Monday, May 19, 2014

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.

Tuesday, May 6, 2014

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. 

Thursday, May 1, 2014

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


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.


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.