ON WHICH SPECIFIC OIL SUPPLY ISSUES ARE YOU MOST FOCUSED?
SHAWN REYNOLDS, CO-PORTFOLIO MANAGER, HARD ASSETS INVESTMENT TEAM: Quite often when we talk about supply and demand in the oil market, the two most important drivers, somewhat jokingly we say, is wars and weather. But given current events, those are the two most important drivers. Obviously, in North Africa and the Middle East, we're having a lot of turmoil there that's affecting supply. And clearly what we're seeing in Japan is going to have both a short-term and a long-term effect on demand.
More specifically, when we think about what's happening in the MENA region, the Middle East North Africa region, we're concerned about Libya. We think Libyan production has been affected already, and it has pretty much been reflected in the price. Algeria is the next most important area, because it's next door, and has had its own history of civil war. Within Algeria, there is plenty of turmoil and animosity seething, and it seems very ripe for civil unrest. However, until now, we've seen no response to production out of Algeria at all. However, if we do, it will tighten up spare capacity quite a bit. That could result in another $10 hike in oil prices.
Saudia Arabia is clearly the next most important area. With the movement of Saudi troops into Bahrain over the last couple of days, that has certainly ratcheted up the potential for production issues in that region. We haven't seen much in Saudi itself. Although the Day of Rage was pretty much a bust, it doesn't mean that nothing's going to happen. As we've seen in Tunisia, Egypt, Libya, the situation can erupt overnight. Our working hypothesis is that Saudi Arabia is going to stay fairly stable, and that we should focus our attention on what's happening in Algeria right now. Longer term, maybe several months from now, we will need to see how Iran and Saudi Arabia deal with each other. This could lead to some very serious geopolitical issues that ultimately may impact oil supply on a longer-term basis.
WHAT ABOUT COMMODITIES OTHER THAN OIL, FOR EXAMPLE GRAIN? WHAT THEMES ARE UNFOLDING AS A RESULT OF THE INSTABILITY IN THESE REGIONS?
SHAWN REYNOLDS: Grain is not having a huge impact from turmoil on either side. You're seeing more of an impact on thermal coal and steel demand. Japan's the largest steel producer in the world behind China. Japan is the largest importer of thermal coal, and it's one of the largest importers of met-coal. Certainly, the power-generation situation in Japan is dire. Thirty percent of Japan’s power generation comes from thermal coal. We'd expect to see a serious ramp-up in thermal-coal-powered electricity in Japan in the very near future. We would also expect to see a tightening in the LNG market, liquefied natural gas. That represents a very large portion of Japan’s energy needs. We expect to see that in the short term and in the long term, because the nuclear power situation means that nuclear energy capacity is going to be out for an extended period of time; the only way Japan can make this up is through LNG and thermal coal.
DAVID SEMPLE, PORTFOLIO MANAGER, EMERGING MARKETS INVESTMENT TEAM: To add to Shawn's comments in terms of thermal coal, it's important to realize that China has turned into a big net importer of thermal coal in the last couple of years. At the same time, India has significant plans to increase its capacity, or increase its power capacity, which will mean a lot of importation of thermal coal. It's really a very tight situation just now; and of course there are still issues with Australia and its supply capacity as its infrastructure has been somewhat constrained. On the other hand, the swing countries, such as Indonesia, look to be in a pretty good position in terms of providing supply into this increasing demand.
WILL THE RECENT RISE IN OIL PRICES DERAIL RECOVERY EFFORT AMONG EMERGING MARKETS IN GENERAL?
DAVID SEMPLE: At this level, we're not too worried. The thing to bear in mind with emerging markets is that oil has a very different impact on different economies. If you take the aggregate emerging markets' outlook, there might not be too much of an impact. But for certain countries, like India, there will be some issues, as the government typically subsidizes certain aspects of fuel products. On the other hand, you've got Russia, which is clearly an economy that is highly geared towards hydrocarbons and will tend to benefit, in the shorter term at least, from higher crude prices.
SHAWN REYNOLDS: I might just add that if you think back to the 2005 to mid-2008 period, when oil prices went from $50 to $150 a barrel, you saw a serious impact on demand from the OECD nations [34 countries comprise the Organization for Economic Co-operation and Development]. But you saw a continued demand growth in the non-OECD markets, so that on an aggregate, global basis, consumption increased. And we're nowhere near $150 oil now, so I think you would expect non-OECD emerging market consumption to continue on some sort of pace of growth. It may be a bit more muted, but I think our experiences in 2005 though 2008 suggest that it's really not going to slow down growth very much at all.
ERIC FINE, MANAGING DIRECTOR, EMERGING MARKETS DEBT STRATEGIST: There might be a slight difference between countries that had bigger bond markets, particularly hard currency bond markets, and countries that have the bigger equity markets. It's a big generalization. The bond markets could be characterized as net exporters of commodities, and equity markets, obviously, differently.
HOW REAL IS THE THREAT OF CONTAGION WITH RESPECT TO POLITICAL UNREST?
DAVID SEMPLE: I'm not a geopolitical analyst and for emerging markets in the immediate area of conflict, it's not significant other than how it impacts oil. There are clearly some significant divisions in the Arab world. My reading of history is that these things don't solve themselves quickly, even if you have turnovers in regimes, which tend to lead to instability rather than immediate stability. I think we've got to be looking at this on a longer-term time frame, and be somewhat worried about what's going on in that region. For emerging market equities, there is little immediate impact. The Gulf countries are actually called "frontier markets", and they're the largest part of the frontier markets, and it's really their impact in terms of oil supply that I think most people will focus on first.
ERIC FINE: I'd also add that national identities are weak in the MENA region, and this is an issue. It's a lot of tension, but that doesn't automatically lead one to the conclusion that it's inexorable.
HOW HAS THE RECENT UPHEAVAL AFFECTED EMERGING MARKETS' SOVEREIGN BOND MARKETS?
ERIC FINE : First, broadly, the spreads widened by maybe 30 basis points and then came all the way back. Broadly speaking, not a significant impact. Then there are specific countries like Egypt that basically saw its hard currency credit spreads double. And you might say something similar for some of the Gulf countries, where their markets came under short-term pressure. The other markets that are worth mentioning are, of course, Bahrain — its spreads are at all-time highs, around 350. And that, so far, is looking like a shift, a more permanent shift. Israel is also worth a mention. Its credit spreads gapped out dramatically, came all the way back, but I don't think markets are going to forget this. And to the extent that there are long-term implications, as David was talking about, they might be clearest, and the most tradeable, in Israel, because these other markets I mentioned are not nearly as deep and as liquid as Israel's market.
ANY SIGNIFICANT MOVEMENTS IN CURRENCY MARKETS?
ERIC FINE: The most interesting thing is that the dollar weakened. That was a huge tailwind for emerging market currencies, and the market's treating that as a good thing. Now, it's good until it's not, and if you look at DXY Index [U.S Dollar Index], the biggest index for the dollar, it is at critical levels. The most interesting thing is, in a period of crisis, the dollar weakened. Also, there are inflation problems, and a lot of emerging economies have very little financial intermediation, so currency is the easiest instrument to deal with inflation. That's a generalization, and it depends on the country of course, but emerging markets currencies broadly are stronger, despite this tension in the Middle East.
ARE ANY OF YOU MAKING CHANGES TO YOUR ACTIVELY MANAGED PORTFOLIOS BASED ON CURRENT GEOPOLITICAL CONSIDERATIONS?
SHAWN REYNOLDS: We are trying to distill down all the volatility into what we believe are long-term fundamentals, because that's really how we try to look at commodity supply and demand and our commodity price forecasts, and how that then dissipates into equities. So we're spending some time, we are making some tactical trades, but in terms of long-term investment decisions, we're still more in assessment mode. I think we're pretty well-positioned already, given that one of our core themes has been unconventional oil in North America. It's a theme we really like to have exposure to, the oil in a non-volatile part of the world. We also have a nice position in thermal coal. And so, as we mentioned earlier, that's going to be a commodity that's going to be fairly well-supported going forward. Other areas that we would probably be looking at fairly closely would be petrochemicals, we'd be looking at long-term impacts on base metals in Japan, while also keeping very close track of oil products on a global basis.
DAVID SEMPLE: I might just add, leveraging on Shawn’s [and his team's] work in the commodities space, we have increased our weightings modestly in the energy sector, including thermal coal, and we feel quite happy about our positioning right now. Russia is the biggest country play for us right now, and, on the other hand, it has been a consensus long so far this year, and has been one of the very few countries that has seen inflows in the emerging markets. Flows turned more in favor of developed markets over the first few months of this year. We think, in respect to emerging markets versus developed market flows, the trends has probably run its course, as economic indicators in developed markets become less of an upside surprise, and people get more comfortable with the tightening measures in emerging markets in relation to the inflation fears that Eric mentioned. So, although we have put some money towards Russia, we're not extremely overweight.
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