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Macro Ideas – Is Iraq the world’s next hot frontier stock market? Money alone will not solve Iraq’s problems of systemic corruption

The Macro View

A dismal legacy of civil war, sanctions, insurgency, foreign invasion and terrorism has had a catastrophic impact on the Iraqi economy. Prime Minister Haider al-Abadi told the assembled global elite at Davos 2018 that Iraq needed $100 billion in postwar construction. Yet money alone will not solve Iraq’s problems of systemic corruption, a society divided by sectarian cleavages, poverty, the displacement of 2 million people and youth unemployment.

The West and the Arab world have a vested interest in leading the reconstruction of Iraq since this pivot state straddles both the Arabian Gulf and the Turkish-Kurdish mountains. There are positive sign that the precarious political situation has stabilized, now that Daesh has been defeated by the Iraqi Army and Kurdish militias. Violence in Baghdad has fallen to 2009 lows. Consumer spending metrics are beginning to exhibit growth and optimism. The share prices of the cellphone operator Asiacell has risen 65% since last summer on stellar sub adds. Iraq sovereign wealth fund has amassed $50 billion in assets. Iraq’s sovereign Eurobond was oversubscribed six times.

Western and Arab investors cannot ignore a fabulously rich country with 40 million citizens that happens to be the second largest oil producer in OPEC after Saudi Arabia. International donors have pledged $30 billion in Iraqi reconstruction. After a stellar 11% GDP growth in 2016, Iraqi real GDP growth fell to near zero in 2017 due to Baghdad’s compliance with the OPEC output cuts. Iraq produces 4.3 million barrels of crude oil a day. However, the surge in Brent crude to $74 due to geopolitical risks, the success of the Saudi-Russian output pact and fears of renewed sanctions on Iran oil and exports are hugely bullish for Iraq, a classic petro-state. The IMF expects Iraq to deliver 2.8% GDP growth in 2018.

Postwar Iraq faces monumental political, social economic and even psychological challenges. 20% of the population lives in poverty. The swaths of Anbar, Diyala and Nineveh provinces under Daesh control have still not been fully stabilized and face economic depression. The government in Baghdad is divided by ethno-sectarian conflicts and unable to resist Iran’s infiltration and manipulation of state institutions. This is the reason the parliamentary elections in May 2018 will be a crucial milestone in the political evolution of post Saddam Iraq.

The Iraqi private sector, while exceptionally resilient, faces huge challenges from corruption, a primitive banking system insecurity and war ravaged infrastructure. Iraq ultimately needs to shed its Baathist era model of state ownership of land and nationalized industries. Iraq needs Big Bang economic reforms that the Abadi team has failed to deliver since it is hostage to contradictory political pressures and rival vote banks. Iraq was the classic example of a failed petro-state, a symbol of the “resource course”, under the Baathist dictatorship of Saddam Hussein, which invaded Iran in 1980, Kuwait in 1990 and conducted a genocidal campaign against the Kurds that culminated in the poison gas attack on Halabja. A generation later, Iraq is quite possible the most attractive frontier market in the Middle East.

Investors in Iraqi stocks faced devastating losses after President Obama withdrew US forces, Prime Minister Nuri Maliki embraced Iran, the Iraqi Army was unable to prevent Daesh’s seizure of Mosul and oil prices crashed in 2014-16. Yet Iraqi stocks are up 10% in 2018, far better than Europe or Japan. While the stock exchange in Baghdad is illiquid and hardly state of the art, its market cap is a mere $10 billion, a pittance in a nation whose proven oil and gas reserves could well top 300 billion barrels.

My experience in the post-Soviet frontier markets tells me Iraqi economic reconstruction could be a secular growth ballast for Iraqi banks (80% of the population does not have a bank account), cellphone operators, consumer companies and, yes, hotels. I concede the Iraqi stock exchange trades behind concrete blast walls. Yet it is one of the top performing stock markets of 2018, though down 60% from its 2014 peaks. I learnt in Karachi in 2011 that the end of a civil war can be a catalyst for a powerful multiyear bull market. George Soros said the big money is made “when things go from godawful to just plain awful”. No guts, no glory is the tagline of my own passage to Iraqi equities!

​Currencies – The long sterling trade idea was a huge winner

The British pound has been the ultimate politics driven currency in the past two years. Sterling plummeted from 1.50 to below 1.20 in the immediate aftermath of the June 2016 Brexit vote, as investors were alarmed by the intransigence of the EU over a divorce bill (“hard Brexit”), the impact of higher inflation on the High Street, political divisions in Westminster and Theresa May’s failure to increase her majority in the 2017 general elections. However, I began to see signs of a sterling trend reversal last autumn when sterling was 1.28. The Conservative Party rallied behind Mrs. May. The EU compromised on a Brexit divorce bill. There was no recession in the EU. The Bank of England begun to hint at two rate hikes in 2018. The US dollar sagged on Trump, trade tensions and the surge in the US budget deficit. Britain negotiated a transition deal with Brussels. My long sterling idea at 1.28 and again at 1.32 (remember the Lloyds Bank ADR trade idea?) began to make money. Last week, sterling hit 1.43 for the first time since the referendum.

Sterling has been the top performing currency in the G-10, up 6% against the US dollar in 2018. The financial markets have now in a soft Brexit, a successful outcome to the Northern Irish border talks and a viable trade deal. Of course, any disappointment on this front will lead to swift spasms of sterling selling.

The London money markets now price 93 per cent odds of a Bank of England base rate hike in May. However, economic growth and High Street consumer sentiment in the sceptered isle has peaked, so it will be rational for Governor Carney to signal a “dovish hike”. Any such dovish hike from Threadneedle Street will unquestionably gore the sterling bulls.

I am also worried about the alarming deterioration in the London office and prime markets, where sanctions on Russia, the Chinese corruption crackdown (the seizure of Anbang), the liquidity crunch in the GCC banking system attest for lower foreign flows into the City of London. Sterling has always punched above its weight in Planet Forex due to London’s role as the capital of the British Empire (the sun once never set on Britannia, but now has gone into an eclipse!), the epicenter of the Eurocurrency markets and, in the early dawn of the Thatcher spring, the North Sea oil bonanza. Sadly, the Brexit referendum will greatly devalue both London’s stature in international finance and offshore demand for sterling.

I expect sterling to maintain its seasonal strength in April, primarily due to the end of the UK tax year and dividend payments by mega UK corporates. The US dollar strength, the rise in the 10 year US Treasury note yield to 2.96 and Governor Carney’s public comment on soft UK data slammed cable to 1.40, yummy. FX folklore contends “the trend is your friend until the trend comes to an end”. This trend has not come to an end.

Trade tensions with China, geopolitical risk, expectations of a Bank of Japan policy normalization, safe haven bids linked to the rise in Volatility and the March sell off in global equities and repatriated fund flows from the end of Japan’s fiscal year led to an alarming 7.5% rise in the Japanese yen from 113 to a high of 104.7 in the first three months of 2018. Deutsche Bank even predicted that 100 Yen was imminent.

The Macro View

About Matein Khalid

Matein Khalid

Matein Khalid is Chief Investment Officer of Asas Capital in the DIFC; he is responsible for global investment strategy and the development of the multi family office platform. He has worked in Wall Street money centre banks, securities firms and hedge funds in New York, London, Chicago and Geneva. In addition, he has been an advisor for royal investment offices in the Gulf for 8 years. Mr Khalid has four degrees in finance, economics, banking and international relations from the Wharton School, University of Pennsylvania. He is a director at the American College of Dubai and has taught MBA level courses in commercial/investment banking at the American University of Sharjah and British University of Dubai. He writes the Global Investing columns for Khaleej Times, Gulf Business and Oman Economic Review.

Articles by Matein Khalid

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