The dovish central bank tone continued in April with a few twists and a realization of a massive fiscal boost by the world’s second-largest economy. This in turn fueled a risk-on mentality particularly in commodities, which are generally perceived as the most (only?) under-valued asset class after losing about 1/3rd of its value during the last twelve months ending March. Stocks and bonds benefited as well, but with less drama. Economic conditions are still wobbly with the IMF lowering its 2016 global GDP growth forecast slightly from +3.4% to +3.2%, with only China showing a modest increase in the large economies. Politically, there are a few nasty surprises hanging over the year: Greece debt negotiations are dragging on, new Spanish elections are required after the previous ones failed to produce a new government, fighting in the Middle East continues (and perhaps will restart broadly in Ukraine) and the US election cycle will enter its final phase into November. While muddling through is still the central scenario, any one of these potential events (or a China slowdown/debt crisis or collapse in Venezuela or other such catalyst) could throw us on a new track – or in front of a speeding train. May looks to be relatively quiet – no central bank policy or OPEC meetings, so enjoy the spring while it lasts. It could be a long, hot summer.
No Action is Action: The Federal Reserve chose to not act on raising rates and the commentary was fairly dovish, sending money into risk-on trades. While we believed that the Fed would not increase rates at this meeting (and they did not), apparently the market was worried enough that the no-action decision sparked a relief rush to buy across commodities, equities and other “risk” assets. The interest rate projections by the members did decline (the infamous “dots”) but the drama was in the reaction not the meeting. June is the big one, however – no meeting in May. Will the economic and geopolitical winds allow for a modest one-step hike?
So far the data says… maybe. US Q1 2016 GDP came in at a disappointing +0.5% annualized rate on lower business investment and contractions in inventories, partially offset by lower but positive consumer and government spending. Existing home sales came in at a nice increase of +1.4% with a positive adjustment to the previous month. Factory goods orders also rose more than expected (+1.1% versus +0.6%) with capital goods ex-defense and ex-aircraft rose +0.1%, an improvement from the previous loss of -2.7%. On the other hand, overall industrial production fell -0.6% in March, below the -0.1% forecasted and both February and January were revised downward. US corporate defaults led global defaults, largely on failed oil shale producers and reach a post-2009 high. Unemployment stayed at 5.0%, though future cuts are coming from Intel, who announced 12,000 eliminations or 11% of its workforce as it transitions further from computer chips towards mobile phones and specialized devices. Job increases disappointed for April (+160k versus +200k expected). Undoubtedly Janet Yellen will be paying close attention to this going into the June meeting.
In non-US news, South and Central America extended their good news / bad news cycle. Argentina successfully sold $16.5 billion in bonds, upsizing the deal on strong investor demand and improving its rates. Now the country has enough money to pay off its old creditors as well as start the new government forward. Cuba also got into the act by meeting with creditors who own defaulted bonds from the 1980s – it is too soon to see a deal but there seems to be steps towards reform in that closed economy. Finally Mexico’s official unemployment continued to fall, as shown on the graph to the left. Puerto Rico and Venezuela, however, continue to move in the opposite direction. Puerto Rico officially defaulted on its government development bank bonds by not paying $400 million in principal due in May (though $72 million in interest and other debts will be paid). The real test is July when a total of $2 billion is due with $805 million due in general obligation bonds, which are supposedly covered by law to be first in line for payment (over government employees and other obligations). We shall see if Congress grants them leniency or lets them default – simply put, they do not have the money. Venezuela also continued its death spiral, as even nature conspired against Maduro. The local drought threatens to shut off the country’s main hydroelectric plant at the Guri dam, which provides one-third the electricity. Officials announced rolling blackouts starting the last week of April. Importing fuel is not much of a solution as foreign reserves fell to dangerously low levels, with only $12 billion available versus being double that a year ago. With only $7.8 billion reportedly in gold, there is little backing payments for oil or diesel. Perhaps the most visible tragedy is the halting of beer production by Venezuela’s largest private company, Polar. With a 75% market share, the brand is a national icon and identity for the country. However, with no access to foreign exchange to buy barley and other materials, there is little to be done except suffer in the sweltering heat. And yes, Brazil’s president Dilma was moved a step closer to impeachment. Not an auspicious sign with the Olympics looming.
Kicking the Can: While no new decisions came out of April’s ECB meeting, Draghi did clarify and expand the types of debt that are permissible under the expanded Q€ program announced in March. Specifically of interest is the acceptability of buying Euro-denominated debt of non-European companies – such as that offered by US companies. This is a large market segment as American firms issued over 20% of Euro-denominated debt in 2015 (such as €2.25 billion last September by Apple). Minimum credit ratings are investment grade: BBB- or higher. Not exactly premium collateral. With the expanded universe including any company of size able to issue in the Euro-area, this is a truly global Q€! And also basically a giant credit hedge fund, being able to issue at government-debt rates and buy yield with proceeds. At least the ECB does not have to pay 2/20 and can print money to cover any losses. Low rates also enabled Belgium to issue 100-year bonds at a 2.3% coupon and France to sell €3 billion in 50-year bonds at 1.9% and €6 billion in 30-year bonds at 1.3%. After inflation, does anyone really think that these are positive-yielding investments?
At least some of the economic news is positive, with Q1 GDP growth at +0.6% for the quarter (not annualized) with France and Spain leading the way (higher than the US (+0.1%) and UK (+0.4%)). However, as the graph shows, there is a lot of catch-up to go (the x-axis is in years starting in 2008, the vertical access has been indexed to 100). Employment also improved in March with a 10.2% level versus 10.4% in February and 11.2% in March 2015. German retail sales had a big miss with a fall of -1.1% in March and Germany has started to recognize the budget impact of the migrant crisis by planning to prohibit refugees from claiming unemployment benefits for five years – longer than first contemplated. We have only begun to see the ramifications of EU generosity on this multi-societal matter.
There are likely bigger issues facing Europe, however. First, Spain has failed to form a government as the parliament was too divided, forcing King Felipe to call for a new election June – basically the party of the Left (the Socialists) failed to form a government with the Far Left (Podemos) and the Center (Cuidadanos) while Podemos demanded that the Socialists kick out Cuidadanos from the proposed coalition. Four months later, the voters (who are still just as divided it seems) will have to try again. Good luck. Meanwhile, Italy is pretending to try to deal with its bad loan situation (estimated at €200 to €360 billion depending on the definition of non-performing loans). The government formed a “bad bank” with contributions from Italian private banks to take on the bad debt but raised only €5 billion. If levered to the maximum, the estimate is that it could buy only €70 billion of the bad debts – not nearly enough to clean up the problem. However, it immediately spent €1.5 billion on an IPO for a mid-tier bank, Banco Popolare di Vicenza so one-third of the capital is unavailable for its original purpose. How do you say “farce” in Italian? Perhaps the ECB will bail them out. Austria did not bail out their failed Heta Bank – they announced that the private banks with the loans will take a 54% loss with a wipeout of the equity. Bloomberg has reported that the debtholders have already written down the debt to 50% so there should not be any surprise losses. The question is about the remaining 46% of assets – who will be paid and how much? Finally, a discussion about bad debts cannot be complete without talking about Greece. As without the money to pay €2.8 billion in principal and interest to the IMF, ECB and EIB (the troika) in July, Greece is negotiating to receive part of the money promised to it under the 2015 negotiations when it was allowed to borrow more money because it could not make payments to the IMF back then. Yet again, the country can only repay today if it borrows more. The troika is becoming a bit worried about continually increasing their exposure to the decaying country and so has been dragging their feet. Will they in the end give enough to kick the can down the road to next summer? Mostly likely yes, but only after many headlines and political accusations (migrant crisis political posturing anyone?). The only question is when this charade collapses, not whether.
Can You Say Fiscal Stimulus? China turned to tried-and-true credit expansion to boost its GDP in Q1, with total net debt increasing about $1 trillion in the first three months of 2016 to a total of about $25 trillion or 237% of March’s GDP per the Financial Times. This percentage is comparable to similar measures in the US and Europe as seen in the graphic to the right which uses numbers from the Bank for International Settlements, and paints the same picture. In comparison, looking at 2007, debt was only 150% of GDP, similar to current emerging market countries. If we look at history, the picture indicates China has had to increase credit growth in order to propel its GPD, and at a faster rate. As the graph below shows, China used to be able to increase its GDP in line with credit growth but since 2009, has had to spend twice to three times as much for each unit of GDP increase. As a lesson to central bankers and politicians everywhere, there is a limit to how much credit can spur economic activity – which seems relevant for not just China but elsewhere too.
The results of all this expenditure has been less than impressive. First, manufacturing is still in the doldrums, with the latest official purchasing managers’ index coming in at 50.1 – essentially not growing (50 is the neutral mark). A private gauge that includes more mid-sized businesses is showing a contraction with a reading of 49.4. The March numbers were decent with retail sales (+10.5%), industrial production (+6.8%) and fixed asset investment (+10.7%) beating expectations. GDP growth however, only met expectations (+6.7%). Automobile sales picked up in March at a +7.8% rate. However, these sales may be illusionary as it takes invoices a record 192 days to be paid per Bloomberg, up from 125 days in 2011, assuming that payments are actually made. If payments take that long, who knows if one will actually be paid in the end? China’s Liaoning province, an industrial base including the prominent city of Dalian, had negative GDP growth in Q1 2016, falling -1.3% in real GDP for the quarter. Dependent on manufacturing and steel mills, it is the epicenter for much of China’s overcapacity issues. Finally, the excitement for March’s exports and imports was short-lived as April’s numbers were both declines. Exports fell -1.8% year-on-year in US dollar terms versus expectations of a -0.1% decline. Imports likewise declined but a more dramatic -10.9 year-on-year) versus -5.0% expected. The trade surplus increased but without imports of raw materials and machinery, market watchers question the GDP growth in the rest of 2016.
In Japan, the central bank made no change in terms for their already-negative rates, bond purchases and QE. It kept its stock market purchases at the same pace (¥3 trillion or $27 billion annually), though it is already in the top 10 individual holder of almost 90% of the names of the Nikkei 225 (and a top 5 holder in about 25%). Sample ownership percentages include 9% of Fast Retailing (the clothing chain Uniqlo), 5% of Kikkoman (processed food) and 3% in Yamaha (conglomerate) and Daiwa House Industry (Japan’s largest homebuilder). What kind of influence does the BOJ wield over these firms? Will it stay a passive holder? What happens if the stock market goes down 10%? It seems like a precarious and narrow-minded situation, even though it does directly prop up equities.
Doh! on Doha: No deal in Doha as the Saudis refuse to freeze production while Iran still increases theirs. Oil prices faltered momentarily on the news but then continued upward as speculators focused on lower US production and disruptions in Kuwait, Venezuela and Nigeria. Kuwait’s oil workers had a brief strike which was resolved in a few days with an apology to the Emir but that got the market excited. Meanwhile, Venezuela is becoming quite desperate, despite having one of the largest oil reserves in the world. Despite needing to pump oil for hard currency, production has declined slightly, not increased. Rolling blackouts plague the capital and the local drought is threatening to shut the Guri dam which provides one-third the country’s power. Rebel attacks in Nigeria have damaged oil platforms and pipelines run by Chevron and Shell respectively. While the total impact has been modest so far, continued attacks could capture the media’s attention. Finally our thoughts go out to the people of Fort McMurray as wildfires swept through the city, causing the evacuation of over 80,000 people. The local oil projects so far have escaped notable damage as fire crews work valiantly to minimize additional destruction. US oil rig count continued its decline from 362 on April 1st to 332 as of April 29th though with higher prices, there is debate how much further this will go. ConocoPhillips cut its 2016 capital spending budget again, this time from $6.4 billion to $5.7 billion. No announcement was made on personnel cuts. On the bullish side, US gasoline demand rose at the fastest annual rate in almost forty years in February (just over +5%). We do still have the most gasoline around in history, both in absolute and on a seasonal basis so keep buying those SUVs. Looking ahead, the EIA expects that the global energy markets will be close to balance by the end of the year. Given how the Saudis, Iranians, Russians and yes even the Americans are mostly keeping up on the supply side and the faltering economies of Venezuela, Brazil, the Middle East and perhaps Asia are weighing on the demand side, I am skeptical that any moves toward $50 in current prices can last, if even get there at all.
In other energy news, Peabody Energy, the world’s largest private coal company declared bankruptcy as the firm lost $2 billion last year. Three of the top four coal companies (41% of US production) are now operating in bankruptcy. With natural gas prices still at lows, coal is step-by-step being removed from the US energy footprint. Note that Saudi Arabia and Exxon Mobil both had their credit ratings lowered, with Exxon losing its AAA status for the first time in 70 years. This leaves only Johnson & Johnson and Microsoft as US corporations with the highest of ratings. China (the number one coal producer) still mines four times as much as number two US so the industry is still facing more restructuring both here and abroad. Finally, the CME is closing the physical trading floor in New York, silencing forever the pits at the NYMEX and COMEX. Chicago still has a physical trading location for financials and options on grains and livestock, but I assure you that it is a shadow of its former frenzy.
In grains, the winter harvesting and spring planting in the Northern Hemisphere is proceeding at a rapid clip, matching or exceeding the results of last year. American inventories (e.g., corn pictured to the right) are expected to be plentiful. This is not just true for the US, but Russia’s wheat harvest is expected to be the largest in eight years, offsetting declines in Ukraine. China is looking to sell out some of its corn and cotton reserves as inventory in storage is outpacing the need. Brazil and Argentina are still expected to deliver good crops despite recent cuts to production on poor weather. The short summary is that the world has plenty of grains and this year is looking like more of the same, despite issues in the Southern Hemisphere. China has no shortage of industrial metals and grains, but it does have a demand for pork as retail pork prices moved from 17.35 yuan per kilogram (~$1.20 per pound) a year ago to 25.76 yuan (~$1.80 per pound) in April. Imports from Europe has led the way but the United States has also stepped in. China also has started to release pork from its reserves in order to combat this food inflation – pork by itself has a 3% weighting in the Chinese consumer price index!
Finally, gold has lost its appeal to silver, at least recently, as a falling US dollar and a bid for industrial metals pushed the grey metal over yellow cousin. However, like other industrial metals, it faces a continued production surplus. Silver production is actually projected by UBS to increase by 20% by 2017. Gold does face challenges if China’s stimulus falters or if the US raises interest rates in June but it still is the classic reserve currency.
David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource
Additional information sources: BAML, BBC, Bloomberg, Deutsche Bank, Financial Times, The Guardian, JP Morgan, PVM, Reuters, South Bay Research, Wall Street Journal and Zerohedge.