Sunday, June 15, 2014

Apocalypse Later

I have been thinking about the kind of tail-risk posed by sudden events that could tank global risk appetite and therefore the financial markets. My conclusion is that the so-called tail-risk are wrong and the immediate threat posed by tail-risk is lower than the market thinks.

Let me explain. There are three sources of event risk that could cause the markets to swoon:
  • Iraq
  • Russia-Ukraine
  • Chinese financial crisis
As I go through this analysis, bear the following in mind. Don't consider the event through a geopolitical lens, which could be potentially serious, but through a market lens. For the purpose of this analysis, it's important to be politically agnostic and think about the potential market impact of the event.

The threat from Iraq
Let's start with the freak-out du jour, Iraq. Andrew Critchlow of The Telegraph sums up the economic risks posed by higher crude prices because of a curtailment of Iraqi oil production (emphasis added):
Open warfare between the government and rebels in Iraq would pose a threat to the global economic recovery should oil production from the war-torn Middle East state suffer a serious disruption, analysts have warned.

Brent oil prices climbed as high as $110.25 (£65.59) on Wednesday amid concerns that 3.5m barrels per day of Iraqi exports could be knocked out of the market by the violence that has seen al-Qaeda forces seize control of Mosul, Tikrit and Samarra.

"The worst case scenario is that we see production from Iraq slip down to levels in the last Gulf war, then oil could spike $20 a barrel very quickly," Ole Hansen, vice-president and head of commodity strategy at Saxo Bank told The Telegraph.

"In that scenario, the entire economic recovery, which is still fragile, could stall and we could even slip back into recession in some regions."
It didn't help matters when elements of the Iraqi Army engaged in mass desertions in the face of the assault, and leaving weapons, vehicles and depots intact for the rebels to seize (via DEBKA):
The Islamists also took over the main crossing from Iraq to Syria at Yaaroubiyeh.

They rode out of the Mosul battle Tuesday with 260 new armored vehicles of various types – enough to equip a full division - taken booty from the Iraqi army. The roads out of the city are clogged with an estimated half a million refugees in flight from the bloodshed and chaos with no means of support.

Although he declared a national state of emergency, Prime Minister Nuri al-Maliki has no illusions about his army standing up to the ferocious al Qaeda fighters. And indeed the tens of thousands of troops stationed in Mosul turned tail Tuesday and fled under the onslaught.
Further analysis reveals that the majority of current Iraqi oil production comes from the south as these graphics from Marketwatch show:

The Marketwatch article went on to detail the current threat to Iraqi oil production, which is not very much at the moment.
An underlying fear in the oil market is that the fighting will spread to Iraq’s main oil-producing areas in the south. Meanwhile, Iraq’s biggest refinery at Baijii in the north remains under government control , Iraqi oil minister Abdul Kareem Luaibi said Thursday, according to Reuters. Luaibi said Iraqi crude exports from its southern terminal at Basra were running at an average of 2.6 million to 2.7 million barrels a day on Wednesday.
(Other reports filed on Friday and over the weekend indicate that ISIS is in control of the Baijii oil refinery.) The threat to oil production is not serious, so far:
“The northern oil fields have been taken yet that area of the country was not really active. There had been damaged pipelines due to sabotage,” said Phil Flynn, senior market analyst at Price Futures Group. “Basra in the south of Iraq seems to be operating normally and any attack on Baghdad may be met with much tougher resistance.”
Most of current Iraqi production leaves through the Persian Gulf. This map of rebel gains (shown in red) and battles (yellow) from The Long War Journal shows the current battle map of Iraq (h/t Across the Curve) :

The rebels appear to be trying to encircle Baghdad, as they are not strong enough to take it by direct assault:
The lightning advance of the Islamic State of Iraq and the Sham and its allies from Mosul to the outskirts of Samarra, as well as its capture of several towns in eastern Diyala, all over the course of several days, appears to be part of a greater strategy to surround the capital of Baghdad before laying siege to it. This plan, to take over the "belt" region outside of Baghdad and cut off the capital, appears to be the same strategy used by the ISIS' predecessor back in 2006.

The 2006 plan, which was drawn up by the Islamic State of Iraq (ISI), the forerunner of the Islamic State of Iraq and the Sham (ISIS), was discovered after the US found a crude map on the body of Abu Musab al Zarqawi, al Qaeda in Iraq's leader who was killed by US forces in Baqubah in June 2006. The "Baghdad belts" map was released by Multinational Forces-Iraq during its offensive to liberate vast areas under al Qaeda/ISI control in 2007 and 2008.

Zarqawi's plan was to seize control of the outer provinces and Baghdad's belts, or key areas surrounding the capital. The ISI would then use its bases in the belts to control access to Baghdad and funnel money, weapons, car bombs, and fighters into the city. The ISI also planned to strangle the US helicopter air lanes by emplacing anti-aircraft cells along known routes in the belts areas around Baghdad.

In the ISI's 2006 plan, the Baghdad belts were divided into five regions: the "Southern Belt," which included northern Babil and southern Diyala provinces; the "Western belt," which included eastern Anbar province and the Thar Thar area; the "Northern belt," which included southern Salahaddin province and cities such as Taji; the "Diyala belt," which included Baqubah and Khalis; and the "Eastern belt," which included the rural areas east of Baghdad.

Watching the ISIS' operations today, it appears the group is attempting to implement a strategy which is very similar, if not identical, to the previous one. This should come as no surprise; Nasser al Din Allah Abu Suleiman, ISIS' current war minister, was a leader in al Qaeda in Iraq/ISI when the Baghdad belt strategy was implemented. Suleiman was appointed by al Qaeda in May 2010 to serve as the terror group's top military commander after his predecessor, Abu Ayyub al Masri, was killed in a raid by Iraqi and US forces in April 2010.
Stratfor's analysis came to a similar conclusion - that these military gains pose no immediate threat to the regime in Baghdad (via Across the Curve, emphasis added):
The Islamic State in Iraq and the Levant knows that its opportunity in Iraq will not stay open for long given that demographic trends in Iraq favor the Shia. It also recognizes its limits among Iraq’s Sunnis. Most important, it understands the convergence of U.S., Iranian and Turkish interests that is underway; for different reasons, none of these three countries can tolerate its expansion in Iraq.

This means the group knows it is not in a position to seize Baghdad just yet. For now, it must try quickly to consolidate itself in the Sunni-dominated provinces of Anbar, Ninawa and Salah ad Din, as well as the mixed provinces of Kirkuk and Diyala. It knows that the outside countries will not send ground forces into Iraq’s Sunni areas and instead will rely on air power and special operations forces against its fighters.

Therefore, the Islamic State in Iraq and the Levant will limit itself to establishing a presence in western Iraq similar to what it has in eastern Syria, where outsiders will fear to tread and where neither the Shiite-dominated central government nor the Kurdistan Regional Government can impose its writ. If the jihadist group can survive, any amount of space where it can enjoy freedom of activity will suffice for its purposes of establishing an emirate in the roughly contiguous cross-border area, affording it strategic depth and a launchpad for later offensives against Baghdad and Damascus.
If there is no immediate military threat to Baghdad regime and the status quo, then there is no no immediate threat to southern oil production. Even if the rebels were to be successful, they have shown themselves to be highly calculating in their management of captured oil production facilities. The Telegraph reported in January that ISIS was selling Syrian oil through the Syrian regime. As well, the New York Times recently reported that ISIS was selling Syrian oil and electricity to finance their military campaign.

While the emergence of this group in Middle East is a geopolitical threat to the status quo, there does not seem to be any threat to global oil production, even if they are successful. (Remember my earlier warning to be politically agnostic when investing.) We are likely seeing the start of a protracted military campaign by ISIS. The current minor market freak-out should fade, just as the last freak-out over the Russia-Ukraine crisis faded from the headlines.

The dire warnings about Russian sanctions
Speaking of Russia-Ukraine,  it seems that news of fighting doesn't matter to the markets anymore. That's why it pays to take a deep breath and be cautious about the market's initial reaction to geopolitical events. If most Americans have trouble placing Ukraine on a world map, as per this Washington Post article, how can you trust the initial knee-jerk market reaction?

Where’s Ukraine? Each dot depicts the location where a U.S. survey respondent situated Ukraine; the dots are colored based on how far removed they are from the actual country, with the most accurate responses in red and the least accurate ones in blue. (Data: Survey Sampling International; Figure: Thomas Zeitzoff/The Monkey Cage)

Recall the headlines then and what has happened since. Ambrose Evans-Pritchard of The Telegraph warned us how American sanctions could bring Russia to its knees:
The United States has constructed a financial neutron bomb. For the past 12 years an elite cell at the US Treasury has been sharpening the tools of economic warfare, designing ways to bring almost any country to its knees without firing a shot.

The strategy relies on hegemonic control over the global banking system, buttressed by a network of allies and the reluctant acquiescence of neutral states. Let us call this the Manhattan Project of the early 21st century...

The stealth weapon is a "scarlet letter", devised under Section 311 of the US Patriot Act. Once a bank is tainted in this way - accused of money-laundering or underwriting terrorist activities, a suitably loose offence - it becomes radioactive, caught in the "boa constrictor's lethal embrace", as Mr Zarate puts it.

This can be a death sentence even if the lender has no operations in the US. European banks do not dare to defy US regulators. They sever all dealings with the victim.
Notwithstanding the fact that an economic war sparked by sanctions could slow eurozone growth and a Russian collapse could threaten the West as the effects of financial contagion ripples through the global financial system, the repercussions could have even been greater. Evans-Pritchard painted an Apocalyptic scenario of what might happen if Putin decided to retaliate:
The greatest risk is surely an "asymmetric" riposte by the Kremlin. Russia's cyber-warfare experts are among the best, and they had their own trial run on Estonia in 2007. A cyber shutdown of an Illinois water system was tracked to Russian sources in 2011. We don't know whether US Homeland Security can counter a full-blown "denial-of-service" attack on electricity grids, water systems, air traffic control, or indeed the New York Stock Exchange, and nor does Washington.

"If we were in a cyberwar today, the US would lose. We're simply the most dependent and most vulnerable," said US spy chief Mike McConnell in 2010.

The US defence secretary Leon Panetta warned of a cyber-Pearl Harbour in 2012. "They could shut down the power grid across large parts of the country. They could derail passenger trains or, even more dangerous, derail passenger trains loaded with lethal chemicals. They could contaminate the water supply in major cities, or shut down the power grid across large parts of the country,” he said. Slapstick exaggeration to extract more funds from Congress? We may find out.
The British, with their classical education, can be always counted on to give us lessons from ancient history:
Sanctions are as old as time. So are the salutary lessons. Pericles tried to cow the city state of Megara in 432 BC by cutting off trade access to markets of the Athenian Empire. He set off the Pelopennesian Wars, bringing Sparta's hoplite infantry crashing down on Athens. Greece's economic system was left in ruins, at the mercy of Persia. That was a taste of asymmetry.
In light of these dire warnings, consider what has happened since. This Bloomberg report informs us that corporate America has been quietly lobbying behind the scenes to blunt the effects of sanctions:
The U.S. is holding off on sanctions against some Russian companies because it doesn’t want to hurt American holders of their debt, according to Fitch Ratings.

“We’ve heard quite a lot of anecdotal evidence that there’s actually a lot of consultation with big investors and bondholders in terms of what sanctions might be imposed by the U.S.,” James Watson, a managing director at Fitch, told reporters today in London. “It seems there has been a significant push back on potentially sanctioning companies that have significant foreign debt.”
So even as Gazprom threatens to cut off gas to Ukraine if the outstanding bills aren't paid, the WSJ reports that the CEO of Exxon Mobil is scheduled to speak at an energy summit in Moscow with Rosneft CEO Sechin. Ho hum  - Apocalypse Later, or maybe Apocalypse Never.

China is (not) collapsing
I have written much about China (see my last two posts Measuring market expectations on China and China turning Japanese). The main catastrophic risk posed to the global markets is a banking crisis in China which unleashes a wave of defaults that spill over to the global financial system. Indeed, the Chinese financial system is looking more wobbly these days as almost every day we are seeing stories of falling property prices and languishing real estate inventory in over-supplied markets. This is particularly important as loans anchored by collateral, namely real estate, rather than cash flow, because financial statements about cash flow are *ahem* unreliable, while real estate is *cough*cough* solid. Falling property prices could therefore set off a wave of defaults as collateral values collapse.

While this dire scenario could still very much in the cards, the near-term outlook seems to be improving. This Bloomberg report indicates that the authorities have resorted to the same-old-same-old policy instrument of credit growth to boost the economy (emphasis added):
China’s new yuan loans and money supply topped estimates in May as the government supports economic growth while reining in shadow banking. 
Local-currency loans were 870.8 billion yuan ($140 billion), the People’s Bank of China said on its website yesterday, higher than 42 out of 43 analyst estimates in a Bloomberg News survey. M2, the broadest measure of money supply, rose 13.4 percent, compared with a median projection for 13.1 percent.

China is in danger of missing a 2014 target for economic growth of about 7.5 percent, prompting Premier Li Keqiang to speed up government spending and make limited cuts to lenders’ reserve requirements. The World Bank warned last week that rapid credit growth and debt accumulation by local governments are risks to financial stability.

May is the first month this year we’ve seen a sizable easing of liquidity as evidenced by the strong new bank loans,” said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong. “It suggests that policy makers are turning more serious about the downside risks to the economy and began ramping up pro-growth measures.”
Indeed, the markets seem to have discounted the risk of an immediate collapse in the Chinese financial system. One measure is the Old China-New China pair trade (see An New China-Old China pair trade). The New China basket (PBJ) consists mainly of shares of companies exposed to the Chinese consumer, while the Old China basket (FXI) is tilted towards the financial sector, which has been the instrument of past government policy to stimulate the economy via credit-driven infrastructure growth. Note how the Old China basket has been rallying against the New China basket since the pair bottomed out in March.

As well, despite the Australia-bearish news about falling iron ore and other base metal prices and the scandal over metal rehypothecation, the AUDCAD cross-rate remains in an uptrend. This cross-rate is an important barometer of market sentiment of infrastructure spending in China because both the Australian and Canadian economies are resource-based, with the Canadian economy more exposed to US growth while the Aussie economy is more sensitive to Chinese growth:

In effect, Mr. Market is telling us that the near-term outlook for China is improving.

Oh well, Apocalypse Later for China, Russia-Ukraine and Iraq. This does not mean that these risks have totally gone away, just that there is little imminent threat of a collapse. This also doesn't mean that I am not concerned about the markets (see How stocks are both cheap AND expensive).

In the meantime, bring on the low VIX and low volatility for financial assets! The current readings of the VIX term structure suggests that complacency levels are not all that elevated (see Worried about a low VIX?). The ECB has decided to throw a party and the party in America is still continuing, so don't be such a worry-wart.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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