From the Middle East to EU & much more
This week we start with "petro-dollars", followed by concerns in ECB. We move to trade war between EU & China & explore Argentina's debts. Finally, is AI able to identify better stocks than humans?
Significant move in Geo-politics
The expiration of the 50-year-old petrodollar agreement between the United States and Saudi Arabia on June 9, 2024, marks a pivotal moment with potentially profound implications for the global financial system.
The term "petrodollar" refers to the U.S. dollar's preeminent role in international crude oil transactions, a system that originated in the 1970s.
This arrangement was established following the U.S.'s abandonment of the gold standard when the United States and Saudi Arabia negotiated a mutually beneficial deal.
Few agreements have been as advantageous to the U.S. economy as the petrodollar pact.
In the wake of the 1973 oil crisis, the formal agreement required Saudi Arabia to price its oil exports exclusively in U.S. dollars and invest surplus oil revenues in U.S. Treasury bonds. In exchange, the U.S. provided military support and protection to the kingdom.
Mandating oil trades in U.S. dollars had far-reaching effects beyond oil and finance. This requirement entrenched the dollar's status as the world's reserve currency by ensuring that global oil sales were conducted in dollars.
This global demand for dollars to purchase oil has bolstered the strength of the U.S. currency, making imports more affordable for American consumers. Additionally, the influx of foreign capital into U.S.
Treasury bonds has sustained low interest rates and a robust bond market.
With the expiration of the petrodollar agreement, there is a risk of weakening the U.S. dollar and, consequently, U.S. financial markets.
Should oil begin to be priced in other currencies, global demand for the dollar could diminish. This shift could lead to higher inflation, increased interest rates, and a weakened bond market in the United States.
The conclusion of the petrodollar agreement marks a significant shift in global power dynamics, highlighting the rising influence of emerging economies and the evolving energy landscape.
Concerns in ECB
The euro’s share of global foreign exchange holdings decreased last year, fueled by concerns that utilizing frozen Russian assets to fund Ukraine might further undermine the attractiveness of Europe’s single currency.
Countries collectively reduced their euro assets in central bank reserves by approximately €100 billion, marking a nearly 5% decline.
This drop brought the euro’s share of global foreign exchange reserves to a three-year low of 20%.
Russia maintains an unusually high proportion of its official foreign exchange assets in euros, about 40%, representing roughly 8% of the total global reserves held in Europe’s single currency.
Following Russia's full-scale invasion of Ukraine in 2022, around $300 billion of its foreign exchange reserves were frozen by international sanctions. G7 leaders are currently discussing plans to mobilize these assets, most of which are denominated in euros.
The European Central Bank has consistently cautioned that outright seizure of these assets could damage the euro’s international role.
Earlier this year, Fabio Panetta, governor of Italy’s central bank, warned that “weaponizing” the single currency could diminish its appeal.
As the world’s second-largest reserve currency, trailing only the US dollar, the euro provides significant advantages to the Eurozone, such as enabling member countries to issue debt at lower costs.
However, the euro’s share of global foreign exchange reserves has declined from 25% two decades ago, as countries have diversified their reserves to include a greater proportion of other currencies like the Chinese renminbi, Australian dollar, and Korean won.
Concurrently, the US dollar’s share has also decreased from nearly 70 percent to just below 60 percent.
The trade war between EU & China around electric vehicles
Starting July’2024, the European Commission will enforce tariffs of up to 25% on Chinese electric vehicles (EVs), aiming to generate over €2 billion annually.
The proposed tariffs have garnered support from France and Spain. However, Germany, Sweden, and Hungary have expressed opposition due to concerns about a potential trade war with China.
China, which currently imposes a 15% tariff on European EVs, has threatened to retaliate and is actively lobbying against the EU's new tariffs.
The tariffs will significantly impact Chinese EV manufacturers and companies like Tesla that have factories in China.
An additional 20% tariff could potentially reduce imports by 25%.
With 500,000 vehicles imported in 2023, this reduction equates to an estimated 125,000 units, valued at almost $4 billion.
Increased tariffs could lead to higher production costs and prices within the EU, raising concerns among EU carmakers about their market access in China. European car manufacturers fear retaliatory actions from China, which could include market restrictions.
In 2022, European brands accounted for about 6% of EV sales in China. Germany, which exported 216,299 cars to China in 2023 (a 15% decrease from the previous year), is particularly concerned. Notable brands like Mercedes and Volkswagen have operational plants in China.
To overturn the decision, Germany, Sweden, and Hungary will need support from at least 11 other EU governments. Other EU countries, particularly those exporting food and luxury goods, also worry about possible Chinese retaliation.
EU member states are scheduled to vote on the tariffs before November 2. If approved, these duties will be in effect for five years.
China to restructure debt for Argentina?
The International Monetary Fund anticipates that China will reorganize the repayment schedule for a portion of the $18 billion currency swap line extended to Argentina.
In June 2024, Argentina is scheduled to repay approximately $2.9 billion to the People’s Bank of China, followed by an additional $1.9 billion in July.
Last year, the administration of former President Alberto Fernandez utilized some of the Chinese funds to partially repay Argentina's loan from the IMF, marking an unprecedented action in the IMF's 80-year history.
Additionally, the Chinese funds were used to finance imports as Argentina faced a shortage of dollars.
AI able to identify better stocks than humans
A recent study conducted by three scholars from the University of Chicago Booth School of Business - Alex Kim, Maximilian Muhn, and Valeri Nikolaev - explored the application of ChatGPT in financial statement analysis.
Their paper demonstrated how the large language model (LLM) was used to generate earnings predictions from financial statements.
With minimal prompting, ChatGPT's predictions outperformed those of human analysts and led to model portfolios that yielded substantial excess returns in back tests.
The researchers fed ChatGPT a vast dataset comprising thousands of balance sheets and income statements, anonymized and spanning from 1968 to 2021, covering over 15,000 companies.
Each dataset included two years of financial data but did not provide the model with any long-term company history. The team then instructed the model to conduct standard financial analyses on these inputs.
They then prompted ChatGPT to create economic narratives that explained the financial analysis outcomes. The model was then asked to predict whether each company's earnings for the next year would increase or decrease, the magnitude of the change (small, medium, or large), and the confidence level of its predictions.
While human analysts' predictions, derived from the same historical database, were accurate approximately 57% of the time, ChatGPT's accuracy increased to 60% after being appropriately prompted.
In back tests, these portfolios significantly outperformed the broad stock market, achieving excess returns of 37 basis points per month on a capitalization-weighted basis and 84 basis points per month on an equal-weighted basis.