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January 2015 Global Macro Recap

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  • Global Macro Recap

January was a month full of surprises:  some met with cheers, some induced panic.  The United States’ big news was the Q4 2014 GDP growth figure, which, while decently positive, was notably below expectations.  +2.6% is a number Europe would kill for but against high expectations around lower gasoline costs and reasonable unemployment numbers, it did not meet forecasts.  Instead, Europe stole the show with four big headlines:  1) the Swiss National Bank letting the Franc float freely after three years of a ceiling with the Euro, 2) an expansion of quantitative easing (Q€ in shorthand) by the ECB to include government bonds, 3) Greeks electing a far-left party to power (actually a coalition of small far-left parties) and 4) a step-up of fighting in Ukraine by the Russian separatists despite the winter weather.  Economically, Europe is still stumbling and, with uncertainty around debt write-offs and a pernicious failure to restart growth, there does not seem to be any relief on the horizon.  Oil’s collapse to the mid-$40s should offer some help to the consumer pocketbook, but with central bank focus on inflation, the macro-optics in the short term look poor.  In Asia too, the economic winds are not blowing in favor, as a slowdown in Europe impacts demand for Chinese products.  Japan is also struggling.  Here, however, the fall in commodities prices in January offer respite to the consumers in the region.  In commodities news, the plunge in oil prices caused a massive pullback in capital spending plans, with the cutbacks in both personnel and expenditure.  Given that US-based shale oil is relatively flexible and responsive to prices, it seems that the US will face the brunt of the cuts, though some will occur in the Middle East, the North Sea (between the UK and Norway) and Asia.  Production will continue to increase in the next few months as the rigs will still operate on the most productive wells and on sites that were under development (might as well earn back the sunk cost).  However, by the middle of the year or so the supply situation may be changing.  Something to monitor.

Hope Springs Eternal:  Going into the first estimate of Q4 2015 GDP, economists as a group expected an annualized growth rate of +3.1%, hoping that the +5.0% growth rate of Q3 would carry over. Fourth Quarter 2014 GDP Growth Alas, at +2.6%, it did not.  While consumer spending performed well, lackluster international trade, business spending and government spending all inhibited economic activity.  Durable goods orders fell -3.4% in December as well.  One silver lining in this is that +2.6% growth is more than the +2.3% average since the recovery began.  Another is that businesses may be holding out for lower input prices to maximize profits before spending money more aggressively, which may show up in 2015 Q1.  All-in-all, the numbers were generally good, not great, which means that their influence on the Federal Reserve upcoming rate hike decision will be modest (as well as not for another five months, at least).  With the continuing fall in food and energy commodities prices in January, one would expect similar impact on that month’s inflation.  That said, declining commodities prices should be transitory so one should reassess at mid-2015.  Employment figures continue to be good with 252,000 jobs created in December, beating estimates and causing the headline unemployment rate to fall to 5.6%.  Retail sales for the holidays in November and December did well, with same-store sales up +5%, topping forecasts.  Again, the takeaway for January is “so far, so good” for the US economy, despite some of the uncertainty out there. 

Venezuela continues on its death spiral, with the IMF projecting a GDP decline of -7%.  Oil revenues have collapsed with oil prices, further compounded by the lower quality crude that Venezuela produces (and the corresponding discount it always receives to benchmark prices).  Their $21 billion of foreign currency reserves can easily cover the $1 billion coming due March but the $9 billion due at the end of the year will be trouble – without help.  And a savior arrived!  President Maduro announced that China gave more funds in exchange for more oil but the terms (and even if this is new money or a repackage of old money) are unknown.  Note that these arrangements make the $20 billion of Chinese “financing” senior to the $75 billion of publically traded debt (note that the total debt is ~$119 billion per the World Bank).  Moody’s downgraded the country to Caa3 in January so the countdown continues.

QE is dead, long live Q€!  The ECB did expand its bond-buying program (TLTRO) to include government bonds as discussed last month, but the surprise move was that the Swiss central bank a week prior announced that it was halting the ceiling on the Franc/Euro exchange rate that it had been defending for the last two years.  In other words, it allowed the CHF to gain against the Euro as investors sought refuge from currency losses due to Q€.  The way the central bank did it though was by complete surprise, like ripping a bandage off a wound.  The price moved from 1.20 to 0.80 to 1.00 CHF/EUR is one of the largest percentage moves in foreign exchange history.  To help people try to comprehend this, imagine the panic if the US Dollar moved 20% in a day!  Swiss companies will have lower profits in CHF terms – hitting their stock prices.  In more unusual fallout, CHF was the currency used for hundreds of thousands of mortgages in Poland and Hungary so those individuals will see higher monthly payments, hitting the GDPs of those emerging market countries.  Not good…

Why did the Swiss do this?  With the ECB moving to broad-based Q€, the wave of money heading to Switzerland could have easily overwhelmed the Swiss ability to maintain the ceiling.  The Swiss bank’s balance sheet had already doubled in the last two years defending the upper limit, reaching 86% of GDP – higher than the Bank of Japan (60%) and the post-QE Federal Reserve (25%).  The Swiss government is benefiting however by expanding negative interest rates, including its 10-year bond.  Investors are paying the Swiss government for holding their money for ten years.  Also, the Danes, who use the Krone, also moved to greater negative interest rates to force currency speculators to pay for the privilege of buying their currency (which is tightly pegged to the Euro).  By early February (jumping ahead a little), Denmark had cut its overnight rate four times from -0.05% to -0.75%.  So more distortions in an excess currency-dominated world. 

The ECB did not wait for Greece to go off the deep end – Draghi pledged to expand and schedule the ECB bond purchases to €60 billion per month, split between private and government debt (in a ratio of about 1:5) starting in March 2015 going through September 2016 at leastQE Eligible Sovereign Debt in Eurozone Greece is not included in the bond purchases as that country has to renegotiate its debt program with the troika, supposedly by the end of February.  Since the new program starts in March, the Greeks may be allowed to join in time but we will not speculate whether they will be included.  We do think that there will be a new lending deal for Greece since they cannot function without more money or defaulting, but not sure what that deal will look like.  There is about €4 trillion of government debt outstanding (per the table from the FT) and the program will look to purchase €0.9 trillion which is almost 25% of all eligible European government debt!  Not only that, given the ratios of government debt between EU countries, a sizable portion will be Germany’s debt – which has negative interest rates out to five years!  Investors can simply buy now and flip their positions to the ECB for a profit – even with the negative rates.  After all, buyers of the 30-year German bonds made 43% in 2014 from capital appreciation.  European inflation may be the lowest on record thanks to falling energy prices – for the record, Europe is technically in a slight deflation for the year ending January (-0.6% annualized).

Greece had an election and everyone voted!  Well, enough to elect a Syriza victory.  Who is Syriza?  It is a conglomeration of seventeen separate left-wing parties (with names that inspire confidence like “New Fighter” and “Renewing Communist Ecological Left”) that seeks to end austerity and, by extension, repudiate the government debt – without leaving the Euro or any negative consequence. Average maturity of Government Debt - Interest Expenditure in % GDP Yes, it is a government platform based on asking for free money and then spending it without reservation (higher pensions, free electricity, free medicine, subsidized housing, 50% higher minimum wage).  The problem is that Greece owes €12 billion in bond payments by August, money it does not have (€20 billion the end of 2015) and most to the IMF which does not want to miss its repayment.  In fact, the country is still trying to get the last €4 billion from the troika under the current program… which expires February 28th.  So will the EU let Greece default?  The expectation is “no” which can only mean that more money must be given to Greece or current debt must be forgiven.  However, only 25% of the current debt is traded by investors (including domestic Greek banks) so the ability for only them to take 100% of the loss like last time (remember?  It was only a few years ago) is very limited.  Also, in looking at the debt profile (right, from the FT), Greece’s debt has a very high average maturity and relatively low interest expense.  This is because a large portion of the troika debt is not due for forty years and interest has been deferred for up to eight years.  In short, Greece, despite the largess extended so far, still cannot make its basic payments.  Thus, who will lose money on the next “extend and pretend?”  The bond holders, i.e., the European governments, because that is who owns the debt.  We are just waiting for the details.  At least whatever the result appears to be approaching soon…  Opa!

Russia stepped up its military efforts in Eastern Ukraine as the situation continued to deteriorate at home.  The Ruble slipped from 60.7 per Dollar to 69.5 at the end of January – a nice 15% drop.  Oil’s collapse to the mid-low $40 per barrel caused the Russian Finance Minster to announce a cut in spending of about 2% of GDP or $45 billion but few specifics were given.  At any rate, the military is still due to receive a year-on-year increase and pensioners (usually targets of budget cuts) were going to instead receive an increase in line with inflation (11.4% in 2014).  The obfuscated effect on the budget and the resulting drain on reserves caused both Fitch and S&P to lower their credit rating – with S&P moving their score to junk (BB+).  As we said at the outset of this crisis, it is a race against time, and Russia has plenty of reserves ($385 billion per the IMF as of December, but down $123 billion for all of 2014) to draw upon in the near term.

Still Shaky:  A weak Europe still translates into an underperforming China, which came out in a number of statistics in January.  At the highest level, 2014 GDP growth was +7.4%, the lowest increase since 1990.  2015 is not expected to be higher, with the IMF projecting a +6.8% figure.  Property sales were down -7.6% in 2014 as real estate spending continued at +10.5%, resulting in an estimated +26.1% increase in unsold floor space.  Prices of new homes in big cities fell -4.3% from a year ago.  The prominent developer Kaisa managed to avoid default at the last minute as 49.3% of it was bought by a rival property developer, restoring value to $2.5 billion of offshore bonds.  A government investigation is still ongoing, however.  Turning to foreign trade, imports plus exports rose +3.4%, half the goal of +7.5%.  All these results are good compared to most other countries, but the slowing trend is worrying.  China’s latest PMI (a measure of factory activity) shrank for the first time in two-and-a-half years with a reading of 49.8 for January.  Like the US, low oil prices are seen as a boon for the economy but as the fourth largest oil producer in the world, it hurts politically important industries. Chinese oil demand still reached a record, based on refinery processing and imports, and the country’s strategic reserve build-out appreciates the low-cost oil.  Looking ahead, in early February, China announced a cut in its required reserve ratio for its banks, effectively adding $96 billion in potential lending.  Are there $96 billion in good-quality loans out there?  Is this a desperate move to try to inflate up the economy one more time?  Or is it a caving into QE?

As a warning to readers about politicians lying while telling the truth, Japan claimed that it is on track to meet its goal of cutting its budget deficit as a percentage of GDP in half before debt issuance and interest costs, largely because of higher tax revenues from the increase in the sales tax last year.  That is semantically true.  Of course, the reality is the total debt will continue to increase as a percentage of GDP as the government does have interest costs and also needs to issue debt (less than 2014, but still has to issue).  QE (Q¥?) may adjust the timing of when that debt will come due, but the bonds still need to be repaid and the government does not have the money.   The actual budget deficit for 2015 is a record $812 billion or almost 20% of GDP.  And yet, Japan’s finance ministry still worries that they are not causing inflation, which moved up in December at +2.5% year-on-year (+0.5% ex-food, which is what they consider as core inflation).  Oil prices will stop going down and the lower fuel prices should ease overall costs for this energy-importing nation, helping businesses and consumers.  But that is for later this year.  Separately in the good news department, India’s growth rate was revised upward for 2014 from +4.7% to +6.9%, though partially due to changes in how the statistics are measured.

Sound Retreat!  The fall of oil futures by another 10% in January set recent low in the mid-$40 range, but with the earnings season upon us, the universal cry of cutbacks in capital spending by the oil majors paused or perhaps finally have halted the collapse from almost $110 per barrel seven months ago.  The price of gasoline stopped going down in the middle of January despite high inventories, as we are close to entering the shutdown season for refinery maintenance. Oil Rigs - BAKEOIL Index The numbers are decently large, with workers laid off from Baker Hughes (7,000) and Schlumberger (9,000) capturing headlines.  Every energy firm announced big spending reductions (e.g., Chevron -$35 billion, Shell -$15 billion, Conoco -$11.5 billion are some of the headline numbers) for 2015 timeframe.  Oil rigs have been coming off line (yellow line below left) as existing wells became uneconomical, falling 24% from the high in October to the end of January (note the graph at left shows the continuing trend through the first week of February).  However, production in terms of barrels is still increasing (white line at right) as oil flow starts strong and then declines. Also there will be drilling to maintain leases, generate cash flow for operations and feed refineries.  The Department of Energy forecast in January still had US production increasing 0.6 million barrels per day to 9.3 million in 2015, though we suspect that there will a leveling off or decline underway by year-end.  This will keep oil prices under pressure in the next few months as inventories increase (highest ever already!  Plenty of room to grow too!) from this strong production and refinery maintenance limit current demand.  The current strike by refinery workers adds further uncertainty into the mix. 

In non-US energy news, the long-expected death of King Abdullah bid Abdulaziz al-Saud of Saudi Arabia caused the ascension of his 79-year-old half-brother Crown Prince Salman bid Abdulaziz to rise to power.  We do not expect much of an immediate difference in policy as the new Crown Prince was pre-determined, but the designation of the Deputy Crown Prince to Mohammed bin Nayef who is of the next generation marks the passing of the direct heirs.  His statements and actions promise to be the ones to watch during the upcoming years.  China’s crude imports in December broke its 7 million barrel per day record as low prices and an expansion of their strategic petroleum reserve prompted opportunistic and planned buying.  Note that China is now the world’s largest oil importer and fourth-largest oil producer (and still growing) so they will find a use for all the crude that the world is sending their way.  Low oil prices are causing government budget freezes in Canada as oil sands projects need to have $60 WTI prices to be profitable, at least for new investments.  Existing plays are still profitable at $30-$35, so, like the US, Canada will face a slow decline in their production in the short term.  Finally what is probably the most unusual corporate event was Schlumberger’s purchase of 45.7% of Russia’s largest drilling company for $1.7 billion with an option to buy the rest within three years.  Obviously a gamble over the future of sanctions against Russia, internal Russian politics and the low price of oil – but we salute their courage!

Best of investing!

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

February 9, 2015

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

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