August 2014 Global Macro Recap

Upon reflection, August felt as if the differentiation that has marked markets the last few months began to reverse as global macro factors appeared to take precedence, at least since the middle of the month.  This is not due to a convergence of economic news (US appears to be slowly recovering while Europe is still sliding and Asia is more or less in the middle) but that Dr. Draghi of the ECB informally announced new QE-style stimulus at the central banking confab at Jackson Hole this August.  With that news, the “risk-on” trade was on, with a currency twist of the US dollar strengthening as well as Euro/Swiss Franc floor set by the Swiss National Bank under threat (the SNB has said that it will not let the EUR/CHF level pass 1.20).  Asian markets (at least the Nikkei 225 and Shanghai Shenzhen CSI300) were flat as their economies still face headwinds.  Although commodity prices were generally synchronized in terms of direction (down), industrial metals stood out with modest gains on hopes for more Chinese stimulus spending.  Russia closed out the month more blatantly interfering in the Ukraine and is on the verge of formally seizing territory.  Appeasement did not work in the 1930s and 40s, and it will not work now with Putin.  Once a Chekist, always a Chekist[1].  While the long-term may hold advantages for Ukraine in terms of economic growth and freedom, Russia seeks to extend its gains while it can.

It’s All About the Benjamins:  The top line of the US economy ticked up as Q2 GDP growth was revised upwards to +4.2% from +4.0% (annualized, seasonally adjusted) as the large inventory contribution was trimmed in favor of improvements in business investment and net trade.  Corporate profits as a percent of GDP also were close to the all-time highs of 2013 (10.6% in Q2 2014 versus 10.7% in Q1 2013).  Industrial output climbed 0.4% in July driven by the sharpest increase in automobile production in five years.  Durable goods orders rose by a record 22.6% in July, propelled by a 318% increase in aircraft orders.  Stripping out that effect, non-defense capital goods orders without aircraft fell by -0.5%, but had a big positive revision for June.  So net-net, positive.  Finally in factory space, the purchasing managers’ index had its best reading since March 2011 of 59.0 in August, fuelling speculation that 2H GDP will be better than Q2.  We do not see the factory improvements in helping net goods exports, which lost a little ground in the first half of 2014 versus a year earlier.  While holding the line in a growing economy is a plus, the stronger dollar and the redoubling of efforts on exports by China and other countries may limit gains. 

On the consumer front, retail sales were unchanged in July versus June as employment Existing Home Sales 2001-2014gained but hourly earnings stayed low, up 2% year-on-year.  That may be enough to counter inflation, but little else.  Overall household spending declined a seasonally adjusted -0.1% in July, reinforcing that data.  Home sales were modestly positive overall, with new homes falling 2.4% (about 10% of home sales), existing home sales (the remaining 90%) growing +2.4% and the percentage of sales classified as distressed declining to 9.0%.  Unemployment for August ticked down to 6.1% as did the underemployment rate (to 12.0% from 12.2%).  The change in non-farm payrolls for August disappointed at growing only 142 thousand, below the 200 thousand seen recently and the 230 thousand expected.  Mass layoffs are still occurring as Cisco Systems is laying off 6,000 (about 8% of its global workforce). 

This muddled labor picture was commented on often by Janet Yellen at the invite-only global central bank meeting in August at Jackson Hole.  Between that and low goods inflation (especially if food and energy prices stay under pressure and the US dollar stay strong), I can see her keep rates this low for the next few years, if not the remainder of her term (through February 2018).  A forecasted risk to this dovish future is the re-expansion of the US deficit starting in 2016 per the latest projections by CBO as older demographics increase social security and medical payments.  The increasing issuance of government bonds due to an increasing deficit may start putting pressure on higher interest rates, assuming the Federal Reserve does not embark on a QE4.  Other risks include some kind of government bailout of Detroit or Puerto Rico, both of which stumbled through the month without defaulting.  Detroit appears to be zeroing in on a plan that will hit pension plan bond insurers (90% loss) and municipal bond holders (26-66% loss depending on the bond) as well as the pension plan (4.5% cut to current retirees and no cost-of-living expense increases (police/fire lose only cost-of-living expense increases)).  Puerto Rico also delayed losses as it announced a deal to defer $9 billion in loan payments until next year.  It still will not have the money but the leaky tire has been patched for now. 

Argentine Peso - Argentine Central Bank ReservesIn the rest of Latin America, Argentina basically defaulted on its debt at the end of July and continued to try to maneuver through August by offering up a swap to its holdout creditors that would fall under Argentine law which would allow for easier defaults and restructurings.  Needless-to-say, no one took up President Kirchner’s “deal.”  Currency reserves are slowly declining as the country’s trade deficit consumes dollars.  In early August, the government confiscated foreign currency held by its banks by lowering the amount of assets Argentine banks can hold in foreign currency.  Another 20% devaluation as seen in January 2014 seems all but inevitable per some analysts.  Venezuela too continued its downward spiral as airlines stopped flying to Caracas since the government refused to pay $3.8 billion owed in foreign currency to airliners.  Without money for fuel or parts, service has been cut in half.  Ironically, the state-run airline had no plane available for its standard Caracas – Buenos Aires route!  Therefore, international travelers are stuck with the bus – good thing the Andes are low!  Brazil slid into a recession in Q2 as the economy contracted by -0.6%, on top of the -0.2% lost in Q1.  This economic malaise coupled with inflation of 6.5% puts President Rousseff in big trouble to keep her seat in the upcoming elections, despite early errors by her main rival Marina Silva.

Misery Loves Misery:  Anyone captivated by Draghi’s smiling face as he announced Eurozone Consumer Price Indexesanother round of lower interest rates and bond-buying is living on hope and prayer.  With Eurozone inflation at a five year low (+0.3% in August – see graph right from the Wall Street Journal), and anemic GDP growth as recovery in Spain was offset by flat or declining results in France and German (see graph below, again WSJ), monetary authorities are worried that inflation will not save their governments from the heavy, if not crushing, debt burdens taken on before and during the financial crisis.  Meanwhile the growth promised by monetary expansion continues to elude policymakers (possibly because no painful fiscal or labor reforms were made).  Q2 GDP grew at 0.0% in the Euro-Zone.  Vaunted manufacturer Germany actually posted -0.6% for the three month period as trade with Russia dried up as well as competition from Japan’s weaker Yen.  The next largest economies, France and Italy, posted Eurozone - Change in inflation-adjusted GDPcontractions as well (-0.1% and -0.2%, respectively), offsetting Spain’s +0.6% and Netherlands’ +0.6%, which round out the top five economies (about 85% of the region’s GDP).  The purchasing managers index – a measure of manufacturing activity – was weaker in July and August – still barely indicating expansion, but at a lower rate than before and below expectations.

In country news, Italy is stuck in reverse, slipping into the third recession since 2008 in Q2 2014.  With public debt expected to reach 135% of GDP this year, Premier Renzi faces a challenge to the perception that he can reform Italy.  A recent embarrassment is the failure to privatize the national post office this year, with the delay to 2015 announced at the end of July.  Due to raise 12 billion, the move to sell off 40% of the organization has been complicated in a scandal related to the post office’s investment in the national airline Alitalia, which is expected to go bankrupt this fall without additional bailouts.  Decaying infrastructure plagues Italy’s highways, railways and ports – the time to ship from an Italian port is 17 days, above the EU average of 11 days, forcing exporters to truck goods elsewhere for export.  And where will the €11 billion needed to make repairs come from?  Send your answers in the mail.

Ukrainian fighting is settling into a new phase.  The fledgling republic was making good headway against the Russian unionists / Ukrainian separatists until the big bear stepped in unabashedly and started firing artillery at Ukrainian positions, moving in tanks and directly controlling Ukrainian soil.  As we predicted last month, Russia had to go all in or go home… and they went in.  Putin perceives the world through the eyes of Lenin (not the barbaric eyes of Stalin), through the vision of power.  One of Lenin’s often-repeated political sayings translated into English was “Who to whom?” or “Who can do as they want to whom?”  Putin will continue to bully others until he’s knocked down.  Will sanctions be enough?  Maybe.  Historically sanctions have not been sufficient to overthrow regimes.  Sanctions will push him away from Europe and towards Asia, though given the rise of China, India and Islamic states, there are few attractive choices in that direction.  And so he is forced to close a few McDonald’s restaurants and ban food imports.  The main question is whether he will invade the Baltics next as they have relatively large Russian populations left over from the Soviet years.  Obama and NATO has said no, but I do not think that Putin takes the US and Europeans very seriously.  However, the summer fighting season will be running out when the rains start, so the opportunities for quick gains are slipping away.

Slowing, slowing… wait for it…:  China and Japan put up sluggish numbers in August Slumping China's Economy Indicatorsas the European slowdown set their economies back.  Industrial production in China fell back -0.2% as new lending has fallen and housing sales dropped (below left).  The PMI (see the second half of the graph to the right) also fell to a marginally expanding reading.  China - New Yuan Loans and Housing Sales 2014The concern over housing has been in play for a few years.  Some statistics that should be sobering, if not surprising.  Per the Financial Times, the ratio of housing prices to annual household income (back in 2011) is about six in New York but twenty-three in Beijing, sixteen in Shanghai and thirteen in Shenzhen (Hong Kong comes in at thirteen and London at seven to give perspective).  In terms of resources, China has produced more cement in two years than the US did in the entire 20th century.  Looking at the importance for local government revenues, land sales made up 60% in 2013 per JP Morgan.  In June 55 of the largest 70 cities had lower real estate prices compared to 35 of 70 in May.  Unsold inventory is said to have reached an all-time high at the end of July.  In reaction, construction has basically stopped (see graph at right from the FT).  Who still owns the stock of Chinese property developers?  At least banks may have a number of alternatives.  The four largest state-owned lenders have started raising $73 billion in debt and equity to cover reserve losses as well as started securitizing loans to suckers investors with asset-backed bonds exceeding $19 billion so for.  Perhaps Draghi will be a buyer if they can sell them through a European subsidiary.  China's Property ConstructionFinally, the government has allowed five local governments to set up “bad banks” to buy out non-performing loans in their region.  Let the bailout begin!  Officially the Chinese economy grew at +7.5% in Q2 2014 but their questionable accounting will catch up with them at some point. 

Turning to Japan, the GDP fell a substantial -6.8% annualized in Q2 as the hike in the sales tax from 5% to 8% on April 1st had a chance to affect the economy.  This more than offset the gain of +6.1% in Q1 as consumers stocked up on goods before the increase took affect.  Consumer prices rose +3.4% in July including the sales tax.  Maybe Abe is getting his inflation but without economic growth to go with it, his citizens will be the poorer for it.  Industrial production moved up slightly by +0.2% in July but not enough to cover June’s slump of -3.3%.  Ironically enough, trade with China has Japan's GDP Quarterly Change 2009-2014improved, growing for the first time in three years (since the beginning of the territorial dispute with China).  The amount though is not enough to make up for the losses so far. Jumping on the economic malaise bandwagon is Thailand which is forecasting GDP growth of +1.5% for 2014, lower than the earlier expectations as tourism and industry are still depressed after the months of civil strife.  

Slowdown Seen in Commodities:  The above news is having a bearish impact on commodities.  Both WTI and Brent Crude Oil have fallen as fall refinery maintenance has started to lower the demand for crude.  Saudi Arabia even lowered its selling prices to Asia.  There are the usual geopolitical worries but they have proved largely irrelevant in markets recently.  “Winter is coming” but in these short-sighted markets, few appear to be worrying about Russian supplies to Europe or disruptions to Libyan or Iraqi exports.  South of the US border, Mexico has moved forward in setting aside exploration rights for foreign investors, a first opening in its government oil monopoly.  Will this change Pemex’s corrupt ways or will the national oil firm slide into marginal relevance, with the resulting impacts on employment, government revenues and domestic politics.  That said, Mexican industrial costs and capacity look to improve as exports of US shale natural gas lower costs, especially versus rivals such as China.  Citibank estimates that Mexico’s manufacturing costs have gone from six percentage points higher to four points cheaper versus China.  NAFTA could see a second wind.  Not to leave China out – Tesla has entered into a joint venture to build 400 charging stations in 120 cities with its cellular partner China Unicom.  Hopefully this innovation will not accelerate the burning of coal!  China does not need more pollution!

The bumper crop of grains in North America, South America and Europe is joined by China as the country is on for an 11th straight year of production increase.  The 75 million tons of excess grain (rice, wheat and corn) are estimated to double what is in storage already in its warehouses.  Any sales will exacerbate the fall in prices already seen in the US, which is expecting record yields (as a side note, our corn estimates in particular are much higher than the most recent government view in August of 167 bushels per acre, which are expected to move to the low 170s in the September report).  US farm incomes are projected to fall 13.8% in 2014, the lowest in four years, per the US Department of Agriculture.  However, that is better than the 27% drop the USDA projected in February, mainly due to the record prices for livestock.  Soft commodities also face gluts, with a strong sugar harvest underway in Brazil and a larger cocoa harvest than expected by about 10% per the International Cocoa Organization.  Only coffee faces a tight harvest with drought in Central America and Brazil (expected to have a 9.3% small harvest).  Sugar also is likely taking a hit from Mexican lawmakers implementing laws that limit the amount of food marketing to children (which unsurprisingly is mostly sugary processed food) in an effort to combat obesity.  With one-third of children overweight and a high rate of diabetes overall, Mexico is taking the lead in this area of public health.  I wonder when the US will do the same (and we would be the better for it).  In corporate news, Cargill is buying ADM’s chocolate business to better compete with the dominant player out of Switzerland, Barry Callebaut AG.

And while you never know what you will find in your carpets, the San Francisco Mint in 1886 found 170 ounces of gold when it burned the rugs from the room where the miners brought in their gold to be weighed.  Not a bad haul!

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

September 10, 2014


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

[1]  A member of the secret police and a term often now applied to the ruling siloviki or “people of power” in Russia especially if they have a KGB or FSB background.