For asset managers on a hunt for growth, 2015 was a disaster. Equity markets turned out to be brutal. Bonds – while safe – were low yielding. Their expectations for 2016 are far more tempered because challenges around macroeconomic stability are likely to exacerbate in 2016. The safe heaven that bonds offered last year also looks less certain as interest rates and inflation are both creeping up.
Every asset manager is watching macroeconomic developments with a keener eye than ever. While the expectation of bear markets is a foregone conclusion, it leaves few safe heavens. As inflation is rising, holding cash, as some preferred to do last year when it became apparent things were unraveling, is no longer possible.
In this piece, we look at five macroeconomic themes, we think, must dominate asset allocation decisions.
1. Opportunities through early economic reforms
Privatization, mega infrastructure and the Port City are back on the economic agenda
Privatization is back on the agenda, and the potential this offers is an avenue for the government to narrow the 2016 budget deficit and for Sri Lankan businesses to enter a phase of acquisition-led growth. Large investments, especially into firms with foreign currency revenues, can be financed with foreign currency debt. Driven by tax breaks, Sri Lanaka’s corporate debt market has also boomed and companies now have the option of financing acquisitions.
A surprising amount of family silver remains in government hands. Some of these will be sold to the private sector in full, in part with management control or minority stakes offered through stock market listings.
Some assets that maybe partly or fully privatized include the following:
East Terminal of the Colombo Port: a 49% stake plus management control
SriLankan Catering: to raise $150 million though an IPO
Lanka Hospitals: controlled by state insurance firm SLIC
Hotel Developers PLC: owners of Hilton Colombo
Hyatt Residencies: controlled by SLIC
Waters Edge
Grand Oriental Hotel: controlled by Bank of Ceylon
Mobitel: owned by SLT
SLIC (Sri Lanka Insurance Corporation)
State-owned commercial banks: People’s Bank and Bank of Ceylon
The privatization wave in 2016 will see firms listed on the Colombo Stock Exchange following their public offering. However, Colombo Port’s East Terminal will be offered to a strategic investor.
The budget is forecasting Rs378 billion in non-tax revenue, excluding grants, during 2016 – almost three times as much as the Rs126 billion it forecasted to raise from non-tax sources in 2015. It’s conceivable the government is forecasting that it can raise funds in a wave of privatizations in 2016.
The enormous scale and speed of the family silver sale may overwhelm Sri Lanka’s small private sector. Few firms here can raise the type of capital needed to acquire large assets, unless they work as consortiums or have foreign partners.
It’s likely the assets will be sold to the highest bidders, local or foreign, and in the same cases, proceeds will accrue to government-owned ventures. For instance, SLIC’s life fund-owned assets belong to policyholders, and in cases like the Colombo Port’s new East Terminal financed by state-owned Sri Lanka Ports Authority, privatization proceeds may have to settle loans obtained for its construction. State-owned insurance company SLIC, the East Terminal and state-owned banks were not part of the finance minister’s list of assets to be privatized or listed in the stock exchange.
Ports Minister Arjuna Ranathunga announced an international call for proposals in January 2016 to operate the deep water East Terminal, the Colombo Port’s second container terminal capable of berthing the largest ships operating today. The first phase of the project was commissioned in April this year with the completion of 400 meters of quay length of a planned 1,200 meters.
Mega infrastructure projects and Port City, a land reclamation project by a private firm, creating a new downtown the size of the principality of Monaco are also on the agenda. However, there may be few opportunities for Sri Lankan companies in the Port City project’s land reclamation stage.Non-financial assets, land, buildings and sub-soil resources like oil and gas can also be offered to investors.
2. End of the commodities super cycle
Sri Lankan businesses and consumers may not fully benefit from the commodity super cycle’s end in 2016
China’s waning appetite for raw materials and anticipated further increases to the Fed Funds Rate in 2016 have ended a decade-long commodities super cycle. Oil has declined sharply last year, and other commodities crucial for manufacturing and infrastructure are also sharply down.
Commodity super cycles take off when investment in mining and developing oil fields lag because existing demand don’t support them. Rising prices then bring forward new sources of supply as extraction from otherwise marginal mines become viable. Consumers then respond by economizing, and any subsequent economic slowdown dampens demand. This cycle played out when shale and hydraulic fracturing boosted oil and gas production. Consumers started economizing, and a slowdown in China – the largest commodities user – led to steep price declines. The commodityprice index of the Economist newspaper is at a multi-year low (see graph).Rich world central banks coordinated monetary policy easing when troubled US banks triggered a global financial crisis in 2009. Cheap money boosted commodities, extending the super cycle. The US has now started to increase interest rates, the first rises since 2006.
What’s the impact of all this on Sri Lankan consumers and businesses? Will lower fuel costs to consumers boost spending on goods and services? Or will reducing fuel prices cut government taxes and strain already weak public finances further.
Sri Lanka’s overreliance on import taxes and indirect taxes (see graphs) is legendary, and those on petroleumbased products account for a chunk. In 2015, taxes on imports generated almost half of government revenue. Import-based taxes include customs duty, VAT, PAL, excise duty and other taxes.
Up to August 2015, expenditure on fuel imports had declined 48% to $1.8 billion, and by 2015, fuel imports were projected to cost $2.8 billion versus $4.5 billion in 2014. However, the budget or other documents discuss the impact of lower fuel prices on government revenue. Lack of a clear plan for fiscal consolidation will narrow options. A cut in fuel prices at the pump will also reduce tax collections. The rupee will also depreciate at the same pace it did in 2015 or faster erasing many of the commodity super cycle’s benefits.
3. Inflation
The trend of low inflation will reverse in 2016
Against the US dollar, the Sri Lankan currency slipped by a rupee a month after the government allowed the market to set the rate in 2015. If that pace of weakening continues, the exchange rate could reach Rs155 to a dollar by end-2016. This is unavoidable unless the Central Bank, which has timidly stood by, starts raising interest rates early and with resolve.
Because imported fuel is going to cost less in 2016, optimists argue the currency won’t depreciate as rapidly. Lower fuel prices will ease pressure on the currency only if they aren’t passed to consumers. If fuel prices are reduced, as the government says will happen when an automatic pricing formula is introduced in 2016, consumers will buy goods and services with the savings. If those are procured from overseas, depreciation pressure will continue unabated.
Inflation will rise in 2016 because of rupee weakness, the impact of state sector salary increases, high budget deficits, doubling NBT (a cascading tax) and the Central Bank’s timidity to hike interest rates.
Sri Lanka’s inflation according to the National Consumer Price Index, the benchmark, accelerated to 4.8% in the 12 months to November 2015 from 3% in October, according to the government statistics office. Prices rose 2.6% during the month as with food prices rising 2.1% and non-food prices up 0.5%, according to the statistics office.
The Central Bank has been accommodating government profligacy, by printing money, at the expense of keeping consumer prices under control and the rupee stable. Depreciation and inflation, if not kept under control, can easily hurt the poorest people. The bank has offered various excuses why monetary policy should not be tightened.
4. Emerging markets’ double whammy
Emerging and developing economy growth may slow if structural problems trigger higher capital outflow
Despite some pockets of resistance, emerging and developing market investors have been heading for the exit. These markets attracted net capital inflows every year for over two decades until the trend reversed in 2015. Investors were spooked by fears of an interest rate increase and a commodity price slump. The IMF projects emerging economies growth will pickup in the next five years. However, it warns of significant risks to economic growth of capital outflow.
There are two factors that contribute to emerging economy capital outflows in the next couple of years. First, it’s the pace of monetary tightening in the rich world. The US Fed has begun rising interest rates, however, the Euro zone’s loose monetary policy continues.
The second reason for an economic growth slowdown the IMF identifies in emerging and developing economies is structural weaknesses (see IMF projections graph). Sri Lanka is exposed to both economic structural weaknesses, due largely to the lack of a fiscal consolidation plan for the medium term, and capital flight that rich world monetary policy can trigger.
Foreign short-term capital – the type of which is invested in government debt – the stock market and some corporate debt is easily spooked by conditions that can trigger local currency weakness. Depreciation of the currency the asset is denominated in narrows returns. They are also
beginning to see higher dollar interest rates. In 2015, the Sri Lankan Rupee depreciated 8.7% to trade at Rs143.80 to the US dollar in the last week of trading. Conditions that can trigger a similar depreciation in 2016 that exist now due to loose fiscal policy may see investors yank their capital out.
Sri Lanka, like all frontier markets, is helpless about interest rate increases in the rich world. Anticipated interest rate increases may also have been priced in. However, Sri Lanka’s structural weaknesses are its own creation and will potentially trigger a double whammy.
If investors do yank their capital out from emerging and developing markets along with an economic slowdown, the IMF thinks such countries will suffer disproportionately in the short run.
In other words, the impact of rich world interest rate increase is unavoidable, but financial-market panic can be self-inflicted.
5. BOP troubles to continue
Balance of Payments troubles indicate short-term economic mismanagement and in Sri Lanka’s case the eroding competitiveness of its manufacturing industry
Balance of payments troubles indicate short-term economic mismanagement, and in Sri Lanka’s case, the eroding competitiveness of its manufacturing industry.
Balance of payments (BOP) is a combination of two types of cross-border transactions: payment for goods and services (exports, imports and remittances) and payments for assets. For Sri Lanka, the outlook appears weak on both these fronts for 2016.
In 2015, exports have been declining, led by a slump in demand for tea and rubber products. The trade deficit, measures of the import and export gap, is up 3.8% up to $6.1 billion by September 2015.
Sri Lanka’s gross foreign reserves fell to $6.4 billion in August 2015, down 30% from a peak of $9.18 billion. Overall, BOP was in deficit of $1.2 billion during the first seven months of 2015, in comparison to a $2billion surplus in the same period in 2014.
The balance of trade isn’t the most important issue, but to sustain economic growth, it will matter. Sri Lanka’s exports relative to the size of its economy have halved in the past two decades. The gap between what the country is able to sell and what it buys from abroad is mostly plugged by remittances of nearly two million people of Sri Lankan birth living and working overseas, tourism and some service industries.
Sri Lanka’s export weakness is symptomatic of its economic ills. In most economies, export firms are the most dynamic; they are the most innovative, pay higher wages than non-exporters and are the most productive. Exports declining, relative to the economy’s size, is an indication of a manufacturing industry’s lack of competitiveness.
The notion that Sri Lanka can somehow import everything it needs, while exporting services to balance it out, is sanguine. Selling goods abroad is a good way of developing a market for services. Exports have declined despite the currency weakening every year too. The Central Bank’s resolute action in raising interest rates can arrest the BOP slide and fix the short-term problem. However, the bank has been extremely timid and hasn’t acted resolutely so far.