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Saudi Arabia's new role in world finance

By Matein Khalid Saudi arabia will increasingly define the economic and security architecture of the Middle East as the US withdraws its combat troops from Iraq and the Israel-Palestine peace process degenerates into diplomatic deep freeze.

The fall of Hosni Mubarak and the resurgent threat from Iran has convinced Saudi Arabia to adopt bolder policies to preserve the geopolitical status quo. This was the reason Saudi Arabia intervened in Bahrain, upgraded its energy infrastructure links with China, negotiated a $60 billion high tech weapons programme with the Pentagon and stakes the kingdom's prestige in the new GCC consensus to suspend Syria's membership in the Arab League.

The Saudis have now concluded that the Baathist regime in Syria, Iran's most reliable Arab ally since Sadat signed the Camp David accords in 1979, is living on borrowed time. In Iraq, Saudi Arabia's clients are Iyad Allawi's Iraqna and the powerful Sunni tribal shaikhs of Anbar/Diyala province. In Lebanon, Saudi allies have challenged the power of Hezbollah as the dominant force in its political calculus. Saudi Arabia has played a critical role in Yemen, a nation of obvious strategic significance to the kingdom.

The most immediate impact of Saudi financial largesse will be felt in Bahrain and Oman in the GCC, Jordan and Pakistan. The recent Saudi decision to buy 72 Euro fighters and 80 F-16 planes is a compelling argument to invest in the shares of Eads and Boeing.

Saudi Arabia's $138 billion social spending programme, expansion of its armed forces under the incoming defence minister Prince Salman and $20 billion in foreign aid commitment means the kingdom will calibrate its oil production to ensure that oil prices do not fall below its $80-$85 level and will make sure the world's oil importers are not devastated by another July 2008 style black gold bubble.

Now that Egypt has negotiated an IMF agreement and has a Muslim Brothers led government in place, it is entirely possible that Saudi Arabia will scale up its $4 billion aid programme for its unsettled Red Sea neighbour. A new elected Egyptian government, allied to the Saudis, would be a force for stability in the Arab world and could even broker a Hamas-Fatah rapprochement that is a prerequisite for a new peace agreement with Israel. Saudi Arabia will also finance reconstruction in post Baathist Syria. This could have huge significance for the extremely high risk premium in Mena countries.

Egypt's EGX30 index has soared an incredible 28 per cent in January after the election of parliament and the new IMF deal. Orascom Telecom doubled in a month! Yet, sadly, this rally will not last. The EGX index trades at a 40 per cent unwarranted valuation premium to Morgan Stanley EM.

The twelve month Egyptian pound NDF is at seven, meaning the FX gnomes price a devaluation. One year Misr T-bills yield 16 per cent, hardly a vote of macro confidence. Central bank reserves are now a mere $18 billion and the IMF loan does not negate the need for external financing. The Saudi Tadawul is a far safer macro a long at 6,200 for a 7,800 year end target.

Dollar-yen exchange headed to 80-82?

The japanese yen has been on of the world's most resilient safe havens, trading near postwar or at least post 1995 highs even though risk metrics in global finance (VIX, debt and FX volatility, credit spreads, etc) have plummeted since October 2011. However, the tight trading range of the yen is about to break on the downside, though declines will be limited, in my opinion, to 80-82. Why? One, the January payroll data confirms the emerging consensus that the US economy is recovering (at last) while US Treasury inflation break even yields are negatives. The Fed can simply not justify QE3 when payrolls rise by 250,000 a month, the stock market has doubled (since March 2009) and Brent crude oil is at $116 while commodities are on fire. This means that US Treasury-JGB interest rates spreads can well rise. Nothing dramatic, I concede, but enough to anchor a dollar bid against the yen.

Two, the Ministry of Finance is clearly unhappy with the uber-high yen, the reason it warned the FX market with its code language ("decisive action") and then decisively intervened in the Tokyo money market. This stealth intervention is no secret to the cognoscenti in the global FX market and the US Treasury. The Japanese do not want to intervene on a post Fukushima scale because Tokyo does not want to embarrass Tim Geithner as Obama faces his rivals in a bitter election battle. However, now that the samurais have descended from heaven, from the mist shrouded peaks of Mount Fujiyama, yen bulls should be on their guard. Japan Inc will simply not allow dollar-yen at 74.

As Fed easing expectations and European sovereign debt risk is priced out of the market, I expect the yen to decline to 80-82in the next two months. Obviously, if the West's cold war with Iran turns hot or a messy Greek/Portuguese default triggers contagion, all bets are off and the yen will surely surge beyond 75. However, this is a tail risk, not a base scenario.

Obviously, FX intervention alone will not work unless the Bank of Japan expands its asset purchase programme, a prospect Governor Yamaguchi has not exactly embraced with frenzied enthusiasm. Yet corporate Japan needs insurance against deflation risk, the current account surplus is at a 15-year low and US recession risk has plummeted. This may finally convince Yamaguchi-san that the Bank of Japan has now choices.

The Nikkei Dow is now 9,000. The Nikkei was 8,000 in 16 January. Sure, Greece/ECB provided rocket fuel. Yet is the prospect of a weaker yen also behind the surge in Toyota, Hitachi and Komatsu shares? There is also increasing political pressure for the Bank of Japan to ease policy as exports soften. Note that dollar-yen held 77 even as global equities tanked on Friday. Sterling-yen and Mexico-yen are obvious carry trades to take advantage of a weaker yen. Sterling-yen call can well head to 126 in the next month.

The Russian riddle and Putin enigma

Winston churchill, lifelong foe of Bolshevism and reluctant war-time ally of Stalin, called Russia a riddle wrapped in a mystery wrapped in an enigma. I feel the same way now that Russian equities have surged 20 per cent since late December amid some of the strongest inflows into the capital markets even as anti-Putin protests in the Kremlin rise on the eve of the most crucial election since the end of the USSR. Short term, both the RTS and Micex are grossly overbought and the VIX at 17 suggests greed, not fear, dominates the psychology of the markets. Yet Brent is $116, Russian assets are at fabulously distressed valuations, the equity risk premium in Russia is stratospheric (with good reason!) and the rouble is clearly undervalued. Russia trades at 5.7 times earnings, the cheapest major emerging market on the planet.

The epic unknown in Russia finance is obviously the presidential election in March. While United Russia and Vladimir Putin will win the election (second round?) but Russia's elites are no longer going to accept the autocratic "managed democracy" of the past decade. As a student of Russian history and literature since my teenage years, I know the politics of the rodina is vulnerable to periodic spasms -- Pugachev's peasant revolt against Catherine II, the Decembrist uprising in 1825 against Tsar Nikolai I, the 1881 assassination of Tsar Alexander II (the liberator of the serfs!), Bloody Sunday in 1906, the 1917 Bolshevik coup, the civil war, Stalin's Red terror, the 1991 KGB coup against Gorbachev and the 1998 Yeltsin rouble debt default.

Yet Russia's demonstrators are not the sans-coulotte of 1789 Paris or Bolchevik proles but Putin-era yuppies who want reforms, who want Lexus, not Lenin. So political risk in Russian equities is excessive. There is even evidence that Putin's Kremlin clans have tried to thaw politics and Tsar Volodya might even ditch Tsarevich Dima (aka, Medvedev, described as "not a lame duck but a dead duck" by the Moscow cognoscenti).

At this point, it just does not look as if worst case, Libya/Egypt style scenarios will happen in Russia. So the smart money bought Russian assets and the RTS Volatility Index has now fallen to 32. Is Russia a leveraged warrant on global risk appetites? Absolutely. Yet a world where Gazprom, owner of history's most fabulous gas reserves, trades at 3.5 time earnings is priced for Armageddon. The Russia index fund has soared from 26 just after the Duma election in December to 32 now. Too much, too fast? Da. A potential winner if post-election Russia does not implode. Double da. A put selling candidate if vols go back to 100-day historical levels at 48-50! Triple da.

I believe consumer shares in the emerging markets will outperform exporters in 2012. This goes for stock indices as well as earnings. I am also skittish on oil and metal prices at current levels. The risk rally on Wall Street, while a fabulous money maker since November is now skating on thin ice. Take profits!

Buy/sell ranges for Goldman Sachs in 2012

Goldman sachs shares lost almost 50 per cent last year, though the post October embrace of risk has seen the global investment banks shares surge from 87 in December to a 117 now. The risk reward on Goldman no longer seems attractive to me, as the market surge is on low volume and tail risks are all too real, from Iran to Greek debt to the risk of contagion in Portuguese debt. In any case, 2011 was an annus horribilis for Goldman. Earnings fell 66 per cent to a $4.5 EPS as the Volcker Rule forced the House of Blankfein to shut down its fabulously profitable proprietary trading business. ROE for the King Croesus of Wall Street was a dismal four per cent. Goldman remained in the crosshairs of the Congress, the SEC and even Occupy Wall Street as the most maligned investment bank in global haute-finance, a symbol of the busted Gilded Age of our times. Ever Lucas van Praag has retired at Death Star.

While it is true that Goldman beat Q4 Street consensus, the beat was only due to a tighter cost base (quelle horreur! Layoffs among the Masters of the Universe?) and lower tax rates. It is also significant that the fall in Goldman revenues was not due to trading blowups but due to regulatory imperatives (Dodd Frank, Volcker Rule, derivatives) and political blowbacks. Ironically, Goldman returned more than double the capital ($6 billion in buy backs) than it generated in earnings ($2.5 billion) in 2011. While mark to markets obviously surged in January, volume and client flows are mediocre. Yet firms have exited entire businesses (eg, French banks in project finance, RBS in cash equities, etc.) though UBS and Macquarie demonstrate the Black Death in I-banking still rages.

As Lazard demonstrates, merger advisory is not a goldmine right now. Cash equities revenues are down at least 15-20 per cent across the Street and even FICC market making/client execution revenues were down five to seven per cent. While equity/debt underwriting revenues were higher, I am concerned by the $8 billion in net AUM outflows in GSAM. Goldman is now trading almost at its tangible book value per common share. Sadly, the macro view suggests a discount. This means I go short GS at 117 for a 108 target.

I believe Goldman Sachs risk/reward is no longer investor friendly at 117, though as the animal spirits of Wall Street are still bullish. There is no point being a short sale matador when the bulls go ballistic in a high beta Pamplona. However, at 117-125, Goldman is skating on very thin ice. Naturally, the mood swings of the capital markets will determine the fate of Goldman Sachs shares. A messy Greek default would be another liquidity shock on the credit markets and thus escalate funding risk on Wall Street. Another Abacus or compensation scandal could hit the shares. Naturally, if equity markets continue to surge higher, Facebook reopens the IPO pipeline, credit spreads continue to compress, China has a soft landing, Goldman EPS could be as high as $15. But I doubt it. My thesis is $12-$13, the 2010 level. This means Goldman trades between 95 and 125, my ideal buy/sell (short?) zone.

© Khaleej Times 2012