Benign to malign

Benign to malign

For 25 years , since the fall of the Berlin Wall, markets have experienced a generally benign geopolitical backdrop. There have been sources of uncertainty - Iraq, Iran, Al-Qaeda - but overall the political backdrop has been supportive of equities and equity valuations. The question facing investors in the wake of the Ukrainian crisis is whether ( continued )

A quieter week ahead ?

Summary : 

Russia seems to have backed away from escalation in Ukraine. Moscow thinks the advent of winter and a shortage of energy will bring Kiev and the EU to the negotiating table. Sanctions are seen as a sop by Obama to the McCain-Graham vocal right. Moscow sees a hike in oil prices to the $110 level is seen a useful counterbalance to sanction costs.

The 10% lightening of non-dollar assets put in place two weeks ago was timed right but markets may now rally. Time to buy EU non-banks.  

In the ECB the exit timing of Draghi increasingly  is tied to the failing health of Giorgio Napolitano the Italian President. Will Jens Weidmann replace Draghi ? Will ECB QE be €600 billion as touted by some IB's or something less ? Will the CC in Karlsruhe become involved ? 

For Obama the return to Iraq ticks all the boxes - allies are reassured, foes made to think again,  the Christian right quieted, oil exports from the Kurdish regions secured and markets reassured. Sisi has arranged another ceasefire in Gaza - one will eventually hold. In Iraq Maliki fired weapons against Mosul - Sunnis are coming to the opinion there is little difference between the Shia government in Iraq and the Caliphate. Al-Qaeda is the real winner.

Markets could fly if Xi and Abe reach agreement over the Sakuku's at APEC in November. With ECB QE more likely sooner rather than later if Draghi moves to the Lateran the bull run could pick up steam again even as Dr.Yellens mood music fades.

In the EU Juncker is under strong pressure to appoint the Polish FM Radek Sikorski as the new Representative for foreign affairs. Italy strongly opposes this.

Ukraine : There was a time last week when Moscow's Federal Security Council gave serious thought to sending in Russian ground forces in a ''humanitarian peacekeeper'' role . Markets reacted strongly to this fresh fear with sharp declines in the DAX and CAC 40. However, by Friday there were signs that Putin had backed away from escalation and was content to stick with its initial strategy - use Spetnatz troops to keep the rebel uprising from being defeated and wait for the onset of winter to starve Ukraine of energy and bring the Kiev government to negotiate. Moscow has taken the view that sanctions have less bite than expected and are primarily designed to appeal to right wing critics in both houses.

Putin's domestic popularity remains high. The government is united in its view that EU or NATO association for Ukraine is a strategic threat to the Russian Federation that cannot be allowed to happen. The sanctions have proven to be an irritant in the near term coming on top of a slowing economy - private pensions have been diverted to the State Budget as they were in 2013 and there are discussions about the reintroduction of mild exchange controls for foreign owners of certain classes of domestic debt - but the CB believes that by November higher oil and gas price should provide a net benefit to the balance of payments. The ban on imported agricultural products ( a $12 bn a year business ) can largely be covered by the use of imports from New Zealand, the RSA and SE Asian middlemen. Bank financing doesn't become a major issue until 2016 although second tier equities are heavily exposed to western financing.

The Security Council has opted for a mild version of autarky although wiser voices amongst its members are doubtful whether this is achievable. Some analyses show non-resource sector ROIC turning negative in 2015 without additional state orders and backing. The governments goal nonetheless marks the end of 25 years of accelerating Russian integration into the global economy. 

Iraq: Interesting development . Obama was almost forced into intervening as a signal to Russia and China ( and America's increasingly nervous allies ) that Washington had not turned its back on global events. Markets may well view this intervention as being a net positive.

Japan - China : The Diaoyu-Senkaku island dispute still our major worry. Beijing is unlikely to act by force in the immediate future but there are those in Beijing who would like to see a removal of this bottle neck by the time the new series of deep water Jinn SLBM's are fully operational by decade end. The waters near th disputed islands, the high seas of the western Pacific and the airspace over the East China Sea are all vital for the PLA Navy and CCG deployment of these new assets. Blue water contact with the Contact with JDF forces is increasing . Japan insists on its rights to international waters, the PLA has demonstrated its commitment to keeping foreign vessels and aircraft away from its units. Although a Code for Unplanned Encounters at Sea has been discussed Beijing say that the political environment prevents it being formalised. We would need to see a Xi-Abe meeting at the APEC summit in November to feel comfortable that tensions are being reduced. A succesful meeting could see a sharp turnaround in Far East flows out of risk assets with new highs across all asset classes.

The Vietnamese standoff with Beijing was resolved by the Chinese withdrawing an oil rig from Vietnamese waters an by Hanoi delaying a provocative ( in Chinese eyes ) trip to DC by their Foreign Minister. There is no sign of such sensitivity in Chino-Japanese relations. This is the issue that if left unresolved could cause markets to fall 50%.

Scotland : Gilts traders will be happy that the first debate went so convincingly to the pro-Union camp. A second debate on July 25th is likely to be more evenly matched. The pro-Independence parties have started on a major canvasing campaign in the poorer , traditionally non-voting, areas of the Central Lowlands. We stand by our long term forecast of a 54-46 vote in favour of staying within the UK. However, the pro-Union sentiment is arguably now at its high point.

ECB and QE : Jens Weidmann continues to manoeuvre to replace Mario Draghi at the ECB. A recent health scare with Italy's President Napolitano has raised the likelihood that Draghi may step down from the ECB and take up the position of Italian President sooner than summer 2015. Paris and Madrid have been canvassing to see what other states might object to a German at the helm of the ECB - Italy in this instance could hardly object. Prime Minister Renzi continues to believe that constitutional reform ( and a new President ) are necessary if lasting change is to be implemented in the Italian economy. Markets may not be a lenient inn their time horizons. 

Gaza : A tragedy but as long a Egypt and Saudi provide covert backing for Israel the situation remains containable. The larger issue of Iran's place in the mid-East remains uncertain. US and UK military action in Iraq is a sign to Tehran that resistance to their policies is increasing. What this means for the stalled nuclear negotiations remains dependent on how Russia responds. Moscow has sold S-400 air defence batteries to the PRC. Will they follow up with a sale to Iran ? this would make the country's nuclear facilities a no-g0 area for the Israeli Air Force.

Cuba : The government is actively courting both Moscow and Beijing to replace Venezuela as its major source of capital. This is a win win for China but stymies any hopes there were for the Obama administration to east the trade embargo.

Early event alerts 

Frank-Walter Steinmeier and Vice Chancellor Gabriel have had to put on hold hopes for a Berlin-Moscow-Paris alliance. However their reluctance over sanctions raises questions as to whether NATO is fit for purpose.

Baltic States watching developments are wondering whether €uro accession provides the security guarantees that they had hoped for.

Oil.

Oil stocks have had a nice run up on the uncertainty surrounding Iraqi production with WTI at 9 month highs. Barring a shock they're probably fairly valued at these levels. However, a shock may be what we get if fundamentalist militias export their vision into Jordan or Lebanon and elicit an Israeli response. Time to lighten but not go aggressively short. Rosneft, Lukoil and Gazprom have made up their post-Crimea sell off. The hidden story here may be the purchasing by Israel of Kurdish oil shipped via Turkey through Ceyhan to Ashkelon. For Turkey in particular the benefits of such a transshipment agreement could be meaningful in equity and FX terms. Some 2 million barrels are already said to have been transported this way with exports forecast to reach an annual rate of 20 million tonnes, some of which will be re-exported to Asia. 

In Europe the British Prime Minister seems to be failing in his attempt to stop the arch-federalist Jean-Claude Juncker from taking over the top slot at the European Commission. There are rumours that at Friday nights dinner in Ypres ( oh the irony of it ! ) he will use the '' Luxembourg Option " and demand that nothing perceived to be of such vital national importance can be taken without a unanimous vote. As they say in France ' bon chance '. Europes real problem is one of adjustment. Britain and France, the old Imperial powers, are seeing their economic and geo-political importance slip away. The Brits are ahead of the French in recognizing this. Germany is the natural aspirant to pole position but its recent ( ie last 150 years ) history makes it loathe to trumpet its ascendancy too loudly. Russia and China are of course delighted to see the EU rocked by a lack of unanimity; America less so.

Despite the Scottish Referendum and the increased likelihood of a British Exit from the EU entering the mainstream , Sterling continues to stick resolutely north of $1.69. The Canadian Dollar is also motoring against signs that further rate cuts are firmly off the table.

A new week

British Prime Minister David Cameron had hoped to rally more support for his blocking tactics against former Luxembourg Prime Minister Jean-Claude Juncker. In this he has been remarkably unsuccessful. The very real possibility now exists that Juncker will be nominated by 25 out of 28 governments and the United Kingdom ( together with Sweden and Hungary ) will find itself with an arch-federalist ( and presumably anti-British ) head of the EU. Ouch ! It has been a long time since the British Foreign Office has failed so miserably and the Brits ( never popular at the best of times ) were left so isolated in Europe. 

London is now desperately hoping that new Italian Prime Minister Matteo Renzi will swing behind the opposition to Juncker. Renzi is young, has a mandate for change and may be willing to see a reform minded President of the Commission emerge. As part of a deal being discussed the current ECB Chief Mario Draghi may be put forward as the governments candidate to replace ageing Italian President Giorgio Napolitano in two years time. Draghi's place would then be taken by Bundesbank President Jens Weidmann. 

With ISIS fundamentalists continuing to advance the US is left in a quandary. There are already signs that the Afghan Taliban are taking heed of what is happening in  Iraq. A US response will need to address not only the situation in Iraq but also the likelihood that a similar reversal may occur in Afghanistan. Expect drone attacks to signal a more hands on response. The resignation of PM Maliki would be a good signal to all parties that reform is belatedly taking hold.

Iraq and the oil price.

The capture of Mosul by the forces of Islamic State of Iraq and al-Sham ( ISIS) could lead to the dismemberment of Iraq. Certainly, the authorities in Baghdad seem unable to respond to the advance of the radicalised Sunni militias in an effective manner. This dismemberment is not something Washington wants. So it looks as if the US will need to reverse its planned withdrawal and increase the level of support it provides the government of Prime Minister Maliki. This is a strange turn of events as it now means that Iran and the US will be working to defeat the Sunni militants and  prevent the collapse of the Iraqi government in Baghdad. Iran is already organizing the arming and transfer of Shia militants from their heartlands in the south to the northern combat zone.

Washington is deeply unhappy. It finds itself sharing goals with Iran in Iraq while at the same time opposing it in Syria . Washington is also making  soundings to Tehran to achieve a breakthrough on Iranian nuclear capabilities. Pity the poor US ambassador in Riyadh who has to reassure his host government that American policy is working.

Expect 1) more US arms sales to Iraq - Apaches, 2) the use of missile equipped US drones to attack ISIS military concentrations, and 3) growing alienation between the Obama administration and Riyadh and America's other allies in the region. To confuse matters further disenchanted ex-military leaders from Saddam Husseins army are said to be making common ground with ISIS in the Ninawa and Diyala provinces. Fragmentation of the country into Sunni and Shia regions is now a real possibility. To top it all the Kurdish Peshmerga forces now find themselves faced with a new threat .

Iraq is OPEC's second largest exporter. Is it any wonder that the oil price has firmed ?

Off to China

Russia's President Putin is off to China this week. The usual defence contracts can be expected. More important will be whether landmark oil and gas deals will be signed. We don't think they will. Gazprom, Rosneft and LUKoil are all looking for alternative markets should sanctions over Ukraine continue. Getting oil and gas to China from Russia will not be easy - new pipelines will have to be built - but markets may put a positive spin on any agreements. From what we hear Gazprom is close to agreeing, or at least wants to, a 30 year deal at a fixed price of $380/MCM.  China, it is suggested, will pay upfront for a pipeline in return for fixed pricing - something Gazprom has so far been reluctant to agree to preferring an oil linked pricing formula as it has with Europe. Negotiations have taken 10 years to get this far. The Chinese are consummate negotiators. We shall see.

Ukraine again.

The headlines in the financial press continue to state that markets remain unsettled by unrest in the Ukraine. We're not so sure.  It's interesting to note that when we last wrote about developments there on April 8th the FTSE was at 6600. A month later the index is at a 6800 level. There have been Russia related right offs AND EARNINGS HITS - Carlsberg and Soc Gen being among a slew of companies that have seen slower Russian demand.

This isn't to say that developments in Ukraine are unimportant. The world ( and markets) could probably understand and live with a Russia that views a western leaning Ukraine as a threat to its security. NATO troops or EU officials on its border might e a step too far for the Kremlin. A neutral, modernized, country might then be a reasonable negotiated outcome. This could be beneficial to all parties, Ukrainians included. What is unsettling is whether Moscow's assertiveness marks a new strand in Russian diplomacy that wishes to intervene wherever there are 'threatened' Russian minorities. The scope for destabilization in the Baltics, Kazakhstan, Moldova, Georgia et al is something that would be profoundly more serious. As it stands we just don't know whether Moscow inspired instability in Eastern Ukraine is a post-Crimea one off , or is part of a larger and more serious change in strategy.

There are two other factors that need to be watched here. Mindful of mid-term elections and accusations he's soft on foreign policy issues, President Obama is slowly responding to Moscow adventurism by ratcheting up sanctions. Although America's diplomatic steps have been incremental and serious there is always the possibility that Congress will look for faster tougher responses. 

A second factor relates to Germany. There is much soul searching in Washington over Berlins unwillingness to support a stronger response to Russia's flouting of the recent Geneva agreement. Former Chancellor Schroder celebrated his 70th birthday with President Putin last week - a symbolic act that was well received in Moscow but raised eyebrows in London, Washington and Paris. Growing anti-Americanism in Germany is now an issue.

With Ukrainian elections scheduled later this month the conflict between Kiev and Moscow for control of the country enters a new, and heightened, phase. Moscow must decide this week whether to intervene while its forces remain on high alert or let the situation continue while western sanctions take effect. Markets will be alert to the loss of earnings and reduction in visibility that comes from tightening sanctions. Austrian banks and companies will be particularly impacted. 

Scotland. It'll be alright on the night. Or will it ?

Summary:

Will Scotland vote for independence ? Probably not but the vote is going to be narrower than expected and will be decided in the last three weeks of polling. If the vote were held today it would probably be 52% for maintenance of the Union.

Could Scotland thrive as an independent entity ? Yes. After a transition period, and assuming that taxes don't rise, the Scottish economy would look pretty much as it does today with unemployment slightly below the UK average. There would be major job losses in finance and defence but these would be compensated for to some degree by increases in Central government employment and enlarged transport links.

What has the market yet to come to terms with ? Few south of the border really believe Scotland will opt for separatism. If it does go there will be major questions over allocating oil assets and the national debt. A period of political turmoil would follow with the possibility of PM Cameron having to resign and Scottish MP's having to leave Westminster after the 2015 election. The impact on Ulster and the Peace Process might also be material. What happens to the UK nuclear deterent if Trident is forced to relocate has a major bearing on the UK's position in the world. Would the UN Security Council seat go  ?

What next ? The election will be held on September 18th . There follows an 18 month period for negotations over allocating the UK balance sheet. Scotland should receive some 8% of the total assets and liabilities. It is possible that if a currency union is not agreed or if EU membership is not forthcoming then there may need to be some form of vote over whether to accept the deal on offer or not.

What can go wrong ?  Plenty. The SNP view is that everything will be alright on the night. By contrast the rump UK government, facing constitutional turmoil, might opt for tough negotiations. Arguments over oil, debt, Sterling and Trident could become acrimonious. An incoming government following UK wide elections in May 2015 may find their electoral agenda hijacked by independence issues.



Overview:

I spent three days in Scotland last week meeting MP's and MSP's on both sides of the political divide with the aim of determining whether independence is likely and what the market implications, North and South, of the border might be.

The leader of the Scottish National Party, Alex Salmond, has driven the pro-independence agenda with a promise that Scotland will keep the Pound, remain in the EU and negotiate an amicable separation for the rest of the UK. Under this scenario the economy would maintain jobs and output levels, there would be no dislocations to trade flows and the standard of living would suffer no negative consequences. The chances of all three of these promises being kept is open to question.

Following our trip we believe that the polls are much closer than the market believes. The population of the North East ( Fife to Aberdeen ) and the Edinburgh area are generally against the split while the heavily populated de-industrialised west, an area covering Linwood and Clydeside, are increasingly pro-independence. As one Tory Member of the Scottish parliament put it '' These third generation unemployed have been failed by successive governments. They've lost hope so who's to blame them if they believe Salmond when he says things can only get better ? ''. Turn out in the Greenock-Port Glasgow constituencies and surrounding areas is expected to be higher than the national average. Some pollsters have spoken of a turnout as high as 80% in these largely pro-independence areas.

What are the likely implications for the economy ? Having recently spoken to management of manufacturing and service companies across the country we think that there are risks to both the Scottish and UK economies from a split. In terms of importance two issues stand out. Access to the currency union and continued membership of the European Union on existing terms. Neither currency union nor painless accession to the EU are certain despite the vehemence with which the SNP makes their claims.

The SNP believes that London will agree to a currency union as currently structured. It also takes the view that Brussels will allow continued membership of the EU without the approval of the other member states. Both issues are the subject of future negotiation but cannot be taken for granted. Tory, Labour and Lib Dem politicians in London have all stated that while Scotland can continue to use the Pound it will not have a voice in setting interest rate policy. Spain, mindful of the precedent independence might set for Catalonia, is likely to be ambivalent  ( at best ) about the admittance of an independent Scotland to the EU. Tempers in Madrid are unlikely to have been settle by recent statements that in the absence of EU membership Scotland would close its waters to Spanish trawlers en route to Norway. If Scotland leaves the UK, it leaves behind all treaty rights and obligations entered into by the UK. Many of these will be renewed but all will be the subject of negotiation. Edinburgh assumes this will be a painless and automatic process. They may be surprised.

Employment in Edinburgh is heavily dependent on technology and finance. If Scotland fails to negotiate a full currency union then the major banks such as Lloyds and RBS  are likely to repatriate jobs to London and the south. Money flows to where the power is.  Similarly, the fund management industry is sensitive to a growing Scotphobia in the  rest of the UK . This has brand and marketing implications. English consumers may be less keen to entrust their pensions and investments to a foreign entity. The fund management sector too is likely to shift resources south. As for defense it's not only Babcock's in Rosyth ( currently the only dry dock in the UK  large enough to take the new Queen Elizabeth class aircraft carrier ) but a whole host of SME's stretching from Paisley across the Central Lowlands and up the North East coast that are uncertain what the impact will be on their order books and access to export credits. The SNP, sensitive to its west coast voting base, is adamant that Trident must be removed - and quickly. This may not play well with the power ministries in London. Certainly , the right wing press - The Mail and Daily Telegraph - are unlikely to be happy with the threat to the nuclear deterrent and by extension Britain's role as a holder of a UN Security Council seat. . There are already signs that inward capital investment in the defence /technology/financial sectors is being delayed. Negotiations over separation may become both protracted and more difficult that the SNP is claiming. How English voters would respond if they woke up to find that 10% of the UK's population and a third of the UK's territory had departed can only be imagined but some growth in negative sentiment is not impossible.

For Scotland the net impact of a Yes vote is likely to be a loss of jobs in the transition phase. 30-40,000 in the financial and defense sectors being a guesstimate. This number would be  offset to some degree by increases in central government employment and expenditure . Air links are also likely to increase with commensurate growth in the air transport sector. The impact on house prices and the construction sector is somewhat dependent on how the banks structure their lending profiles in an independent Scotland. 

Issues of whether Scotland is allowed to become an EU member at the outset or has to wait ; whether it has to impose border controls; whether its tax structures diverge from those elsewhere in the UK are all issues that corporate managements are grappling with. The biggest issue of course remains access to Sterling and a say in setting interest rates. Rate setting without representation is not sovereignty. 

The bottom line is that there is a risk component to independence that its advocates downplay and its opponents find difficult to enumerate. It's rather like crossing the road. It's wise to look both ways. If you don't you're probably alright but there's always a chance that the unexpected will happen. The risk to employment and the  standard of living is not being discussed in this campaign. It is shouted down by a beligerent Yes camp that would prefer to address uncertainties after the vote has been cast and independence confirmed.

The polls at the start of May are showing the Yes side in the high 40's with the possibility of a Yes vote getting close to even by the time we enter June. There is a momentum developing within Scotland that reflects the psychology at play with UKIP - if it wasn't for the EU everything would be great. Substitute English for the EU and you've got the Scottish story in a nutshell. Against the uncertainties surrounding the split of debt, the structure of a currency union, the allocation of oil and gas, the constitutional uncertainties over what a Unionist Prime Minister would do if Scotland severs its links with London and what will happen to Scottish Westminster MP's in a transition parliament we believe there are implications for holders of UK financial instruments. 

There is another issue that has so far attracted little attention . What happens if Scotland cannot negotiate the agreements the SNP has categorically stated they will put in place ? Will there be a second referendum if EU membership is not deemed automatic, if England claims a portion of North Sea oil or if the Sterling link is weakened ? More probably Scotland will have to trade continued us of the Faslane nuclear submarine base in return for continued use of the Pound.

Against these constitutional uncertainties - the growing likelihood of Scottish independence, the possibility that the UK Prime Minister at the time of a ''Yes'' vote would have to resign, the projected withdrawal of Scottish MP's from Westminster and the electoral calculus and anger that would follow, the rise of UKIP, the possibility of an English referendum on EU membership - investors might well decide that the Sterling strength forever story may be overplayed.

To conclude. Scotland can thrive in independence. Tourism, whisky, oil and specialist manufacturing all provide a sound underpinning to the economy. There will be a transition period where many jobs in the financial component are relocated south. This will put a brake on the health of the services sector. Defence procurement is also an area where contraction can be expected. These loses can in some part be offset by the establishment of new central government organizations and the expansion of direct flight links. If however agreement cannot be reached on an amicable use of  Sterling or an equitable debt split then the new country could find itself exposed to higher borrowing costs and lower growth. The 'Yes' campaign is adopting a position that says there will be little change other than a more focused spening of Scotlands taxes on Scotlands needs. Negotiators in London and Brussel may yet provide some nasty surprises.

Are markets really worried about Ukraine ?

No one will go to war over Ukraine. Moscow knows this. So does Washington. So does the market. Recent calls from pro-Russian 'rebel' factions in Donetsk for independence from Ukraine are no real surprise although EM traders seem to have been taken aback by fresh selling pressure on MICEX. Moscow can,and will, use western indecision as an opportunity to continue to stir up trouble in its Ukrainian neighbour. Senior Staff in the Kreml, Defense and Foreign Ministries are united in viewing events there are being a threat to the cohesion and stability of Russia itself.

The Kremlin has been delighted with the lack of response from the US and the EU to its takeover of Crimea. Frank-Walter Steinmeier, the anti-US, anti-NATO German Foreign Minister, has been instrumental in shaping a policy of 'don't bait the bear'. In this he follows in the pro-Russian foreign policy footsteps of his friend and mentor, former Bundeschancellor Gerhard Schroder. Frau Merkel may talk a somewhat tougher line but she does so in the knowledge that Steinmeier and his SPD colleagues have won the public argument within Germany. He is now deemed the country's most popular politician. Other EU states have fallen in line. France , in part, because of the dependence of its naval shipyards on a Russian order for Mistral assault ships, and the UK because of the large ( although not as large as some might imagine ) Russian presence in Cayman Island and BVI structures in London's financial centre.

The running with regards to sanctions has been made by the US administration. The White House has until very recently failed to understand that Russia has no interest in a reset of relations. In fact Moscow understands that in a world where US hegemony is on the wane its own regional power can increase. President Obama's advisers have belatedly come to this realisation and are now faced with formulating some response , as much for domestic political reasons as for any deep seated foreign policy goals, to halt further expansion into Eastern Ukraine.

Until this week investors have responded to these developments with indifference. There has however been a recent change of tone. Defensive stocks have benefited from  strong rotational inflows.  Markets seem to be coming to the view that 1) Russia will continue its opportunistic adventures, 2) sanctions will only serve to shift the economic centre of gravity in the Russian economy towards China ( look for major oil, gas and defense deals being signed in Beijing when Putin visits in May ) and 3) America having downgraded the importance of its old allies ( Israel, UK, Saudi, Japan ) is finding it difficult to find new ones. As such the days of a pax Americana are well and truly over and geopolitical risk in investment determination is back on the table. Could we now see a repatriation of funds out of EM's into DM safe havens?