ISSUE 31: 2016

Global Insights

Investing in Iran: Roses or Thorns?

In a nation newly open to foreign commerce, we find an abundance of investment opportunities — and caveats.

Photograph by Andy Ryan

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“He who wants a rose must respect the thorn.”
— Ancient Persian proverb

Iran, with its roughly $400 billion market potential, abundant natural resources and young, well-educated population, is open for business. In the wake of several major economic sanctions being lifted in January 2016, the Middle Eastern country has emerged as one of the last frontiers for emerging markets — a relatively unspoiled canvas with significant potential across various industries, including aerospace, agriculture, technology and travel.1

What Iran needs

In place for decades, Western sanctions — on banking, investments, imports and more — essentially hamstrung the nation, with dire results. While estimates vary, Iran’s capital-starved energy infrastructure could need a $1 trillion investment over the next decade. And with fewer than 100 hotels in Tehran compared with some 270 in New York City, the nation’s tourist infrastructure appears woefully undercapitalized. In addition, some aircraft in the Iranian national fleet predate the 1979 revolution, and the airline’s safety record is among the poorest in the world. Similarly, about one million of the cars currently driving on Iranian roads are more than two decades old.2 The current outlook finds the country expecting to plow billions of dollars into its energy grid and rail and water infrastructures in the years ahead.

BUSINESS OPPORTUNITIES IN THE COUNTRY SHOULD BE PLENTIFUL, BUT THEY ARE NOT FOR EVERYBODY.

Unequal access

Given these recent developments, business opportunities in the country should be — and it seems are — plentiful, but are not without risk or for everyone, specifically firms based in the United States. While international sanctions connected to Iran’s nuclear program were lifted at the beginning of the year, other restrictions — related to accusations of state-sponsored terrorism and human rights violations — remain in place. As a consequence, trade that is outside areas such as aviation, carpets and agricultural products remains largely off limits to U.S. companies. Meanwhile, however, the door has opened for businesses operating in European and Asian countries:3

  • A European aviation company has already signed a deal to deliver more than 100 aircraft to Iran.
  • A French automaker is set to sink over $400 million into a new plant and equipment.
  • French, Italian and Chinese mining and energy companies are vying for business in Iran’s energy sector.  
  • Iran reportedly has signed a $600 billion trade deal with China and $55 billion in commercial deals with Italy and France. 

But even these firms and countries may not find Iran an easy place to do business. Indigenous vested interests — notably the commercially minded branch of the Islamic Revolutionary Guard — appear to be well entrenched in the economy and represent significant barriers for outside companies.

Looking forward

We believe that Iran’s economic outlook remains quite promising, assuming there is no “snap-back” in sanctions. As capital flows back into the oil and gas sector, oil exports are forecast to rise by roughly 700,000 barrels per day by the end of the year.4 Iran earned just over $41 billion in oil exports in 2015, and that figure could almost double by 2020.5 Near term, however, depressed oil and gas prices are clouding Iran’s energy earnings potential. In the financial sector, the reincorporation of Iran into the Society for Worldwide Interbank Financial Telecommunications (SWIFT) network earlier this year should help grease the wheels of commerce. On the downside, the availability of U.S. dollars remains constrained by U.S. restrictions on bank lending and loans. As for the Iranian consumer, retail sales plummeted 11.3% in 2013, and dropped another 19% and 2.5% in 2014 and 2015, respectively, as sanctions bit deeper into the economy.6 Yet, pent-up demand and elevated job growth should help boost consumer spending in the near term, adding more heft to Iran’s growth outlook. Young and tech-savvy, Iran’s consumer base represents significant up­side for leading technology firms.

 

The big picture

Adding all this up, we expect Iran’s economy to expand by 5% this year, and potentially do so for the remainder of the decade, making the Persian regional economic power among the most dynamic in the Middle East. In time, America’s leading multinationals may garner an increasingly larger portion of the Iranian economic pie. For now, though, the most effective way for U.S. investors to play Iran is indirectly — mainly via large-cap European firms in energy, infrastructure, banking, capital goods, tourism and autos. When it comes to investing in Iran, at least for the time being, expect both roses and thorns.

1, 3, 4, 5, 6 “All That Glitters—Assessing Opportunities and Risks in Post-sanctions Iran,” The Economist Intelligence Unit, 2016.

2 International Organization of Motor Vehicle Manufacturers, June 2016.

Photograph of floral mural by Eric Lafforgue/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.

Technology stocks may be more volatile than stocks in other sectors.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.

Nonfinancial Assets Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks, including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations and lack of liquidity. Nonfinancial assets are not suitable for all investors.

In early 2016, the permabears — economists and others with consistently negative views of the economy — were again forecasting a global recession and financial catastrophe. So, it was ironic that as their pronouncements reached a peak, there was a bottom in the negative momentum created by the dollar’s sharp rise and the plunge in oil prices during 2015. Indeed, when almost everyone decided that central banks were ineffective, their accommodative policies significantly reduced real long-term interest rates in the United States and abroad, thus raising economic momentum.

Key to the permabears’ Armageddon-like vision was an assumption of a sustained uptrend in the dollar that they believed would force a massive devaluation in the Chinese yuan and unleash commodity deflation. Instead, by early May, the dollar had stabilized, the yuan had proved resilient and the commodity downtrend had reversed. Still, the dollar’s adjustment, from about 25% undervalued to roughly fair value in May, was tough on commodity markets, U.S. manufacturing exports and multinationals’ foreign earnings. Yet, those adjustments are largely behind us now, and the positive impact of lower oil prices and a more balanced global growth mix are becoming apparent. As a result, there is no sign of a recession on the horizon.

The fed’s policy has fostered a long recovery, low inflation and full employment.

The bearish vision of a soaring dollar was predicated on the notion that central banks were locked into a counterproductive, mutually destructive path — yet another example of misguided views that have appeared since the financial crisis (similar to predictions of hyperinflation due to the Federal Reserve’s quantitative easing, or QE). Instead, the Fed’s policy has fostered a long recovery, low inflation and full employment, with little evidence of equity-market bubble valuations. As those predictions failed to materialize, the permabears said that central banks had run out of ammunition, which The Economist hinted at earlier this year.1

What turned things around?

The strong dollar substantially tightened global financial conditions late last year, obviating the need for as much rate “normalization” as had been previously expected from the Fed. Similarly, rhetoric and policy in other countries shifted to moderate currency depreciation. The first big shift in this direction was the European
Central Bank’s (ECB) disappointing December easing, which caused the euro’s unexpected rise. The Bank of Japan’s (BoJ) shift to negative rates had a similar effect on the yen in January. China did its part by resisting calls for a destabilizing devaluation. Instead, it stuck to its trade-weighted currency basket — focusing on the euro and the yen, whose recent relative strength diminished the pressure for depreciation of the yuan against the dollar. Also, China’s shift from goods exporting to domestic-demand and services should benefit from a strong currency, negating the need for a massive devaluation of the yuan.

A key point missed in the market’s “currency wars” narrative was that currencies had settled into a more favorable pattern for growth. Because the U.S. adopted QE early and aggressively, the dollar fell two standard deviations below fair value, helping the U.S. economy to recover before the economies of reluctant QE adopters like Europe and Japan. After 2014, the dollar returned to fair value, helping shift global demand from the U.S. to Europe and Japan precisely when the Fed needed to remove accommodation. Basically, the stronger dollar had an effect similar to U.S. rate hikes, helping keep interest rates lower than they otherwise would have been.

 

Since the dollar and oil accounted for most of the earnings momentum decline over the past year, their stabilization has set up an earnings inflection point, which global equity markets appear to reflect. Barring any significant increase in the dollar, which is unlikely given its sharp run-up since June 2014, the global economy is positioned for faster growth.

Lower real rates

The real 10-year Treasury rate was deeply negative before the Fed signaled that it would taper its QE program in 2013. Now it is at the low end of the higher, but barely positive, range that has prevailed since the late-2013 “taper tantrum,” dropping from about 0.8% to 0.2% since early 2016 as expectations for Fed tightening have diminished. In turn, lower real rates have capped the dollar’s rise. (See “Stable Dollar Good for Global Growth,” above.)

Lower interest rates abroad also helped lower U.S. rates. As long as inflation is contained, negative yields on most high-quality 10-year sovereign debt will be a strong anchor on U.S. yields, which stimulates the economy.

In addition, some homeowners are starting to tap their restored home equity values for renovations. What’s more, millennials’ shifting from apartments to single-family residences is driving double-digit growth in residential investment.

What it all means

We have seen a mid-cycle transition rather than the prelude to a recession. The global economy is rebalancing, with a higher dollar and lower oil prices coming at the right time to increase global demand and stimulate economies through weaker currencies. The U.S. economy has benefited from the restraining influence of the stronger dollar at a time when full employment is the main threat to expansion.

THE STRONGER DOLLAR HAD AN EFFECT SIMILAR TO U.S. RATE HIKES, HELPING KEEP INTEREST RATES LOWER THAN THEY OTHERWISE WOULD’VE BEEN.

Expectations of recession have proved groundless, as was the case in 2011, the mid-1990s and the mid-1980s. In those instances, when financial conditions tightened and fears of recession rose without much inflation threat, the Fed eased and expansions continued for several years. It did the same in March, when its expectation for short-term interest rates shifted down, reflecting less need for tightening. This is another example of why market veterans “don’t fight the Fed” and regard magazine covers as contrarian indicators.

1 “The World Economy: Out of ammo?,” The Economist, Feb. 20, 2016.

Photograph of The Fed by Traveler1116/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Currency The risk that exchange rate fluctuations will reduce the value of returns. This arises when investments denominated in foreign currencies are purchased.