minute is talking about specific geopolitical risk. May be we want to try and get it to be a little granular. But let me give you a scenario. We are going to stick with Scotland and my question to both of you assume my scenario is well is relatively coherent it’s a risk from an investment point of view what are you going to do about it?
Richard: One argument that was put forward, I think was by The Economist this weekend after the poll. Let’s assume that Scotland votes for independence on the 18th of September. Now that has certain impact within the UK but the Economist’ argument was, if I recall correctly, was the impact of Scottish Independence on Europe and the national desire for further fragmentation of Europe into certain nationalities. Catalonia in Spain being one, the whole re-surfacing of the Patricia Trianon which is the division of Hungary, post the war. The Hungarians, I know because my partner is Hungarian still feel nearly a hundred years later that half their country was stolen. The population of Romania is about 30 percent ethnically and linguistically Hungarian. So they feel they want it back. So there are lots of little pockets of borders within Europe within EU which according to people that live there demands a right of self determination. The scenario is this, Scotland votes in favor of independence and that sparks the beginning of the re-invigorated separatists movement within Europe and that then paralyses the decision making powers of the EU .You see that risk emerging after next 6 to 8 months, from an investment point of view how do you manage that risk?
Raghu: I think the risk is very simply a currency risk, because the pound has to be re-structured in a way that reflects the Scottish independence. The risk is the loss of the pulling power of UK, among the G-7 because it is no longer a United Kingdom by definition anymore once Scotland is out of the UK. In a global regrouping, where G-20 is trying to be more aggressive than G-7 and then one of the members of G-7 gets reduced in stature, in terms of their currency powers and what have yop, then it might have impact on the 2nd leg of my analysis which is capital, trade flows and labor flows.
Richard: We are talking about Europe, in further politically paralized because of this, the Catalonians, or the Hungarians or the Transylvanians decide to ask for a separate nation it is going to cause tremendous political problems within the EU. What do you, as an investor, do about it?
Raghu: See all political risk at the end of the day manifests itself into an economic risk; I see that manifestation more serious rather than the political risk that comes out of this. That is my take on the subject. So you should be more worried if the answer is yes, what is really going to happen to Britain, in terms of its ability to pull strings among the GCC. Because a lot of economic problems today are centered on developed world of which UK is a very integral part. Obviously it will impact the EU and 50% of the EU’s population is concentrated among 4 countries where the growth has plummeted.
Richard: I don’t know how many billions of dollars these people in this room own and have in their pockets. Should they be worried about? Should they be shorting the pound, should they short the Euro, should they have some hedge? What would that hedge be?
Tom: Well nothing will change overnight. People’s perception will change overnight. It seems to me that the biggest effect on Scotland would be the possibility of multinational corporations that are based in Scotland feel that they are part of the UK might decide might decide to move to London. It just represents the normal evolution of different cultures realizing that the whole reason they are together in the first place is mutual self-defense. So may be they are feeling that they need not worry about the Norwegians coming over and taking over Scotland and by the way you still have Wales and Northern Ireland and can still call yourself the United Kingdom.
Richard: Technically Northern Ireland is a Principality; anyways this is about two Kingdoms, Scotland and England. We can carry on with that, God knows what Northern Ireland is because it is mainly Scottish. Anyway that’s a slightly different thing.
Raghu: I personally don’t think there will be a Knee jerk reaction on 18th. Because what you will know on 18th whether it is a Yes or no. Right now it is only a 5% point difference between yes or no according to the survey. But if it’s a yes, what happens is that the process of negotiation begins then and it can go on for 6 months or a year to really put all the building blocks together and the market will react on a piece-meal basis as the news comes.
Richard: That’s what I am trying to get to, nobody knows what’s going to happen, you can create all sorts of scenarios. Scotland is not just a UK question, it’s a European Question. We have now isolated the political risk and now the question is what we do about it? The answer is not very much from an investors’ point of view. Would you alter you investment position on basis of what might happen in Scotland?
Raghu: Again, we need to look at this question from whether you are a global investor or whether you have a lot of home bias. If you have invested from the UK, the way you go and manage that risk is going to be completely different compared to a Middle East investor whose exposure to that geography may not push him too much into protecting that risk as aggressively as if you are based in the UK.
Tom: You could look at Quebec, for example you had a referendum in 1985 and there was a referendum in 1995. In 1995, it was extremely close. I think it was won by 50.7%, the SS had a lot of momentum going into the referendum. But what I think changed the peoples mind was the CEO one of the biggest corporations in Quebec, Laurent Boudain (CEO of Bombardier), in front of a packed hotel banquet room said “Look if you vote to cecede, we are leaving”, I mean he could have moved across the border into New York state extremely easily and they would have realized immediately. He said “We need the full financial capability of the Canadian government” and not just what people thought would have been the 17th largest country in the world in terms of GDP. It’s not a small province but even then people ultimately decided that it was not the right thing. They started to think about printing new passports, printing new currency and all other things that come along with being able to lean on a federal government for those services. From an investment perspective, I don’t think people really need to worry about whether or not they will be paid back on gilts or whether the trade is going to change dramatically. I think it really has much to do with corporate decision making.
Richard: Thank you, Tom. What I getting to there was, political risk impacting specific corporate entities, as opposed to being a generalized market risk. We may see a bump up and down…..
Tom: Well in the States, we have been having debates over the last year or so about re-authorizing the export import bank. This is something which utilizes the full faith and credit of the US government that would guarantee their bonds so that the companies who want to export the goods can go and get the financing. Without that financing they would be dependent on private markets and the trade would not be as simple as it is today with the Exim bank.
Richard: Before we come and talk about this particular region, the meaning of changes that has been happening over the last 18 months. I would like to open it up to the audience.
Audience: In an earlier session, you fielded a question on the VIX as an indicator and you were saying that even with all the political turmoil the VIX has hardly moved. Last time we saw a big move on the VIX was post Lehman where it went to a record high. How good an indicator is VIX and how would you think about it as an indicator of political risk?
Raghu: VIX is a great indicator for financial market volatility. I don’t know about how much of a geopolitical risk it reflects frankly speaking because Volatility is a very integral part of financial markets on a day to day basis. Every day you have volatility, you profit through volatility but how much of that volatility can be impacted by geo-political risk is a very event specific question. It normally has a very short-term impact especially on the day of the impact, you can see lot of volatility on the markets but then one week from that it completely vanishes and two weeks there is no trace of it. So this is the impact of geo-political risk on the financial markets. Financial markets, of course have other sources of volatility to worry about on a day-to-day basis including earnings etc., but how much of it is because of geo political , I am not sure
Tom: I like the VIX a lot as an indicator. I wrote about it when they 1st started publishing it in the 1980’s. There are lot of surveys out there about whether the investors are bullish or bearish and you always have to worry about if are asking a random sample of investors, how important are those investors, are they really saying what they mean etc.
The good thing about VIX is it reflects about what people do and not what they say. The VIX goes up primarily because the demand for put options rises not because of the demand for call options rises. If people are extremely bullish and they think the market can go up a lot, they know what stocks to buy, if people get to be bearish, they don’t know what to sell. They are like deer in the headlights, they just want to buy a put on the S&P 500 which causes the VIX index to go higher. Raghu is absolutely correct, anything can cause the volatility; anything can cause the stock prices to go down. Now I have a different take than Ralph on the VIX because through Quantitative easing, the Fed has been buying not recently but in all during 2013 they were buying USD 100 Bn dollars a month in securities, that money had to be flowing through the treasury market, through the corporate market and into the investors pocket through increased dividends and increased share repurchase. So when that slows down the issue of corporate debts is going to slow, the share re-purchase is going to slow and the market is going to go towards its more natural state, in that the companies are not going to have so much funds to be able to re-purchase shares. In the last couple of years every time the market goes down the bond yields go down. If we should start to see an inflationary wave that causes the market to go down because the interest rates are going up, then the companies are going to be less interested in selling more bonds and buy fewer shares and they are going to suck out less volatility on the downside. I think it will be interesting in the very least when QE tapers off.
Raghu: That’s a very interesting explanation about how things flow. But I am really worried about it, because for some reason you had a low interest environment which makes it propicious for anybody to borrow at a very cheap price. It should be putting that to productive use. If you are just using that money to buy back shares and artificially inflate the EPS and create this feel good factor in the market. I don’t know if it’s a very productive result of least expensive resource for some reason that is available for the longest period in our lives probably. Interest rates have never remained this low for this long and I don’t know what consequences this is going to have in the future. I am sure we are going to pay a very big price for this because we have been living in this artificially low interest rates for I don’t know how many years now?? With no sight as to when it starts to go up. Every time something happens and we are going to see a postponement of that rise in the interest rate scenario. But in your assessment is that a very productive use of low cost money?
Tom: Well it’s the most productive use of money when you think about nothing but the share price. We need to consider how many corporate executives are compensated based on meeting certain targets of ROE, EPS growth etc., so it’s mutually reinforcing.
Audience: We have been talking about the case of Scotland which is very interesting and being Canadian, Tom was right we had a very close call in Canada but the upside is that we have put the issue of Quebec independence to bed and we have had political stability ever since. But I wanted to bring the discussion closer to home, and talk about the elusiveness of an ever closer union in the GCC- Saudi Arabia, the UAE and Bahrain have still not returned their ambassadors to Doha. So how do you think it is impacting geo-political risk and financial returns in this region?
Raghu: As I said in my opening note, Geo political risks happen all the time, all the day cross the world in some form or the other. The only thing we should worry about is whether it has impacted any vital infrastructure or whether it has impacted the trade flows, capital flows or labor flows. I don’t think anything of that sort has happened in Saudi Arabia or in Qatar. It is just a diplomatic spat among these countries, it will be handled diplomatically and as of now I don’t see any impact of that in terms of attracting FDI, in terms of investors going elsewhere or the stock market. Qatar stock market has been doing very well, Saudi Stock market has been doing very well so these are probably localized geo-political risk that will be contained diplomatically unless you see the noise becoming a crisis after some time.
Richard: I am going to follow that up by saying that the common view from the rest of the world Middle East is a risky region and a highly unstable region and so on. But that doesn’t really matter as the event risk is what is important. What do you see as the biggest risk in this part of the world over the next 12 months?
Raghu: For the foreseeable future the only risk which you should be worried about is the oil price and that’s a huge field of analysis as to what can impact the oil price. So far the going has been good for oil and you know it’s unbelievable and they had such an excellent run for so many years in a row which is never the scenario in terms of oil price. Oil price is the most volatile component in a commodity basket but that’s not the case anymore but I will be deeply worried about the demand supply shift happening in the world that will have a very deep impact on GCC. Especially the largest consumers of oil is where our attention should be focused, obviously US is the largest consumer followed by China and India. So it will be interesting to see what will happen among these three largest consumers, especially the US which consumes 18 Million barrels a day and it produces about 10 million now. It is the largest producer in the world now and it still imports 8 million barrels from people like us but how quickly they are going to close this gap and when are they going to become self-sufficient is something that needs to closely observed. There is a World Economic forum study that shows that by 2020 their consumption will equal their production that is going to be a very interesting tectonic shift point in the oil industry for me. China and India, China ofcourse is the next biggest consumer of oil they consume 10 million barrels of oil a day but they only produce half of that so still they depend on GCC especially for their imports which is good and is a strong point for GCC. India even so because, India produces even less than China. India produces only 20% of its consumption and imports 80% of its oil again from GCC. So China and India are going to be the balancing factor as far as GCC is concerned. While US is going to slow in a measured manner become energy independent. As of now the good news for GCC is that there is an archaic law in 1975 in US that prohibits from exporting crude oil. So they have to first remove that law so that they if there is excess production after 2020 they can flood the market with their own oil which is currently not a huge threat. But if I am in this region I will only worry about geopolitical impact on the oil price.
Richard: One quick follow-up question to you Raghu. What you say given the scenario that you painted. US moving towards self-sufficiency in terms of hydrocarbons, China and India needing to have more and not being self-sufficient. Do you see that is behind the US re-alignment away from this region??
Raghu: Probably yes, What they call as pivot towards the Asia-Pacific, US definitely has seen the big picture and they are not going to be so dependent on the Middle East for the oil. So that will definitely disengage them from the region. They are happy to support that financially but not through supply of people on the ground to wage wars. But they are moving their attention towards Asia pacific while China and Russia are moving their attention to the Middle East. So the US in its realignment process somehow make the blunder of completely getting out of this space, then China and Russia would be more than happy to occupy that because it is a great opportunity for them to assert their authority especially the Chinese.
Tom: You mentioned that US does not allow exporting crude oil, but we are exporting products so the product exports have gone up from 1 million barrels per day in 2007 to 4 Million barrels per day.
Raghu: Even in Crude oil, I believe they have allowed condensate to be exported which is what sparked the big row as to if they are going to start exporting big time
Tom: The trade balance, in petroleum products was USD 280 Bn a year in 2005 and now that’s down to USD 124 Bn this year and would probably spring to a trade surplus in the next couple of years. The other thing I wanted to point out is Mexico, Pemex has been spectacularly unsuccessful in increasing their production over the last thirty years and they have just changed their rules there to allow foreign investments in Mexico. My guess is that you are going to see significantly greater production in the American continent.
Richard: So, We shouldn’t be just looking at US but all of North America?
Tom: Yes, I think the technology is exportable as well, horizontal drilling and hydraulic fracturing is able to get oil out of structures that previously considered being unrewarding.
Richard: Interesting, I was speaking to SABIC about the same thing, they are worried about the European markets, because they feel that the Americans are just going to come and dump their products. I don’t know if that’s true
Tom: Dumping is what we see when the government subsidizes the industry something which I don’t see a lot of it going around in the US.
Raghu: The subsidy is also at play in US by the way; the differential between WTI and Brent is reflective of that. That is one of the reason that the lobby that is against the exports is very keen on not allowing exports as they don’t want to lose cheap oil.
Richard: We could go on all day. We will be covering this topic frequently as there is lot of things that I want to talk about. Time is always an enemy with these conferences but please join me in thanking Tom and Raghu.