Putting the 'Middle' in Middle East

The Rise of Gulf Nations, And What I'm Hearing On The Ground In Abu Dhabi

There are few places in the world today that are growing (economically) and exemplify progress better than two Gulf nation states: the UAE and Saudi Arabia. I’ve had the pleasure of working and visiting the Gulf since 2005, and it’s hard to understand the scale of change (both developmental and social) that has taken place across both nations.

There is true dynamism in both countries, and yet one thing still holds true: they put the capital in ‘relationship capital’. Visiting the region on business requires a delicate balancing act between art and science when it comes to scheduling meetings and how to manage around them. And of course, it would be culturally inappropriate to just get down to business if you haven’t had the chance to make friends over dates and Arabic coffee.

Fortunately for a sweet-tooth coffee lover like me, that’s great. This is my 17th year since I set foot in the Gulf, and I’m enjoying every bit of it. For those of you who haven’t yet had the chance to visit, here’s a picture of Dubai in the early 90s and another of modern-day Dubai.

Maybe the saying is true after all:

‘build it, and they will come’.

The 30,000 feet view:

Having just returned from the Milken Institute in Abu Dhabi, via the vibrant city of Dubai, a few things marked me during my trip.

The First, is how much more the UAE felt at the ‘center’ of the world. Everything from language used by senior officials to boots on the ground indicate a certain rapprochement to China and Russia. The Gulf policymakers are hedging their bets and putting their money where their mouth is. Mubadala, one of the Sovereign Wealth Funds of the UAE, has about 38% of its portfolio deployed in the US. That’s a significant concentration, yet one that continues to decline over time.

Where is the new money going? No points for guessing this one… China. And they are not alone: executives from major investment firms are very constructive on China (namely Bridgewater, the global hedge fund, and General Atlantic, the major private equity firm), and are also talking about the rise, prosperity and engine of innovation that is the red dragon of Asia.

All this to say that: the UAE is putting the ‘Middle’ in Middle East right now, bridging both the West and the East.

The Second notable thing, is that the UAE is certainly not immune to inflationary pressures, despite being an oil hub. I hadn’t been back to Dubai in about a year now, yet the influx of new arrivals from Europe, Asia and Russia has created pressure on real estate markets, hospitality venues, and overall prices. So much so, that I (half) joked during my stay that the only way to save money in Dubai, was to actually remain in the comfort of your own home.

Plus, in another recent boost to the UAE’s hospitality sector: Qatar banned all beer sales during the World Cup only 48 hours before the tournament was due to take place. That is no surprise for someone like me, having operated in the Gulf for over 17 years: you get used to last-minute curveballs of all shapes and sizes. That said, the size of this one was big enough to deliver a painful blow to Budweiser and their $75mm sponsorship of the FIFA tournament.

Ouch, or as the Arabs say: ‘Akh’…

The Thematic Deeper Dive

And then there’s the macro narrative coming out of the Milken conference, which I’ll touch on below. I break these down by themes that I found interesting.  

Theme 1: The US Economy

Where are we today?

Well, this inflationary environment is a monetary induced inflation (super low rates + QE money-printing), which has now triggered a tightening in monetary policy. It seems that what will follow next will be a period of stagflation (high inflation + low growth). Although earned income has collapsed over the years (wages were practically stagnant and tech created deflationary pressures), as we reach full employment, we are now facing wage inflation. You can see this in the labor market: it’s hard to find people, and we need to pay them more as a result.

To put things in context: this has been the second most aggressive period of monetary tightening since Paul Volker’s regime at the Fed. What follows next will likely be a downturn, and it’s going to be hard for the Fed to hit both inflation (i.e., reduce it) and growth goals (keep the economy growing in real terms).

So, what will the Fed do? Well, looking at a few historical points from periods before the 2008 financial crisis, the tendency will be to see where inflation settles out. Bridgewater (and many others) seem to think around 4% is where we’ll end up settling at in terms of structural inflation.

But that’s not great… why? Well, the market is expecting us to go back down to the historical 2% mark over the last decade. And what happens if we don’t? Well, there is likely a second round of Fed tightening, which clearly isn’t being considered by market participants.

There is a Silver Lining in all this: the recession is not inevitable, seriously. Household balance sheets remain strong, as they’ve accumulated some cash and home values have risen up nicely, until now.

I suspect the real danger signs will be that if we see unemployment tick up by about 2% and corporate earnings decline by ~20% in the post-holiday earnings season, then UhOh…

But hey, remember: a recession is not inevitable.

And what about them mid-term elections huh? Another insightful thing that I heard over the conference came from General Atlantic’s Bill Ford. We talked about the result of the US mid-terms being a divided government, yet Bill’s view is that a divided government is basically positive for the economy and innovation. Why?

Well because the policy is somewhat stable in a divided government, and one party or the other won’t be able to push through significant changes.

Some positive considerations there after all vs. Doom and Gloom.

Theme 2: Crypto

Speaking of Doom, Dr. Doom aka Nouriel Roubini was being his sensationalist self onstage in Abu Dhabi. He described the 7 Cs of crypto (see below) and made a big fuss about how come Binance is listed and regulated in the UAE, when it’s also a ticking bomb.

Nouriel Roubini @Nouriel

Nouriel Roubini takes a swipe at crypto industry after FTX collapse . Nouriel Roubini, chief economist Atlas Capital Team and chair of Roubini Macro Associates, lays out the “seven Cs” of the industry.

cnb.cxNouriel Roubini takes a swipe at crypto industry after FTX collapseNouriel Roubini, chief economist Atlas Capital Team and chair of Roubini Macro Associates, lays out the “seven Cs” of the industry.

I guess Nouriel didn’t get the memo… when you’re invited to the Middle East, you don’t make people look bad in their own home.

Bad manners Dr. Doom…

There’s been a lot covered on the FTX scandal and it is turning out to be the biggest case of corporate fraud in history (bigger than Enron!). I won’t elaborate more on this, but if you wanted to get a take and implications from a good friend of mine in crypto – check out this link by Aadil Mamujee

There are a few obvious things here:

• We need crypto regulation, and crypto institutions should be regulated like normal financial institutions.

• The type of class and eloquence you find in TradFi isn’t really apparent in crypto. It’s all gloves are off here: Roubini insulting CZ (founder of Binance), CZ hitting back and of course CZ calling SBF (founder of FTX) a ‘complete psychopath’.

• Klarna’s co-founder and CEO believes Blockchain is ‘pointless’, slow and that his data is just fine as is.

Keep it classy gents (yes, and it’s also male dominated) 👌🏻.

Theme 3: China

What’s apparent to me here is that investment executives continue to sing China’s praises as an engine of growth and innovation, while both US Democrat and Republican policymakers (as well as European ones) seem to agree on one thing: the need to counter it.  

Yes, China is moving more towards national security and ideology, but they must balance that with economic growth.

China is, whether we like it or not, the world’s supply chain, so despite our efforts to re-shore these supply chains, all I heard during conference panels was that we will basically end up at China +1. In plain English, that means that it’s mainly China, and another diversification geography e.g., SE Asia or Mexico.

Folks, looks like we won’t be witnessing a hard de-globalization after all.

The more insightful part of the China conversation was the discussion about energy security. I didn’t know this but according to the secretary-general of the International Energy Forum:

China’s energy demand is already above pre-Covid levels.

That means that, if they re-open their economy (they’ve had a strict Zero Covid policy for those of you living under a rock), that’s going to put even more pressure on already tight demand for oil. And because US shale producers are not back to pre-covid levels, what that means in turn is that we are going to have to ask OPEC to keep pumping.

Remember how that last request went?

Well, it didn’t: we said ‘please pump’ and OPEC said ‘no thanks, we cut’. But let’s be realistic, OPEC can’t solve all this market’s problems, and we’ll need non-OPEC interventions and investment. In the words of Steve Mnuchin himself (far right pictured below):

“How can we ask OPEC to pump more oil when we’re not even doing it in the US?!”.

Touché Mr. Secretary of the Treasury. The panel pictured below, moderated by the excellent Hadley Gamble was a good one.

Let’s move to energy markets on that note…

Theme 4: Energy

Let’s pick up where we left off, the US. They have a lot of gas and shale investments, but there’s been pressure against this type of carbon investments lately (think ESG). Honestly, we need to consider energy security.

Did you know that London’s Heathrow airport consumes more energy than the entire country of Sierra Leone?

We talk about decarbonizing Africa, yet the continent pushes back on this notion and argues that it needs to carbonize and develop first, before achieving the latter.

I love our planet, and those of you who know me can clearly see that I’m a nature + ocean guy. Being a kitesurfer, I also strongly believe in the power of wind and solar energy. Yes, wind and solar are great, and if you are starting a company today you should absolutely be focused on climate-tech. But frankly they only get us halfway in solving the problem. The other 50% is new technologies that we need to develop, which we haven’t yet… so we are going to need a lot more solar and wind in the meantime, and that’s not enough!

If you find out where the next wind farms are being built, please give me a shout: always looking for new kite spots :)

I also like to finish off this section with a Silver Lining. What’s that for higher oil prices? Well, at least if they are high, then it encourages investment in the space.

And Finally, The Investment Section: Credit Spotlight

One of the things I’ve been pounding the table for, is that it’s a great time to be adding to bonds.

The macro environment didn’t matter as much before, we were swimming in easy money (described earlier), and we had compression of rates and spreads all the way through to this year. That includes cap rates (a measure of real estate valuations – definition here).

But let’s not get ahead of ourselves.

Here’s the eye-opening part, let’s take the UK: around 30% of 2-5y UK mortgages will expire in the next quarter or so. What does that mean? Well, it means that we may very well be in a distressed situation as people may not be able to refinance. Let me illustrate this for you.

Let’s say you are paying GBP 500 a month for your mortgage; you may very be faced with the possibility of tripling payments up to GBP 1,500.

That’s not good news…

The US, in contrast, have 30-year fixed mortgages that have been taken out, so the consumer is in healthier shape there. They don’t have re-financing risk, but you are seeing some consumer stress come through in the form of delinquent credit / loans ticking up slowly. That said, the US consumer is strong. Where there could be pressure in the US is in commercial real estate, where many transactions were refinanced on floating rates around 5-7 years ago. And given where rates are going now, plus this hybrid / remote work trend, here’s what it looks like in simple math:

Higher rates + higher vacancies = more pressure on commercial real estate.

“Oh God Jean, where’s the Silver Lining in this one??”

Well, all this to say is that bonds have good value today, you earn decent income and most of the pain has been felt so far this year.

And what about the considerations above? Well, if you’re in credit today, there’s a lot of great opportunities to rotate into and pick from. Underwriting credit risk will become more selective now, and focused on quality and ability to pay vs. assessing refinancing risk. You might actually be able to generate equity-like returns, but with downside protection as a creditor. Sounds like a free lunch, right?

Bonds are a different flavor, and more of an acquired taste. They are also rather technical instruments so if you’re looking to better understand them, I found this WSJ high level guide to be quite helpful in thinking about them in the context of a broader portfolio.

https://www.wsj.com/articles/bond-market-best-income-11667577473

As always, drop me a line if you want to explore any of these topics further. We can also talk about some of the gossip behinds the scenes at Milken, like Paris Hilton taking selfies with Binance’s CZ. “Oh my God, new besties!!”

Until next time.

Jean