The Weekly Update

The G20 summit in the Chinese city of Chengdu was, unsurprisingly, dominated by discussions about Brexit. The communique issued by the G20 ministers at the end of the weekend’s gathering, said Brexit had added to uncertainty in the global economy where growth was already “weaker than desirable”. However, they insisted that they had the tools available and were “well positioned to proactively address the potential economic and financial consequences”. This comes shortly after the IMF’s economic update on 19th July that contained yet another downward revision to their global growth estimates: now running at 3.1 percent for 2016 and 3.4 percent for 2017. The growth forecasts for the UK saw a modest downgrade to 1.7 percent in 2016 but the 2017 estimate was slashed by 0.9 percent to 1.3 percent.

Last week’s UK PMI data corroborated the IMF’s gloomier outlook with the UK PMI composite index falling to 47.7 in July from 54.2 in June to trade at its lowest level since April 2009. The services component was particularly weak. Equally, in a report last week from consultant Wood Mackenzie the price of Brent crude at around $50 a barrel has left about 30% of fields in the North Sea, one of the highest-cost regions, operating at a loss. Compounded by the uncertainty surrounding the political outlook caused by Brexit, more producers are looking to plug wells. Projected spending on decommissioning has jumped 16% since Oil and Gas UK produced their ten year forecast in 2014 rising to a cost of £16.9 billion for producers in the area. According to BP, oil production in the region was just 965,000 barrels a day (bpd) last year down from 2.9 million bpd in 1999. About a third of operating platforms are older than their original design life and the costs of upgrades are just too much with oil at today’s pricing. Shell for instance is producing from just one of the four platforms in the Brent field, where the name of North Sea production derived its name. According to sources a full shutdown removes about 100,000 tons of metal from each platform but still potentially leaves concrete columns half the size of the Eiffel tower jutting from the water. Oil and Gas companies are expected to invest 40% less this year than in 2014 in production and refitting, by the end of the year an estimated 120,000 jobs will have been lost due to the downturn, according to Oil and Gas UK.

As the example above illustrates, lower energy prices will lead to a fall in investment, and unless this is offset by increased demand from energy importing countries, the overall impact of a fall in energy prices is a reduction in global growth. As we have written before, demographic trends and secular stagnation also point to a slower growth paradigm. Elevated global debt levels compound this; in many cases prompting austerity driven policy and the rise in inequality promoting a rise in ‘populist politics’. With these trends it comes as little surprise that interest rates are at such low or negative levels and that inflation remains benign.

On a more positive note, the one area where the IMF’s growth estimates were upwardly revised was Russia: 2016 growth was revised up by 0.6 percent to -1.2 percent and the 2017 growth estimate was increased by 0.2 percent to 1 percent. Low oil prices and sanctions remain constraining factors but it does nevertheless look like the worst has passed. Sanctions, despite growing questions about their effectiveness, remain in place as the implementation of the Minsk II agreement continues to drag on. Sergey Lavrov, the Russian Foreign Minister, notes that in order for border control to be returned to the Ukraine certain clauses of the Minsk II agreement still need to be fulfilled by them: “we have explained to them many times that without an amnesty and a law on the special status, which will really guarantee additional rights to the (self-proclaimed) territories and so long as these rights are not enshrined permanently in Ukraine’s constitution, it is hard to believe that Donetsk and Lugansk will agree to implement in advance what is supposed to wind up the political process under the Minsk Accords rather than to be a preliminary condition."

Like Russia, China’s economic data which has been a bit more encouraging of late, has helped temper slowdown fears; industrial production and retail sales beat market expectations in June. The economy expanded to 6.7% yoy in Q2’16, ahead of market consensus, and falls in-line with the government's 6.5-7% target. Last week Standard and Poor, the rating agency bumped up China’s 2016 and 2017 growth estimates by 0.25% to 6.6% and 6.3% respectively; citing the “stronger-than-expected GDP print for the second quarter”. We believe that both global economic uncertainty and domestic headwinds will continue to weigh on China’s economy, however, the government has ample fiscal capacity to support the economy; with the fiscal deficit at only 3% of GDP.

The situation in Turkey is quite the opposite. After the failed coup attempt last weekend, S and P downgraded Turkey’s sovereign credit rating from BB+ to BB adding that the outlook has also become negative. In a statement after the downgrade the rating agency said, "Following the attempted coup in the Republic of Turkey on July 15, we believe the polarisation of Turkey's political landscape has further eroded its institutional checks and balances" adding that there would be “a period of heightened unpredictability that could constrain capital inflows into Turkey’s externally leveraged economy”. According to S and P, Turkey has approximately USD170bln of external debt that it must roll over in the next 12 months. With this in mind they went on to say, "The negative outlook reflects our view that Turkey's economic, fiscal, and debt metrics could deteriorate beyond what we expect, if political uncertainty contributed to further weakening in the investment environment, potentially intensifying balance-of-payment pressures".

Along with the downgrade, Turkeys President Erdogan announced a 3-month state of emergency. The state of emergency is seen as a milder category than that of martial law. During a state of emergency, rights of freedom can be curtailed and a Council of Ministers may issue decrees having the force of law, however given what happened over the weekend the declaration of a three-month period of state of emergency does not seem to be an excessive measure – it is neither as severe as declaring martial law, nor was it announced for the maximum possible term of six months.

Overall, the global economic backdrop makes yields in excess of 4% available in investment grade bonds in creditor nations look a particularly attractive place to be positioned with the indebted nations, like Turkey, looking increasingly vulnerable.