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July 2014 Global Macro Recap

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  • Global Macro Recap

The June trend towards differentiating markets continued in July, with the US putting up some better economic numbers, Europe putting up some worse economic numbers and Asia holding out the possibility of recovery.  One can see this play out in the stock markets to a certain extent, with the S&P 500 (-1.3% (in USD)) down less than the EuroStoxx50 at (-3.5% (in EUR)).  Asian markets (at least the Nikkei 225 and Shanghai Shenzhen CSI300) were up on speculation that local stimulus measures were going to return prosperity to their economies, but part of those gains were catch-up after starting the year badly.  The Middle East saw renewed violence in the Gaza strip between Israel and Egypt but like with Syria, there was little global macro-economic impact.  South America faced its first sovereign default in a few years with Argentina deciding that it did not want to face up to its past sins of leverage.  It will be interesting to see how they maneuver their way through this.  They have reached out to China and Russia for funds, but President Kirchner has very few options, and no good long-term ones.  Although commodity prices were generally synchronized in terms of direction (down), industrial metals stood out with modest gains on the Chinese stimulus spending.  The rest were subject to shaky economic conditions (less stable demand), growing inventories (more plentiful supply) and less easy monetary conditions (at least in the US).  In August, the weather is likely to either deliver for the longs in grains, natural gas and livestock if there is scorching heat or cause a capitulation as pleasant temperatures ensure strong supply gains.  Wildcards remain, most likely Russia’s actions against Ukraine (e.g., an invasion), but also Middle East or Asia fighting / tensions that escalate into real damage to supply or logistics.  The odds are slim on these but their effects would be dramatic.

Need for Speed:  Hopes for escape velocity came with a +4% Q2 GDP figure, especially when combined with the upward revision of Q1 GDP to -2.1% from -2.9%.  With the prior adjustments for 2013 and 2012, the picture is still modest GDP growth.  The only question mark lies in inventories, which accounted for almost half the increase.  This raises the question on whether this increase is due to businesses anticipating higher sales in the future or is it a surprise build-up as a result of an unexpected decline in sales.  Final sales from the GDP figures were higher by +2.8% and the growth of June’s retail sales was up as well, so our interpretation about inventory growth is for the former (to support higher future sales) rather than the latter (retailers unintentionally stuck with excess goods).  However, with a particularly large increase in auto shipments, we have to see if these “sales” are for real or represent channel stuffing.  The IMF offset the good news by cutting the US 2014 GDP forecast by -0.4% to +1.8% instead of +2.2% as it also lowered many of the large emerging market economies, particularly Russia (from +1.3% to +0.2% on the Ukraine conflict) and Brazil (from +1.9% to +1.3% on their economic slowdown).  Digging into more of the July numbers, the news seems positive on the housing front as previously-owned home sales continued to recover and distressed sales declined (see graphics at right).  Foreign buyers are still going strong in the US market with $92.2 billion of home sales to non-US citizens/recent immigrants in 2013 which is a 35% increase versus 2012.  While the Chinese percentage has been growing regularly the last few years from 5% to 16% of foreign purchasers, Canadians are still the largest foreign home buyer in the US at 19%.  Strong home sales (and high prices) historically are tied to decent employment growth and that correlation has stayed.   Jobless claims hit an 8½-year low in mid-July as job growth stayed above 200,000 positions in July, although it was below expectations.  The unemployment rate edged up to 6.2%.  Durable orders also improved, rising a seasonally adjusted 0.7% in May.  All in all, a few “green shoots” that will keep Dr. Yellen firmly on the tapering path but dovish in terms of future rate increases (i.e., not for a sustained period).

Flying south to Puerto Rico, the island’s electric company bought some time by convincing its banks to delay $671 million in payments due by mid-August.  With the government passing a law last month allowing the default of the utilities’ debts, one wonders if these lenders will be paid in full.  Hopefully Citibank and ScotiaBank have taken loss reserves against their loans.  Of course, the big headline was the actual default by Argentina for the eighth time since independence 200 years ago.  It was well anticipated so no panic developed.  The test will be when the government tries to borrow more and investors will have to decide to chase yield further.  The payments for the current debt are now in suspense as the current holders cannot be paid until the old ones receive their due.  Any buyers nowadays are speculating that they will receive their interest, as well as principal.  Venezuela is Argentina’s future as that country spirals ever downward.  Car production there is down 80% as firms cannot get foreign exchange to buy parts.  President Maduro has to understand that $0.05 per gallon for gasoline has no benefit if there are no cars.  China has stepped in with pledges of more lending on top of the $40 billion it has extended so far in exchange for more oil but with the Venezuelan government owing $40 billion to companies and individuals, any fresh funds will be quickly gone.   Finally, Brazil is injecting $20 billion into its economy indirectly by lower bank reserve requirements and lowering risk standards for loans.  In this way, its banks can lend more money to lower-quality borrowers.  Given how well sub-prime lending worked in the US, I do not have high hopes for the Brazilian plan. 


Battlefield 4:
  Ironically, Brazil’s former colonizer, Portugal, just had their (formerly) largest bank by market capital, Banco Espirito Santo (BES), collapse due to bad loans.  Not a good omen for Brazil’s lowering of credit standards!  The timing could hardly be worse for investors as BES raised €1 billion in a rights issue in May and Portugal received $4.5 billion from a ten-year bond sale at the beginning of July.  So much for the return of peripheral Europe!  Basically the family that ran BES, the Salgados, were unable to pay a least €1.6 billion in loans and capital to the bank, though the accounting irregularities involved make it unclear publically as to the exact size and nature of the default.  In addition, there was a loan made backed by equity shares that required more capital as the share price fell – Enron-style – which exacerbated the situation as shares were sold to maintain the required loan collateral.  As the scheme unraveled in the middle of the month, the bank filed for creditor protection (AKA bankruptcy).  At month-end, the half-year’s financial results came out worse than expected with a loss of €3.6 billion. In a few days, the Portuguese government took their July bond proceeds and used them (and more) to break BES into two portions:  a bad bank with about €13 billion in suspect assets owned by the equity (effectively wiped out) and junior bondholders (valued at about 20 cents on the Euro), and a good bank owned by the government, with no direct losses to the senior bondholders and depositors.  The €4.9 billion in equity injected by the government should not cost the taxpayers anything assuming that the bad assets were properly identified and transferred to the bad bank.  However, until the IPO, the government (and thus the taxpayers) are on the hook.  That will be too late for French bank Crédit Agricole, which owned 20% of BES.  Their Q2 profits were basically zero after the resulting €708 million writedown.  “Who’s next?” is what the markets should be asking themselves.

Greece is an obvious consideration as it had to dramatically scale back its July bond offering, accepting €1.5 billion of the €3 billion offered, a slap in the face compared to the €20 billion in orders for €3 billion of debt offered in April.  If Greece falls short of its €8 billion debt plan, the current bailout deal with the troika could flounder.  After all, these are the “assets” that Greece has to sell as part of its privatization plan: http://www.zerohedge.com/news/2014-08-07/ten-years-later-greek-olympic-wasteland-photos.  By the way, I have not heard much progress on this so-called plan.  Have you?  Thought not.  Spain at least is showing some progress with unemployment falling from 26% to 24.5% from the first to second quarter.  However, the IMF projects that the unemployment will stay above 20% for another four years so no light at the end of the tunnel yet.  Leading Spanish bank BBVA at least was able to show at their earnings review that bad loans are falling as part of its loan book.  A net profit decline of 40% is still worrisome.  Banks generally were fortunate in their timing in dumping assets in front of ECB stress tests to be conducted at the end of July, with 2014 asset sales at €83 billion, well ahead of the €63 billion for all of 2013.  However, with BES hanging over the market, one wonders if private equity and distressed funds will be so eager to buy.  The European junk bond market, which has issued more low-grade paper this year versus the United States, also has stalled out. How’s that new bank-lending TLTRO program working out Draghi?  Boosting lending?  Or have macro events overtaken your wall of money?

As we discussed a few months ago when the conflict first started, Russia would be ahead of the early game, but as time went on, it would face more and more difficult choices.  The trend of last month where we described the gains made by the Ukrainian military has continued, putting the choice right in front of Russia whether to intervene or not.  At the current rate, I think that the point of no return on that decision will pass in a few weeks, given the Ukrainian progress on ground.  The rebels (with direct Russian assistance, if not them actually pulling the trigger) shooting down the Malaysian passenger jet, the firing of Russian artillery against Ukrainian positions and the subsequent European escalation of trade and financial sanctions has put Putin on his back foot.  His significant tax increases scheduled for the end of the year further demonstrate his precarious fiscal and economic position.  Russia’s private finances are now almost completely dependent on government largess, as banks and firms no longer have access to capital in Europe.  Certainly China and Qatar can lend him money, but most of his “allies” need money themselves (Argentina, Syria, Cuba, Venezuela).  Of course the sanctions hurt European companies/economies as well as the Ukraine itself and “Winter is coming”, so Putin may only have to last a few months.  But it could be tough.  Those oligarchs like their London homes, German automobiles and Norwegian salmon.  Yukos would like to negotiate the $50 billion in damages it owes European shareholders or at least avoid expropriation of its assets as payment.  An interesting article on the state of Putin’s situation can be found here:  http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/11017413/Vladimir-Putins-pointless-conflict-with-Europe-leaves-it-a-vassal-of-China.html.  The game of chicken continues.

Titanfall:  China may be slowing but the market sticks to the assumption that they have plenty of resources to draw upon.  The results of the Chinese government relaxing credit standards and reserve requirements last month (sound familiar, Brazil?) have started to flow through the economy with new credit reaching Rmb1.96 trillion ($316 billion) in June, back to March’s level and double that of a year ago.  Q2 GDP came in as planned by growing 7.5% annualized for the quarter, with fiscal spending increasing in parallel.  Industrial production continued its modest recovery as indicated in the graphic on the left.  However, exports rose less than expected at +7.2% for June (+10% was the median forecast increase).  The housing sector also showed an improvement in June as the declining sales pace fell less for the second month in a row.  However, housing sales are still down 9.2% for the first half of 2014.  The slowing property market is still hitting corporate earnings with three property companies issuing profit warnings in mid-July.  Externally, we note that Australia’s unemployment rate hit a twelve-year peak of 6.4% as their mining sector continued its weakness.  Meanwhile, in the broadening but still opaque industrial metal warehouse scandal that we reported on last month, the estimated potential losses to banks on the missing copper and aluminum could reach $3.2 billion.  The situation is clearer with Shanghai Husi Food Co, which was selling expired beef and chicken products to Starbucks, McDonald’s, KFC and Pizza Hut locations in China.  With McDonald’s same-store-sales down -3.6% in China over the last twelve months, they cannot afford any hit to their reputation.  With the Walmart fox-meat-sold-as-donkey-meat scandal only a few months old, American brands apparently have not learned quality control lessons yet in that country.

Meanwhile, in Japan, Abe continues to face headwinds as industrial output continued to fall in June by -3.3%, as we still monitor the impact of the April tax hike increase.  Inflation is low with an annualized consumer price increase of +1.3% in June notably lower than the +2% target.  So far Abe is not rapidly inflating away his government’s $10.5 trillion public debt (more than twice the Japanese GDP).  Company profits are up and unemployment is down on the plus side but real year-on-year wages are also down -3.8% as of May.  Not quite the recovery Abe promised from his massive monetary stimulus.  One positive item however is that Japan’s nuclear regulatory agency has given two power plants the clearance to restart. 

Plants vs. Zombies:  While the Federal Reserve may appreciate that the US core inflation is still below 2%, energy (basically gasoline prices) rose +3.2% year-on-year as the US heads into the August driving season.  On the other hand, oil prices look wobbly as fighting in various countries (Ukraine, Israel, Libya, Nigeria and Iraq) has not caused any particular shortages.  Indeed, between maintenance season coming, new pipelines and an uncertain global economy, oil inventories may even rise at the primarily US delivery points.  The strife did not bar the Saudi government to announce that their stock market will become open to foreigners early next year.  As the largest equity market in the MENA zone, this change in policy is timed to coincide with the need to raise capital for infrastructure projects as the kingdom looks past energy as the basis for its revenues. 

In the world of grains, the collapse in prices in anticipation of strong row crops this year means that farmers are not expected to cover their costs since 2006 per the Wall Street Journal.  Grain processors (ethanol makers, soybean crushers and bakers) are benefiting from the price slump as their input costs fall.  The Russian food import ban that Putin just implemented should redirect European supplies elsewhere and South America still is working off its harvest.  China will import corn but is on track to produce its eleventh-largest harvest in twelve years.  India meanwhile is sitting on reserves of 73 million tonnes of rice and wheat and is under pressure to work that down given that it is over three times the amount it had in 2006, and twice as much as projected needs.  A dump in international markets is another wildcard.  On opposite side of bumper crops is California’s drought that is expected to cost the state $2.2 billion in lost revenues and extra costs, and while putting 17,000 (3.8%) farm jobs on the cutting board.  And so far, the prognosis for 2015 is no better. 

 

If you buy your bratwursts from Europe (Trader Joes perhaps), you may want to know that German sausage makers were fined €338 million for price fixing their links for decades.  Eleven companies co-operated with the investigation in exchange for lighter fines but others, including the famous Böklunder, Wiesenhof and Rügenwalder brands, were hit.  German breweries were hit for the same amount earlier this year and in February Germany’s three largest sugar producers were charged €280 million in fines.  Separately in meat news, China lifted its 2012 ban on Brazilian beef imports as it looks to lower meat prices and find alternatives to Australia, Canada and the US

 

Industrial metal producer Freeport McMoRan and local exporters Sebuku Iron Lateritic Ores, and Lumbung Mineral Stocks have finally capitulated to the Indonesian government and are paying new export taxes despite valid contracts with the government that permitted exports without tax until 2021.  Now Newmont Mining has to decide what to do as the focus of the Indonesian government to force producers to smelt locally will threaten a showdown with Chinese smelters who would lose tremendous business as the value-added business is shifted.  Perhaps a demonstration of China’s new aircraft carrier? 

 

And while gold seems to be holding its current level at $1300 +/- $50 per ounce, keep in mind that China’s gold demand is about 20% lower from 706 to 569 tonnes in the first half of 2014 versus the same period in 2013.  Gold coin sales fell 44% and small bar sales by 62% but jewelry and industrial demand both rose 11%.  As the world’s largest gold producer, Chinese gold miners increased output by 9% to 211 tonnes for the same period.  So if there is ever a serious flight to gold (say, from real estate), the buying pressure could be significant.  Not seeing it right now, but keep an eye out for it.

 

David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource    

August 12, 2014

Additional information sources:  Bloomberg, Financial Times, South Bay Research, United ICAP, WSJ and Zerohedge. 

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