Kingdom’s Fiscal Position Shows Positive Trajectory

by shariff mohammed | Nov 29, 2017

Global financial markets continue to perform well, bolstered by expanding economic activity in an environment of low inflation, and still accommodative monetary policy from key central banks which is perpetuating the search for yield. Almost all assets are posting strong gains, with equity markets hitting record highs, and corporate bond yields near post-crisis lows. However, with the US Fed in tightening mode and the ECB looking to end its asset purchase program next year, the tide of liquidity is beginning to ebb and is likely to expose serious mis-pricing of risk in many markets.

Oil prices have rebounded strongly from their summer lows and are back trading near $60/b. OPEC production cuts and healthy demand growth are finally leading to the long awaited rebalancing of the market, and this is being reflected in sharp stock draws. However, OPEC faces a tricky exit from cuts next year, at a time when US production looks likely to be growing. Average prices thus seem likely to be held at around $56/b in 2018, up from $54/b this year, but with improving prospects out towards 2020.

The Saudi government’s fiscal position continues to improve, albeit slowly. First half results were better than expected and provide the government with some ammunition to increase capital spending in the second half of the year. PMI data suggest that this might be starting to trickle through to the real economy. Consumption also appears to be ticking up a bit, though the scheduled introduction of VAT next January is an obvious headwind. VAT should jolt inflation back into positive territory.

Global Economic Growth and Inflation

United States

US economic policy remains constrained by increasingly tense relations between the President and Congress. Many senior Republican lawmakers, especially in the Senate, remain uneasy about Donald Trump’s style of governing, as well as his legislative agenda. This has left Mr Trump unable to push through key policy initiatives such as health care reform and, for the moment at least, tax reform.

This impasse led the President to cut a surprise deal with Democrat Congressional leaders covering the looming debt ceiling, government funding, and relief for Hurricane Harvey. The deal, which was proposed by Democrats, ties a three month suspension of the debt ceiling limit to a Hurricane Harvey relief measure, and throws in a stopgap Continuing Resolution to fund the government until December 8th. The new fiscal year begins on October 1st, but the government is in no position to pass a budget given a lack of detail from the Administration’s budget proposal, the short time frame, and more general Congressional strife. Without a budget or a Continuing Resolution, the Federal government would be facing shutdown, as happened in 2013.

The country could live with a government shutdown. Mr Trump’s deal is much more important because it forestalls a debt-ceiling crunch. The Treasury was expected to run out of options to avoid hitting the ceiling by early- to mid-October. Failure to raise (or suspend) the ceiling would have made it virtually impossible for the Treasury to avoid defaulting on some of its debt obligations. A government default on its debt would be almost unprecedented (there was a technical default in 1979) and likely cause severe disruption in financial markets. It is impossible to know how this might unfold, but doubts about the safety of a security that underpins so much of the world’s assessment and pricing of risk could be catastrophic.

The deal is expected to be approved by Republicans, however reluctantly, as they cannot afford to be seen to be denying or delaying the disbursement of aid to Harvey victims. The Republicans had wanted to pass a bill to push the next fight about the limit beyond the November 2018 mid-term elections. Many Republicans complain that by pushing the reckoning on debt and the budget only to December of this year, it increases the Democrats’ leverage.

The politics are likely to get more rancorous as December approaches. And this suggests that no meaningful White House policy initiative (including a budget) will be passed this calendar year. Granted, in late September Mr. Trump proposed sweeping tax changes, but they remain light on detail in terms of how they will be funded.

Meanwhile, the US economy appears in reasonably good shape. Second quarter GDP came in at a robust 3 percent annualized, following a weak reading which traditionally impacts the first quarter. As ever, the driver was private consumption, which grew by a brisk 3.3 percent. One uncomfortable caveat is that revisions to prior year’s show that the personal savings rate has plummeted since the end of 2015. In other words, at least some of the economic gains of the past couple of years have resulted from Americans spending more of their take home pay, not from their take home pay growing.

Indeed, the fact that wage growth—and hence inflation—remains so weak despite what appears to be a very tight labor market, is the main puzzle that the Federal Reserve is grappling with. Average hourly earnings’ growth (year-on-year) has been stuck at around 2.5 percent for the past two years. The Fed’s preferred measure of inflation, core personal consumption expenditure, has also been drifting down this year and at 1.4 percent in July sits comfortably below the Fed’s target of 2 percent. This is despite years of solid jobs growth that has seen unemployment fall from almost 10 percent to 4.4 percent over the eight years of recovery.

There are a number of potential explanations, but the most plausible seems to be the recovery in the participation rate (PR). The PR denotes the number of people either working or actively looking for work as a proportion of the population. Since the Great Recession of 2008 this has declined sharply as workers became “discouraged” and simply stopped looking for work (the retirement bulge of the Baby Boomers also played a role). In the past two years or so this trend has begun to reverse (albeit hesitantly) suggesting that previously discouraged Americans are looking for work again. All else being equal, this trend could well be keeping wage growth in check.

Whatever the reason, soggy wage growth and weakening inflation left the Federal Open Market Committee divided at its mid-September meeting, with four members voting to hold fire on another rate rise this year. However, the hawks appear to have held sway: while acknowledging that the low inflation readings were something of a “mystery” to the Fed’s Open Market Committee, Chair Janet Yellen indicated to reporters after the meeting that the Fed should not sit back and let the economy “overheat”. Thus, most observers—including us—think that there will be a further 25bps hike in the Fed Funds target rate in December. We are also sticking with our forecast for a further three rate hikes in 2018, which is also consistent with the forecast of the majority of Fed policymakers.

As part of its efforts to “normalize” monetary policy the Fed will begin to unwind its $4.5tn balance sheet in October. For US Treasuries, the Fed expects to let $6 billion roll off its balance sheet (by not reinvesting the proceeds from maturing bonds) every month initially and steadily rising every quarter until it reaches monthly reductions of $30  billion . For agency debt and mortgage backed securities, this cap would be $4 billion per month, rising $4 billion  per quarter, until a cap of $20 billion  per month is reached. The slow initial pace of unwind should allow the markets to digest the process without alarm.

The dollar strengthened somewhat following Ms. Yellen’s press conference, reflecting the fact that a majority of traders had assumed that there would be no further rate hikes this year. This halted, at least temporarily, an apparently inexorable decline versus the euro since the beginning of the year. Dollar weakness appears set to return before the year is out, however, as the debt ceiling “debate” resurfaces in December. With the ECB also gently moving towards a more neutral stance, the dollar seems set to ease down against the euro in 2018.

Europe and Japan

The ECB kept policy unchanged at its September meeting, but indicated that it will take the “bulk of decisions” on tapering its monthly asset purchase program (QE) next month. We still expect that the QE program will be wound down over the first nine months of next year, and maintain our view that rates will only hiked in 2019 at the earliest, once QE has ended. ECB asset purchases will continue at €60 billion a month through end-December, but then seem likely to be tapered to €40 billion from January, with further reductions likely at intervals through 2018. The pace of these reductions will be dictated by the data, with Draghi making it clear that the Euro exchange rate would play an important role in the decision on the future monetary policy stance. In sum, the path towards policy normalization is still expected to be a long one, and ECB guidance will be focused on trying to avoid any “taper tantrums” (sharp corrections in financial markets, particularly for bonds).

 

The motivation for a gradual unwinding of exceptionally loose monetary policy is the healthy recovery now underway in the EZ economy, which has also come with a relative pickup in inflation. The EZ data flow has continued to be positive, with Q2 growth confirmed at 0.6 percent, up from 0.5 percent in Q1, and equivalent to 2.3 percent year-on-year. Services remain the main driver, although industry and construction have also made healthy contributions. Exports are performing well, the labor market is recovering, and financial conditions remain favorable. With growth broad based across both countries and sectors, the ECB has revised up its annual real GDP forecast to 2.2 percent this year, 1.8 percent next and 1.7 percent in 2019. We too have revised up our projections, but are slightly less bullish, as we think growth likely peaked in Q2 and see more modest gains ahead from employment and consumption. More timely PMI data, tend to support this view, as indices have fallen back somewhat, although they remain near multi-year highs.

Headline inflation has fallen from its 2 percent highs seen early in the year, and was holding at 1.5 percent in August. The decline mainly reflects weaker oil prices, and core inflation has fared somewhat better. It is currently back up at 1.2 percent, and there is some evidence that wage growth has started to pick up and will push the rate up higher. However, there is no getting away from the fact that inflation has been subdued, weighed down by both weaker oil prices and a stronger Euro, and the ECB has cut its inflation forecasts for a second time in succession. Although it maintains a 1.5 percent projection for this year, it now expects inflation to average just 1.2 percent in 2018 and 1.5 percent in 2019. These projections are still someway short of the ECB’s 2 percent inflation target, and argue for a slow normalization of policy.

The downgrades in the ECB inflation outlook largely reflect the appreciation of the Euro which has lowered import costs. As political risks have faded and the economic recovery gathered pace, the euro has strengthened and topped $1.20 for the first time since late-2014, boosted by the continued weakening of the dollar against all major developed market currencies. As well as dampening inflation, the appreciation (14 percent against the dollar this year) risks undermining export competitiveness and holding back European equity markets. With less aggressive US Fed tightening now seen as more likely, Euro strength seems here to stay, if dimmed temporarily by the strong showing for the Eurosceptic AFD party in Germany’s recent elections.

Brexit still clouds European outlook

While political risks have receded in Europe as recent elections results reduce the prospects for populist, anti EU parties assuming power, the lack of progress on talks related the UK’s exit from the EU continues to create uncertainty. Having held up surprisingly well, UK growth is now starting to weaken, and the economic outlook is uncertain, as is Brexit’s eventual impact on the EZ economy and its finances. From a central bank perspective, the weakening economy, low wage growth, and uncertain outlook may persuade the Bank of England to hold off raising its base rate (0.25 percent) until 2018. However, pressure is mounting as inflation has risen to near 3 percent, mainly stemming from the pounds large depreciation, and the unemployment rate has fallen to a 42 year low of 4.3 percent.

China and Emerging Asia

Industrial output slows but consumption indicators are upbeat

In China, manufacturing output picked up again in August, following a subdued July. Much of this is export-driven, reflecting generally robust demand from Europe and the US. Consumption indicators are also broadly upbeat. Retail sales appear to have stabilized at around 10 percent annual growth. Consumer confidence appears robust and the proportion of depositors saying that they would rather spend than invest or save rose to its highest mark since 2009 (China has long had an awkwardly high savings rate). Nor are there any signs of stress in the labor market, with the ratio of jobs to job seekers comfortably above 1.1. Government efforts to cool property price growth in large cities appear to be paying off, but prices have held up better in so-called Tier 2 cities.

The president is keen to have a supportive economic backdrop to the forthcoming People’s Congress, and while he earlier indicated that financial deleveraging should take priority over growth, the central bank appears to have loosened the reins a little in recent months. Bloomberg’s “credit impulse”, which measures the change in new credit as a percentage of GDP, ticked back in to positive territory in July. The change was small, but was enough to make credit a tailwind rather than a headwind to growth. Given also low and stable money market rates the impression is that the central bank is likely to hold monetary conditions stable following the squeeze in money supply in the first half. A big increase in local government bond issuance–supporting continued rapid expansion in infrastructure spending—is another reminder of how much policy support is going into keeping growth stable.

In fact, it is not clear that deleveraging is happening in any meaningful way. To be sure, M2 growth has slowed sharply, but many analysts argue that this is an excessively narrow gauge, while total social finance (TSF) which includes uncollateralized securities of dubious provenance, has continued to climb this year despite the central bank’s best efforts. According to Natixis’s measure, which includes newer and more popular securities, TSF’s share of the economy grew by 11 percentage points in the year to July, reaching 231 percent.

This ratio illustrates the increasingly poor return on investment in an economy where inefficiency in the state sector is rife. It is also, of course, a threatening ratio since any abrupt deleveraging could lead to widespread losses and bankruptcies, with negative repercussions for economic growth both in China and abroad.

How would such a scenario impact the rest of East Asia? Regional lenders with exposure to China credits would clearly be affected, and here the most exposed is Hong Kong where loans to China account for 45 percent of total lending. For others the main channel is likely to be trade. The most exposed East Asian countries (in terms of exports’ value added) are Hong Kong, Malaysia and Taiwan: the latter for example has exposure worth about 10 percent of its GDP. However, Indonesia would also be impacted since any sharp downturn in China would mean a collapse in commodity prices (Indonesia is a big exporter of hydrocarbons, wood and rubber). Other countries would be helped by a collapse in commodities prices, most notably India and the Philippines, both of which could expect lower inflation and improved current account balances.

East Asian exports are doing well

Returning to the current picture, East Asian exports are doing well. In the first seven months of 2017 East Asian exports grew by 11 percent in dollar terms—South Korea and Vietnam are leading the way. Much of this has been driven by price effects stemming from the rebound of commodity prices, after a particularly weak H1 2016. But global demand is also having an impact, with about half of the value change driven by volume gains. Prospects for the second half are not quite so good: the base for the comparator will mean a less favorable dollar gain and volume growth is also likely to ease somewhat with global GDP. All in all, however, Asian exports are set to fare well over the next year or so, certainly much better than during the 2015-16 period.

 

Overall, fears that trade-focused EMs would suffer from growing trade protectionism, a stronger dollar and a sharp rise in US yields have not materialised. President Trump’s protectionist instincts have yet to be demonstrated in meaningful initiatives, while the policy quagmire that has stymied his “reflation trade” has meant a weaker dollar and subdued yields.

 

Global Financial Markets

Equities: US stocks power ahead

The S&P 500 has powered on to fresh highs, with the index reaching 2,500 in mid-September, a near 12 percent year-to-date gain. The price/earnings ratio is 21, which is alarming for some, but earnings per share have at least been supported by profit growth so far in 2017, rather than the share buybacks that were a prominent feature of 2015 and 2016. Profit growth in the second quarter was almost 10 percent year on year, with energy firms a big outlier given the rebound in oil prices. But tech and financials also posted strong returns, the latter benefitting from a rebound in risk assets as well as decent growth in retail services. Moreover, S&P earnings were supported by solid sales growth of 5 percent.

Analysts expect the strong earnings performance to continue. The 3rd quarter consensus projection is for profit growth of 14 percent, easing to 12 percent in the fourth quarter. Is this realistic? Analysts tend to be over-optimistic with earnings forecasts, but their projections appear to be more firmly grounded this time. Wage growth is running at around 2.5 percent but core inflation has slid to just 1.4 percent. With jobs growth also strong, nominal disposable income has grown by 2.6 percent year to date. All this bodes well for consumer-focused firms. However, the prospect of a resurgence in buybacks, which would also buttress the market, has faded. Hopes were high on this front earlier in the year given a mooted tax deal that would include a repatriation holiday for US firms holding large piles of cash overseas. Some predicted that this would provide a $150 billion boost to the stock market as firms would likely use much of this cash to buy back their own shares. However, hopes of any type of tax reform—this year at least—now appear remote given the White House’s relations with Congress. A further headwind is that the S&P’s elevated level makes buybacks that much more expensive to undertake.

Buybacks aside, it would seem that the S&P can withstand its stretched valuation and the rally probably has further to run. Capital Economics believes that the fair value of the US stock market has risen as a consequence of the secular decline in interest rates. In their view, the “equilibrium” price/earnings ratio is just over 22. Deutsche Bank, meanwhile, is also fairly bullish and projects that the S&P will finish the year at 2,600.

 

European stocks still in favor

Having drifted down since their April highs, European equities picked up again in September, and the broad Eurostoxx index was back up 7 percent on a year-to-date (y-t-d) basis in mid-month. In US dollar terms Euro area equities have rallied to new highs, up 22 percent y-t-d, although concerns are mounting that the stronger Euro will undermine the recent recovery in earnings. This does appear a risk, but is being offset by healthy world trade and growth. In addition, fundamental drivers for equities remain positive with increasing economic activity and subdued inflation offering support to profit margins. Financial conditions are also likely to remain supportive as the ECB takes a gradualist approach. Valuations are looking somewhat stretched, but Euro equities are likely to remain in favour with investors.

The Nikkei has traded in a relatively narrow range over the last quarter, buffeted by concerns over North Korea, as well as movements in the Yen/$ rate stemming from shifting perceptions of US policy and economic growth. However, more recently investors appear to have welcomed Prime Minister Abe’s cabinet reshuffle, and calling of an early election, seeing it as signalling a continuation of supportive policies for equities, including from the BOJ. Meanwhile, healthy domestic growth is supporting earnings, and exporters have continued to do well despite the relative strengthening of the Yen this year. Valuation indicators suggest that Japanese equities are fairly priced, but market prospects are still vulnerable to possible global financial markets corrections as monetary policy starts to tighten in the EZ, and the US Fed looks to reduce its balance sheet and raise rates further. As ever, movements in the Yen will remain a key driver of earnings.

 

Credit Markets

No end in sight to the US bond market rally

In the bond market there is no end to the rally in both high yield and investment grade paper. The Bloomberg investment grade USD index has put on almost 6 percent year-to-date and, in a testament to the endurance of the rally is up 22 percent on its level 5 years ago. High yield debt, which tends to move in line with the stock market, has also climbed, but spreads have narrowed even as benchmark yields remain low. The Barclays option-adjusted spread widened in August, but that was mainly a reflection of Hurricane Harvey’s potential impact on shale oil producers, which make up a large chunk of the high yield universe, and the spread has since narrowed again. Indeed, average junk bond prices now surpass the full face value of the bonds, which is quite something for an asset class that has historically traded at heavy discounts to face value.

 

There are plenty of examples of what might be called “irrational exuberance” in the bond market, but which is really just a function of excess liquidity in an era of low benchmark yields. In mid-September Austria sold $3.5 billion of 100-year dated bonds with a yield below that of US Ten Year Treasuries. It is not just the relative pricing that is remarkable, but the fact that the duration of the Austrian issue means that any tiny shift in yield can have an outsize impact on capital gains. A one basis point change in yield will move the price by 43 cents. At the opposite end of the political risk spectrum is Iraq. Yet the war-torn country, which has only just defeated an insurrection by Islamic State, sold an unsupported $1 billion bond (rated B- by S&P) with bids almost seven times the issue size.

The reach for yield that these type of issues demonstrate has its own logic. As increasing numbers of investors become willing to take on more risk, so liquidity increases and volatility declines. This in turn convinces many that the environment is benign. They then become more willing to use price dips to build positions. The upshot is that global volatility remains extremely low despite heightened geopolitical tensions.

Short of nuclear war (which cannot be ruled out) there does not seem to be much that is likely to disrupt investors’ complacency in the near term. Granted, the Fed is in a rate-rising cycle, but this is likely to be very gentle. The wind-down of the Fed’s balance sheet is also set to be configured in such a way that markets will find easy to digest. Meanwhile, although there has been much talk of the ECB’s tightening plans, for the moment it is offering -0.4 percent on deposits and is still making asset purchases of €60 billion  a month. Japan’s central bank offers a similar set of policies and is nowhere near tightening.

European bond market outlook

Yields in European bond markets continue to be suppressed by the ECB’s monthly asset purchase program (which includes corporate bonds) and negative policy interest rates for deposits (-0.4 percent), which is being mirrored in negative interbank rates. Benchmark German government 10 year bunds have risen his year. But they remain around 0.4 percent, while most EZ sovereign yields are still negative out to 5 years – with the exception of the peripheral countries of Spain, Italy, Portugal, Cyprus and Greece. Meanwhile, both high yield and investment grade corporate bond yields remain near post crisis lows, and spreads have generally continued to tighten. However, bond markets are increasingly vulnerable to shifts in expectations on ECB policy and the timing of the eventual end of asset purchases. Markets did experience a mild sell off over the summer, and there are concerns that a more disorderly correction could be on the cards over the next 12-18 months as both the ECB and US Fed simultaneously move towards a slow normalisation of monetary policy (corrections tend to correlate across credit markets). This is not our base outlook, but certainly the prospects for European yields and spreads is less benign, and both are expected to start trending higher, although still weak inflation will help to dampen market moves.

 

Emerging Markets

EM equities continue to rally strongly

Emerging Market equities continue to enjoy a stellar year. By mid-September the MSCI EM index was up 29 percent year-to-date in dollar terms, with the index closing in on its 2011 peak. A good deal of the gain reflects a weaker dollar, though there have also been some standout performances: Ukraine for example was up 42 percent in local currency terms, Turkey 36 percent, and even South Africa, with its acute political problems, is up 13 percent. Brazil, whose market was hammered in 2015 and where political problems appear intractable, was up 26 percent year-to-date. Of the large EMs, only Russia and Pakistan have seen declines this year.

The MSCI EM’s current p/e is a reasonable 16, and with the recovery in global manufacturing indices and rising demand in both the US and especially Europe the outlook for earnings is good. Thus, the forward p/e is just 12, compared with 14 for the MSCI’s developed market index.

Having spiked in the wake of Donald Trump’s presidential election victory, the JP Morgan EM bond spread has narrowed by around 100 basis points and is now at its lowest point for two years. This reflects something of a relief rally given the pronounced fears that EMs would suffer from Mr Trump’s protectionist bent and a stronger US dollar. In the event, the dollar has weakened and the White House has passed very little legislation. And of course abundant liquidity and the search for yield remain the fundamental drivers: it is notable that the spread compression on EM debt has moved almost in lock step with that on US corporate debt.

Oil markets: Oil prices rebound

Oil prices have rebounded strongly, but financial shorts, producer hedging, and computer driven investment trading activity are still holding back gains, despite a strong tightening in market fundamentals. Investors also continue to be concerned over recovering US shale production, particularly next year when markets will have to also absorb a return of OPEC and Russian supply when their production cut agreement runs out. Prices have rebounded from a $46/b low in June, and are in backwardation for Brent (i.e. spot prices are higher than forwards, a sign of market tightness). They have recently pushed up near $60/b, as markets worry about the risk of Turkey disrupting flows of Kurdish oil. Hurricanes in the US have also, led to some volatility, but so far this year Brent has averaged $53/b, some 10 percent higher than the annual average for 2016.

 

Since March, US crude stocks have drawn down sharply and consistently, excepting a recent build due to hurricane-related disruption to US refineries. Weekly drawdowns have been exceptionally high, albeit from exceptionally high starting levels. Markets have also drawn some comfort from the stalling in weekly US rig counts which have held at around 763 since July, having previously risen steadily from their 316 low in June last year. That said, both US shale production and total US crude output have continued to rise, with the latter hitting 9.53mb/d, before hurricanes induced declines. Total average production year-to-date (y-t-d) is now running near 450,000b/d higher than in 2016, more or less in line with our assumptions in the previous monitor, and offset by an 800,000b/d decline in average y-t-d OPEC production.

Individual OPEC producer compliance with agreed output cuts continues to be strong, and the earlier pick up in total OPEC production above the 32.5mb/d target mainly reflects a surprising surge in Libyan supply to 1mb/d, and recovering Nigerian production (both countries are exempt from the agreed cuts). However, it is thought that the Libyan supply surge will be hard to sustain (output has already slipped back to 890,000b/d), while Nigeria had suggested it might cap production. In addition, in an echo of the ECB’s president statements at the height of the EZ debt crisis, OPEC and its partners have indicated that they will do “whatever it takes” to rebalance the market. Saudi Arabia in particular has noted that it will cut exports, and we think that OPEC and Russia will agree to some kind of extension to the current production cut agreement which runs through end-March 2018. However, the emergence of US shale as a source a short-term price elastic supply has reduced the ability of OPEC to manage global supply, suggesting that prices may struggle to push sustainably higher.

The market is tightening but outlook still vulnerable

Global oil demand is holding up well, boosted by strong growth in the US and Europe. In fact most agencies and banks have substantially revised up their growth projections for this year to between 1.4-1.6mb/d, and now see growth of over 1mb/d in 2018 and 2019. As evidenced by the large stock drawdowns, this is combining with OPEC/Russia production cuts to bring about the long anticipated tightening in market fundamentals, and we expect this trend to continue through Q1-2018. However, the need to find an exit from production cuts, and expectations of strong growth in US shale oil, suggest that the outlook for both fundamentals and prices is precarious. We still think prices will push higher into Q1-2018. But then seem likely to retreat, despite extended OPEC production restraint, before firming again in the latter quarter as markets start to factor in concerns over medium term supply in the wake of collapsed investment during 2014-16. However, we have tweaked down our price projections to a $54/b average this year, and $56/b next. The latter is subject to downside risks, but it is also notable that markets are now more susceptible to unplanned supply disruptions than they have been for many years.

Saudi Arabia

The Saudi government’s fiscal position continues to improve, albeit slowly. First half results were better than expected and provide the government with some ammunition to increase capital spending in the second half of the year. PMI data suggest that this might be starting to trickle through to the real economy. Consumption also appears to be ticking up a bit, though the scheduled introduction of VAT next January is an obvious headwind.

The authorities have released second quarter fiscal data. These show the deficit increasing to SR45.5  billion  compared with SR26.2 billion in the first quarter. For the half year the deficit was SR72 billion  less than half the SR149 billion  recorded in H1 16. Annualized, the 2017 deficit is SR144 billion , comfortably lower than both last year’s actual of SR400 billion  (our estimate) and the SR198 billion  projected in the 2017 budget.

The improved fiscal performance was largely down to a pickup in oil revenues, which grew by 63 percent in the first half compared with the same period of last year. This reflects the impact of the OPEC and non-supply cuts that were initiated at the beginning of this year and have helped to push the price of Brent above $55/b. By contrast, nonoil revenue fell by 12 percent in the first half, with gains in taxes on foreign firms being nullified by sharp falls in customs revenue, reflecting the collapse in import spending. There was also an 18 percent downturn in returns from SAMA and the Public Investment Fund. However, this probably reflects the re-allocation of capital away from SAMA to the PIF, with the latter only now beginning to make investments which will presumably generate future returns.

Overall spending fell by 2 percent in the first half, year on year. Public sector wages and salaries is by far the largest expenditure item, accounting for 52 percent of total spending in the second half. This saw a 3 percent decline compared with H1 2016, though it is not clear if back payments for reinstated public sector allowances are accounted for in the figures. If they are, then the 3 percent reduction represents good progress in rationalising public sector expenditure given a Saudi national population growth rate of well over 2 percent (meaning that some 200,000 Saudis enter the jobs market every year).

 

The biggest saving was made on procurement of goods and services, which fell by over a third. This of course helps explain the collapse in import spending since the vast majority of these goods and services are imported (healthcare imports have been particularly hard hit). Areas of expenditure that grew included social benefits (primarily unemployment support) and debt financing costs which, although small, are likely to show strong growth in the years ahead given the fiscal outlook.

 

Notwithstanding the fact that the improved fiscal performance was largely down to higher oil prices, the first half results give the government some breathing space. The fiscal adjustment of the past two years has been exceptional and although it has put the public finances on a more sustainable footing, it has taken a heavy toll on economic activity (see below). Various reports suggest that the government is preparing to adjust the parameters of its National Transformation Programme. The details of such changes are not yet available, but it is likely to mean some targets being pushed out beyond 2020 in order to make the overall transformation easier for the private sector to digest (indeed, this is in line with advice from the IMF among others).

 

As part of this process we think that the fiscal reins will also be loosened slightly. In the near term, this is likely to mean a pick-up in capital spending, which has been tightly squeezed over the past couple of years. We had already expected a pick-up in public investment but we now think that this will be firmer than previously anticipated. Note however that the government will remain committed to reducing the fiscal deficit over the medium term and there will be no return to the free-spending ways of the early part of this decade.

 

Nonoil revenues should be helped by a striking surge in religious pilgrims during the Hajj. Total visitors grew by 26 percent, despite higher fees. This should buttress nonoil revenues in the second half and is particularly encouraging since the development of religious tourism is at the heart of the NTP. It will also help the current account, though this should record a decent surplus this year anyway. Overall, therefore, we think that the fiscal deficit will shrink this year by around SR110 billion  to some SR290 billion  or 13.6 percent of projected GDP.

 

This is still a sizeable deficit, but in our view the government’s commitment to fiscal consolidation is resolute and the medium term path of the deficit is a narrowing one. Fiscal financing options are also plentiful, with a mix of domestic and external, conventional and sukuk offering flexibility: the Kingdom is pushing ahead with a $12.5 billion sovereign bond issue which is likely to be oversubscribed. Ainancial markets seem sanguine. The spread on the Kingdom’s conventional ten-year bond (issued last October) has tightened during the course of the year, the CDS has also come in sharply in the past few months, while the 2 year SAR forward contract has also narrowed. Nor is there any sign of stress in the domestic market with 3 month SAIBOR, the benchmark interbank rate, stable and low (though this largely reflects weak credit demand).

 

How has the fiscal squeeze impacted the real economy? Construction and transport sectors have been hard hit, and there have been some high-profile casualties. The fiscal data show that only a quarter of the allocation for “Infrastructure and Transportation” had been spent in the first half. Contractors of all types have also faced headwinds as the government has vigorously reduced its consumption of goods and services. That said, there are some early signs of improvement for contractors, if the purchasing managers’ index is any guide. The PMI for August showed a decent bounce-back in the New Orders component with nearly three times as many respondents reporting a rise rather than a fall in new business, suggesting that the government is indeed begin to loosen the purse strings.

 

Encouragement can also be taken from the latest points of sale transaction data, which are a proxy for retail sales. The value of sales has stabilised in positive territory: year-on-year sales grew by 7.5 percent in August (3 month rolling average). Volume growth continues at around 30 percent reflecting deep and regular discounting by retailers, which is reflected in more general deflation.

 

The growth in sales values cannot be explained by additional credit: consumer loan growth has stagnated over the past year or so. Population growth is a fundamental driver, but given the public sector wage freeze, it seems likely that savings are also being drawn down. Bank deposit data, which admittedly are not disaggregated between households and businesses, appear to back this up: in August savings deposits were down some 9 percent from their peak in October last year (current account holdings have also been declining, though more gently).The outlook for consumption remains finely balanced. Nominal wages are unlikely to increase much in the years ahead given the government’s fiscal stance, but deflation has supported purchasing power. One headwind is a further cut to gasoline subsidies, which is mooted to take place in November. A more material impact will come from the introduction of VAT, which is scheduled to take place in January 2018, though it is possible that VAT could be delayed in line with the more general reconfiguring of the NTP. Assuming VAT goes ahead on schedule then there will be an upward shift in the consumer price index in January; there will be exemptions but we think that roughly two-thirds of items in the basket will be subject to VAT. Underlying price pressures will remain weak, but this coupled with the depressed 2017 base suggests that inflation will average 3.6 percent next year.

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