The summit between North Korea’s Kim Jong-un and America’s shoot from the lip President is either on or off depending on which day of the week you read this. Two super-egos are shadow-boxing prior to the real event. Or perhaps it is all “fake news.” Are we the only ones who can’t recall seeing that phrase prior to the Trump presidency?
Something that definitely isn’t fake news is the second-coming of 92 year-old Mahathir Mohamad to the Prime Ministership of Malaysia – leading a four-party coalition in the first transition of power since independence in August 1957. In a “you couldn’t make it up” scenario, Mr. Mahathir became Malaysia’s fourth Prime Minister in 1981 and stepped down after twenty two years in office and five years after sacking his deputy Anwar Ibrahim on trumped up sexual misconduct and corruption charges (for which Anwar eventually served approximately seven years imprisonment in two tranches). Mahathir and Anwar became bitter adversaries but now Mahathir has announced he plans handing over the leader’s reins to Anwar in around two years’ time. Meanwhile Anwar’s wife, Wan Azizah Wan Ismail, has been appointed Deputy Prime Minister. Anwar, now 70 years of age, was given a royal pardon and released from prison on May 16th.
At the same time the outgoing Prime Minister, Najib Abdul Razak (nine years in office), is being investigated in relation to misappropriation of vast sums of money (allegedly at least U.S. $4.5 billion and possibly as much as U.S. $6 billion) from Malaysia’s sovereign wealth fund – 1Malaysia Development Berhad (1MDB). The fund was set up by Mr. Najib in 2009 and apparently has debts of more than U.S. $8 billion and a very meager cash flow. In 2012 and 2013 around U.S. $6.5 billion was raised via international bonds underwritten and sold by Goldman Sachs. The allegation is that much of this money was fraudulently removed from the fund.
In June 2015 the Wall Street Journal alleged that around U.S. $700m was deposited in Najib’s personal bank account. He claimed it was a gift from a Saudi benefactor. On May 25th Malaysian police announced they seized more than 400 handbags and almost U.S. $30m in cash in raids on two luxury apartments linked to Najib Razak. Large quantities of watches and jewelry were also seized. 400 handbags? – is that unusual?
This financial scandal is so staggeringly large it may possibly end up being adjudged the greatest in the sad and long line of financial misdeeds that litter the history books. The U.S. Justice Department is actively pursuing the case along with authorities in at least five other countries. One of the early tests of Mr. Mahathir’s latest premiership will be whether he effectively follows-through on the comprehensive investigation he promised to the electorate.
We have always been positive about the economic potential of Malaysia and with the wily veteran now back in the top chair our enthusiasm is undimmed. There is much to be done and a significant mess to clean up but the voting public appear to have made a sensible choice.
Populist movement in Italy
The other extraordinary political news during May was the turmoil surrounding the formation of a new government in Italy. In the elections on March 4th around 20% voted for the Northern League Party of Matteo Salvini and one-third for the Five Star Movement, the Party founded by stand-up comedian Beppe Grillo and headed by Luigi di Maio. Both Parties are deeply Euro-sceptic – one left wing and the other far right – an unlikely combination but one that nevertheless agreed to come together to form a coalition. But then: in what amounted to a remarkable assault on the democratic process this proposal was blocked by Italy’s President – Sergio Mattarella. But now: it appears that the coalition is back on track although the situation is so fluid that it all could have changed again by the time this reaches your inbox.
The President had planned to ask an unelected official, Carlo Cottarelli, to take office as interim Prime Minister heading a stopgap “technical” administration pending fresh elections. Mr. Cottarelli is a former officer of the International Monetary Fund. On the other hand the coalition plans to install Giuseppe Conte, a university law professor with no political experience as their choice as leader.
One of the many controversial issues in this political storm was the proposal by the coalition to appoint 81 year-old economist Paolo Savona as Finance Minister. Mr. Savona is a former minister and Bank of Italy official who is on record as saying that Italy’s membership of the eurozone is a “historic error.” Other key members of the eurozone were aghast at such a proposed appointment. Now it appears the compromise is to appoint Mr. Savona as European Affairs Minister. Even that will rankle with many.
During the election campaign the two Parties proposed, among other things, the abandonment of austerity measures, deportation of half a million migrants, a basic “citizen’s salary” of 780 euros a month and flat tax rates of 15% and 20%. Now, we wait to see how much of this is to be shelved or at best substantially modified. The powerful vested interests in the European Union appear to have won this battle – although perhaps only temporarily.
Italy is the third biggest economy in the eurozone hence its plight does matter. Its GDP is almost ten times the size of that of its troubled near neighbor, Greece. According to the latest data from the IMF, its general government gross debt to GDP ratio stood at 131% at the end of 2017 and is forecast to be much the same at the end of the current year. Among eurozone countries only Greece has a higher debt to GDP ratio. The IMF forecasts that in the current year the combination of maturing central government debt and the budget deficit will result in a gross financing requirement equivalent to 22.2% of GDP. That is an extremely heavy burden for any country but particularly one trapped within a currency union.
Italy has experienced no productivity growth since the end of the financial crisis whilst real GDP has barely grown since the start of the eurozone in 1999. Once again, only Greece has performed worse. Youth unemployment (aged under 25) is a little over 30%.
Recent OECD data indicates that Italy has by far the highest level of non-performing loans and advances among eurozone countries – standing at €179 billion at the end of the 3rd quarter in 2017. The next on the list is France at €132 billion. It is little wonder that many banking stocks have been weak.
In these circumstances it is hardly surprising that the “populist” and euro-sceptic movement in Italy has gained a powerful voice. The Italian economic performance has been bleak with a capital “B”. Faced with no prospect (within the constraints of the eurozone) of turning to the printing presses, benefiting from currency flexibility or employing significant fiscal and monetary
initiatives the siren call of an “exit” becomes seductive.
We don’t know how this is going to end but turmoil and schisms are set to continue. Once again the prospect of a partial eurozone breakup is on the table.
Markets in May
In the U.S. the benchmark 10-year bond yield moved decisively above the magic 3% level during May and then, equally decisively, it retreated below 3%. It finished the month at 2.86%. Nevertheless the yield is higher than that on offer in almost all other developed nations and has helped to push the dollar higher in the last two months – making life tough for a number of emerging markets that are competing for dollars and have significant slices of debt denominated in dollars. The travails of Turkey and Argentina are only too familiar to emerging market watchers but to the list must now be added Indonesia and Brazil – all suffering from currency weakness and capital flight. The go-to weapon of the respective central banks is to raise rates but that only exacerbates the internal economic difficulties. As long as the U.S. dollar holds such sway over the financial affairs of so many other countries it will be impossible to escape this sort of volatility.
The U.S. stock market has remained relatively buoyant although the key indices are flat for the year. From our perspective the interesting feature is that it has been U.S. companies purchasing their own stock that have been the sole net contributors to the stock market inward flow. Data released by the U.S. Federal Reserve indicates that corporates have contributed 100% of the net dollar inflow over the last three calendar years whilst year-to-date tabulations suggest that 2018 may end up being a record year for buybacks.
We have no particular quarrel with buybacks unless the price is wrong (too high); the motivation is misguided (incentives tied to earnings per share and the stock price?); and/or excessive debt is used to fund the purchase. In terms of the price it is our unqualified view that the U.S. stock market is expensive. But that is hardly a Robinson Crusoe opinion. And debt? Non-financial corporate debt has reached a record level relative to GDP (source: Federal Reserve). So, yes, we are starting to get quarrelsome.
Most stock markets experienced falling prices during May. In particular, the Italian political fracas negatively impacted the European markets. Utilizing MSCI price indices and expressed in local currencies the Italian bourse fell by 9.57%; Spain 6.1%; Austria 5.7%; Switzerland 4.4%; Belgium 2.8%; France 1.7% and Germany 1.5%. In contrast, the U.K., inching ever-closer to an exit from the European Union, experienced a 2.1% lift in market prices.
Outside Europe and again utilizing MSCI price indices in local currencies, the Australian market rose by 0.5%; the U.S. market was up 2.2%; Canada a solid 3.0% and New Zealand a robust 4.3%. Negatives were recorded by: Singapore: -6.2%; Japan: -1.8% and Hong Kong: -0.2%.
Government bond markets were the center of increased volatility in May due to the Italian situation – causing a number of the financially fragile countries in the eurozone to suffer from sharply rising yields whilst the traditional safe havens enjoyed capital inflows and falling yields. The yield on Italian 10-year bonds rose from 1.78% to 2.84%; Greek from 4.17% to 4.77%; Spanish 1.28% to 1.48% and Portuguese from 1.48% to 1.96%. On the other hand, German 10-year bond yields fell from 0.56% to 0.34%; Swiss 0.091% to a negative 0.073%; U.K. 1.41% to 1.22%; U.S. 2.95% to 2.86%; Australia 2.76% to 2.67%; Canada from 2.30% to 2.25% and Japan from 0.055% to 0.037% (source: Reuters).
Whilst the Italian situation remains in flux it is unlikely that volatility will subside. Add to this renewed political uncertainty in Spain and the confirmed moves by President Trump to sign into law various controversial and divisive protectionist measures we have a recipe for a particularly muddy global situation.
Pyrford International is registered as an investment adviser with the Securities and Exchange Commission and is a wholly-owned subsidiary of BMO Financial Group.