October 2014 Global Macro Recap

  • Global Macro Recap

For the third month running, global macro factors maintained their dominance over the markets as central banks adjusted policies amidst a shifting and shifty economic environment.  The US Dollar was again the safe haven of choice, with gains of +2.4% versus the Yen, +0.9% versus the Euro and +1.4% versus Sterling.  The Federal Reserve welcomed the inflows by ending the latest round of QE, confidently knowing that those dollars have to go into some kind of asset, most likely government bonds.  With repeated assurances that rates will stay low for the considerable future, Yellen is in stand-by mode – ready to act with a carefully crafted phrase and backed by printing press if necessary.  Velvet glove and iron fist.  The way is clear for Europe and Japan to take up the monetary excess slack and they are taking it up with gusto.  I am still skeptical towards their excuse on deflation, but regardless the carry trade needs to be fed.  Draghi and Kuroda have unabashedly stepped up to the task.  Certainly the buy-the-dip mentality worked in October in the US, with the S&P 500 hitting a new high after being down 10% (intraday, not close-to-close) from the peak during the course of the month.  Elsewhere overseas, we have the semi-cold war between Ukraine (sort of backed by Europe and the US) and Russia, a few spiraling downward South American countries and questions on Chinese recovery (China missed the 7.5% GDP growth rate, but just by a few ticks to keep the confidence going).  The grain harvest is coming in slowly but surely around the Northern Hemisphere, and US gasoline is averaging $3.00 a gallon at retail.  With all this money coming into the US and the big hits in the commodity indices, is it time to put risk on?  Guess we will find out if there are any production cuts agreed upon at the OPEC meeting coming November 27th, or will Saudi Arabia decide that market share (and punishing Russia and Iran) is more important?  Let the volatility continue.

All’s Well That Ends Well:  QE has ended, the American asset markets ended back on high notes (not only equities at highs, but thirty-year bonds also moved to their 2014 month-end highs), and the economy continued on its sputtering recovery.  The reasoning for the end of QE has been steady improvement in the headline employment numbers, such as the initial claims for jobless benefits hit fourteen-year lows, and low core inflation (strong US Dollar will do that too).  As I feel it is a destructive and unnecessary policy (seniors/pensioners and savers generally should not be forced to subsidize the desire of government debtors for low interest rates), hopefully our society will move on from this.  QE certainly has been successful in causing investors to embrace risk.  Note a few data points.  First, subprime automobile asset-backed securities (i.e., bonds backed by car buyers with poor credit) is on track for another $20 billion issuance year, matching last year though still short of the $26 billion issued in 2005.  Overall junk-rated debt is at record issuance of $359 billion.  Leveraged bank loans and bonds backed by collateralized bank loans (again, usually lower rated debts) is also both reached record sales.  Finally, debt related to equity shares (AKA margin debt) has been relatively steady at $463 billion, just shy of the record.  In comparison, the 2007 peak was $381 billion and the 2009 low was $173 billion.  Risk is out there, waiting to come out of hibernation.  The only blatant positive I could find was that the US Treasury is almost free from one of its few large TARP bailout positions, the shares of the “bad bank” spinoff from General Motors.  Last November it held 74% of the company, now it is 11%.  Looking ahead, I think that QE will come back when leveraged debtors cry for it at the next crisis and the US government will again try to ride to the rescue.  Gone but do not forget. 

The “real” economy on the other hand is doing okay – Q3 2014 GDP growth came in at a headlining +3.5% annualized rate, well ahead of the +3.1% expectations.  In the details, the US government spent significantly more on defense than expected and net exports add +1.3% to the total – quite surprising given the stronger US Dollar over the course of the quarter.  In conclusion, a pleasant result, though not easily repeatable.  It was good enough for the IMF to increase its 2014 US GDP forecast by +0.5%, the only improving economy in the countries its forecasts.  Industrial activity was mixed with durable goods orders falling -1.7% ex-aircraft (there was a large plane order in August so ex-aircraft is a more appropriate comparison) but ISM indicators showed good expansion in new orders for October, and greater for the US than for other countries, including China.  Finally in a repeat from last month, job growth stayed strong at over 200,000 new jobs in September and upward revisions for August, keeping the headline unemployment rate low at 5.8%.

October was debtor-decision month.  Here in the US, both the cities of Stockton and Detroit made progress on finalizing their bankruptcies.  In California, a judge allowed Stockton, the largest city in the state to go under from the real estate crisis, to exit its two-year bankruptcy by raising taxes and cutting payments to bondholders while maintaining its obligations to the city employee pension plan.  Detroit has started closing arguments for its bankruptcy trial after the last main holdout over a $1 billion loan agreed to swap the debt for equity in a real estate development deal underwritten by the city.  This final piece should finalize the historic bankruptcy with a writedown from $18 billion in obligations to bondholders, vendors and city employees to $7 billion in long-term commitments.  While there are a few last objections, the federal judge hearing the case made a ruling in early November.  Painful but necessary, and what needs to happen on a broader scale around the world, in my opinion.  Puerto Rico is one such location but they blissfully put off what needs to be done by selling $1.2 billion in bonds in October to be due in June 2015, but only on the condition that the debt not be sold to third parties, thus ensuring its value remains at par (no-mark-to-market that may affect other debt values).  At 7.75% interest, the holders (all banks) are compensated for the risk as well as having the first right of repayment from tax notes (more debt!) that expected to be sold next year. 

In South America, Argentina sold $983 million in debt domestically under local laws since it cannot sell debt internationally after its default last month.  This is the third domestic borrowing this year but the first in US Dollars and underscores the country’s financial isolation.  Venezuela has continued to make bond payments but as the country spirals downward from economic mismanagement and low oil prices, its yields have hit 16%.  Default would be particularly costly as it has substantial assets abroad.  In short, it needs Saudi Arabia and Kuwait to cut production at the next OPEC meeting in last November, but even if it gets it, it may be too little, too late.  Finally, Brazil re-elected Roussseff to lead the country which suffered from a nasty political mudslinging over income inequality claims.  Investors sent its currency down about 15% in the last two months as the stock exchange lost about 20% of its value form its high.  Low oil prices also hit its largest firms, particularly Petrobras which has lost $69 billion in market value since September 2nd.  They too would like OPEC to cut production as Brazil’s new deep-water wells supply some of the priciest crude oil on the market.

Healthy Banks Mean More QE?  It is a bit odd timing but the European Central Bank came out with its latest “stress test” on its banks financial health using data from the end of 2013 and gave the vast majority a passing grade… and even the big ones that failed are the usual suspects (Cypriot, Greek and Italian) and the group only has to raise about €9.5 billion in additional capital as many took care of their shortfalls during this year.  Meanwhile, Draghi’s ECB has begun buying bonds on the open market and from banks as part of its €650 balance sheet expansion (the TLTRO program).  However, only a few billion were bought, leading commentators to wonder how successful the program was going to be.  After all, sellers have to reinvest the proceeds and the ECB pays negative interest on its deposits so there’s not very many places to put the funds.  German bonds at 0.5% yields?  QE is a headache not a gift! 

Tensions also bubbled up between the EU and both Italy and France wanted to ignore the EU budget agreement over the maximum deficit permitted by member states.  Non-compliance is supposed to be enforced by fines but in the fiscal crisis, countries (i.e., France, Cyprus and the PIGS) received waivers.  Clearly France expected more of the same.  In the end, both countries made small adjustments with Italy eliminating plannedItalian debt reductiontax cuts and France including a number of subjective measures including €900 million from cracking down on tax evasion.  Really?  That old excuse?  That is not really austerity either.  Needless to say, these adjustments still fall short but Brussels decided not to press the issue at this stage.  There is still a final review that in theory could assign fines, but I do not think it is likely at this stage.  So these countries will get away with skirting the rules.  All well and good, but why should any country abide by the EU pact if they have the political power to do avoid the bits that they do not like?  Why pay heed to the budgetary process at all?  Spending without restraint until it breaks would at least be simpler. 

Economically, the European numbers continue to disappoint.  The IMF forecast referenced earlier has the Eurozone growing at 0.8% in 2014, down from 1.2% and at 1.1% in 2015, down from 1.7% so nothing good there.  Germany, France and Italy all were cut, with Italy shrinking by 0.4% in 2014.  German exports collapsed 5.8% in August, at least partially due to the sanctions against Russia with exports there falling 25% year-on-year to €2.5 billion.  However, with Russia only 3% of German exports before the Ukrainian conflict, this is a misleading sound bite.  I would look at continued slowdown in Asia and the improved competitiveness of Japan due to the weakness of the Yen as initial culprits.  The graphs to the left underscore Italy’s predicament as the economy is dependent on bank lending which has been declining the last few years – not coincidently Italian banks had the toughest time in the ECB stress test.  With €320Italy GDP vs Lendingbillion in bad debts (16% of outstanding loans), Italians banks are in poor shape – and the ECB is not likely to buy those toxic assets no matter how overly-securitized.  At least, the ECB will not buy if it intends to retain a scrap of credibility.  Private equity groups have stepped in but there is a lot of chaff and little wheat to sort through.  There is some small progress – Spain’s unemployment fell from 24.5% to 23.7% during the third quarter.  Ireland refinanced about 20% of its IMF bond at lower rates – Greece would like to but when its bonds spiked to 9% interest from 5.5% during October’s market decline, I think that dream is impossible. 

The Ukrainian-Russian conflict stayed in cold war mode in November with the main events political – a vote by the separatist regions to leave and a new parliament for the rest of Ukraine, which is now so pro-EU that the former Communist Party failed to gain any seats!  October ended as quietly as could be expected but November has startedruble vs dollaroff with a bang as again Russian troops invaded to protect separatists from losing to a renewed Ukrainian offensive.  The real action in October was on the financial front with the Rouble falling 8% or so despite currency intervention by the Kremlin (estimated at a cost of $30 billion) and an increase in domestic interest rates from 8% to 9.5%.  In financial markets, this type of currency movement is known as a “flight to safety!”  Russia also expanded its cold war actions by flying over NATO allies with fighter jets, bombers and spy planes, threatening the West in speeches, kidnapping government officials by snatching people across the border, cyber-attacks and general intimidation.  Typical hooliganism.  However, on the plus side, Russia reached a deal to supply Ukraine with natural gas this winter in exchange for $3.1 billion to settle past debts as well as $1.5 billion in pre-payments for the upcoming months.  With Russia’s GDP expected to grow only by 0.9% in 2015 per the World Bank, even they need to cut a few deals.

Tora! Tora! Tora!  With a nod to the famous WWII film and code-word indicating complete surprise[1], Bank of Japan Governor Kuroda caught the financial markets off-guard with his substantial expansion of QE from ¥70 trillion to ¥80 trillion per year or bychange from previous year for various investmentsabout $8 billion per month.  While smaller in nominal terms than the Federal Reserve’s QE, the Bank of Japan assets will be shortly heading well over 60% of GDP, as compared to the US and Europe’s 26%.  This action is designed to offset the bond selling of about ¥32 trillion ($280 billion) from the Japan’s national pension plan which is lowering its domestic bond holdings from 60% to 35% by increasing equities (both domestic and foreign) by 26% and foreign bonds by 4% (the 5% in cash is being eliminated).  The ¥127 trillion ($1.15 trillion) plan therefore will be a bullish underpinning to the world financial markets during the near future, and to the equity markets in particular.  With the Yen already moving lower, it is a good thing that oil prices are also moving down, which should be supportive economically.  But there are still big questions out there such as the restarting of Japan’s nuclear electrical generation program and the next hike in the national sales tax next October.  Like the Japanese military planners seventy years ago, Abe is going all in on his bid for victory (though in the economic realm rather than the geo-military one).

Macau’s losing streak continues per the Wall Street Journal with its monthly gross gambling number for October at -23% year-on-year.  Chinese Q3 GDP growth missed the +7.5% target to come in at +7.3%, technically a miss but still close and higher than the most dire predictions.  Industrial Production rose in September, but Retail Sales and Fixed Asset Investment had slower rates of growth, month-on-month (though still sizably positive in absolute magnitude as per the graphs to the immediate left).  Note that while housing sales have declined over 10% for the same period a year earlier, investment in real estate still increased, exacerbating the oversupply.  Total debt is running at 251% of GDP per Standard Chartered Bank (was at 147% at the end of 2008) and credit is still growing at nearly twice the rate of nominal GDP despite the slowdown in new lending.

Hey!  Where Did My $100 Oil Go?  Finally, energy consumers are seeing relief as oil prices tumbled from about $91 per barrel for US WTI crude to under $81 during the month of October.  While we at Coloma have felt for the last number of years that the oil markets have been reasonably supplied, prices stubbornly refused to comply.  falling cost of shale productionWhat changed?  Undoubtedly the shale market has played its role with cost per well declining overall as recently noted by the Financial Times for a prominent shale player (and arguably one of the best shale producers, EOG Resources (the old Enron Oil and Gas which survived the Enron blow-up as it was already spun off)).  While not every firm can match its cost structure, in its recent financial reporting, EOG noted that its best wells would still generate a 10% return even if WTI oil prices slipped to $40 per barrel.  The research firm IHS published recently that the median North American shale development needs WTI oil at $57 per barrel versus last year’s estimate of $70 per barrel.  Simply put, the US can produce oil cheaply, and it is.  Meanwhile, other nations that have more expensive production costs or face a lack of investment – Brazil, Venezuela, Russia, Iran have been slowing their production growth.  The Middle Eastern low cost producers – Saudi Arabia, Kuwait, UAE and Qatar have recently decided to not cut back production to maintain prices but instead expand market share.  Some of this is geopolitically related – low prices have a very damaging effect on political enemies (e.g., Russia depends on oil exports for 40% of its government revenues).  Some of this may be related to gaining leverage at theOPEC price crunchupcoming OPEC meeting on November 27th.  Other possibilities are related to the idea that OPEC needs to undercut alternative fuels.  However, the plentiful supply is being met with an anemic demand – slow Europe, slowing Asia.  The US is meeting much of its demand from supplies in its own hemisphere – Nigeria which used to export up to 1.6 million barrels a day (about 8% of US demand) to the US, now sends zero barrels of its high quality crude – for the first time since 1973.  This month, Saudi Arabia actually reduced its selling price to the US while increasing the Asian selling price.  One item to monitor is that US oil and gas explorers have issued a lot of high-yield debt – about 20% of the issuance in YTD 2014 – and if they cannot pay, then that will generate volatility in the markets. 

In other energy news, fuel efficiency improvements have slowed as SUV sales have increased with the EPA estimating that 2014 will see a gain of 0.1 mile per gallon of gasoline instead of the 0.5 mile in 2013.  With gasoline in the low $3 range in northern California (one of the most expensive areas in an expensive state), one can understand the temptation.  With low oil prices, India has backed away from its state controls on retail diesel prices in order to reduce the cost of fuel subsidies which cost $11 billion in the fiscal year just ending (subsidies still are in place for cooking gas and kerosene).  Even Tesla reacted with lowering lease rates on its electric cars by 25% to make its cars more competitive – sales of its Model S sedan are down 26% year-on-year for the nine months ending September.

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

Additional information sources:  Bloomberg, Financial Times, New York Times, South Bay Research, United ICAP, Wall Street Journal and Zerohedge.

[1]  See!_Tora!_Tora! for reviews/details on the noted film that was nominated for five Academy Awards as well was a big hit in Japan with both American and Japanese directors, cinematographers and screenwriters.  And in case I did not state my views clearly enough, I make the comparison only from the view of a surprise and not a suggestion that Japan today is an aggressive or militaristic nation.  I think that Japan has a very restrained foreign policy, especially compared to China and North Korea, and view Japan as a valuable ally and friend to the United States with a transcendent culture and dynamic history.

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