August 2015 Global Macro Recap

The United States continued to generate positive though generally mediocre economic headlines in August with the most important being a substantial upward revision in Q2 GDP from 2.3% to 3.7%.  All components improved, from government spending to business investment to household consumption.  However, a wobbly stock market fell into retrenchment mode as overseas news, particularly from China, triggered a mini correction.  Levered players, particularly global macro and risk parity strategies, were forced sellers as they had to rebalance risk or try to cover in the face of the reversing trends.  The upcoming FOMC meeting in September may see the Federal Reserve raising rates a token 0.25% but even that small move is still in doubt.  Europe still is showing mixed economic signals as to a true recovery and is facing geopolitical risk in the form of a Greek election in September which will determine whether the bailout goes through, an increasingly hot war in Ukraine and refugee crisis that threatens to divide society further and add costs to a region already in deficit.  China stepped up its crackdown on those individuals and firms that it blamed for lower stock prices that threaten the confidence in Xi’s leadership.  So far these measures have failed with the Shanghai Composite down -11.8% for August.  Further measures are underway but as long as the government continues its heavy-handed approach, domestic and foreign investment will stay away and undermine Xi’s goals.  In short, the government is shooting itself in the foot.  However, given Xi’s harder-line predilections, I see little chance of a real turnaround in policy.  The government has plenty of reserves that it can draw upon so the economy can at least keep growing but not with the innovation and vibrancy that Xi is looking for.  To quote last month’s commentary, “since history shows that stocks can go down even without massive selling, my thought is to stay away until the market returns to normal (which could be a few years).”  We are still seeing a lot of commodity production despite some more coordinated attempts to rein it in at the end of the month.  Oil prices staged a strong rally during the three last days of the month with US-based WTI Crude Oil moving from $38 to over $49 per barrel.  Rumors of Saudi negotiations to increase crude oil prices, downward revisions in 2015 US oil production and the Saudi invasion of Yemen all sparked the turnaround.  However, with the broad indices flat to down, even this dramatic move was just noise in the grand scheme of things.

Sloppy Summer Skittishness:  When the humans are away on vacation, the algobots take over the markets and sometimes strange things happen. After meandering all year around flat, the stock market took a 10% hit on ideas that the Federal Reserve may raise interest rates 0.25% at their September meeting as Q2 GDP came in surprisingly stronger at +3.7%, an upward revision of 1.4% over the first estimate and 0.3% higher than economist estimates.  All factors contributed to the upward revision, with business investment the strongest contributor (primarily on intellectual property) followed by business inventories.  Inventory builds can be negative as they sometimes indicate weaker demand but with consumer spending also revised upward, that may not be the case.  It certainly reinforces last month’s upward revision in Q1 GDP to positive territory and thoughts that the US economy is still heading in the right direction.  Factory production rose more than forecast in July (+0.8% versus +0.4% expected) due to record automobile assembly and oil drilling moved upward from its lows, pushing up total industrial production (+0.6% versus +0.3% expected) for the month as well.  Seasonally, however, South Bay Research pointed out that the main manufacturing push for 2015 is over and the fall/winter should see a decline in payrolls going into next year.  Given the quality of these jobs, this could be a strong headwind.  The latest unemployment report has the rate at 5.1%, down -0.2% on a modest increase of 173,000 and upward revisions for the last two months.  For now, all is well with the consumer as Retail Sales rose in July +0.6% and June’s negative number revised upward to 0.0%. 

All this decent to good news does not necessarily mean that the US’ Federal Reserve will raise rates at their upcoming September 16th-17th meeting.  There was no real signal at their Jackson Hole annual conference in August (in fact, it seems that the overall mood was dovish) and the skittishness in the stock market will also give the FOMC pause (though it should be ignored, in my opinion).  China’s selling of US Treasury bills/notes/bonds over the last few months also may prompt Yellen to hold off ending QE as someone needs to absorb their volume.  Inflation still is missing, though the deflationary food and energy components of the last twelve months or so have reached pretty low levels and are more likely to stay flat or move up instead of fall further.  While I feel that a rate increase would be perfectly acceptable and perhaps welcome by the markets if accompanied by lower expectations for 2016, I suspect that uber-dove Yellen and committee will not raise rates this month and perhaps even this year (let alone during an election cycle in 2016).  No obvious inflation so why tempt fate when there are other policy agenda items in play?

In our Puerto Rico debt monitoring, the territory w its first default as the public utility PREPA negotiated a 15% reduction in principal on $5.7 billion of its bonds.  Given that the island has over $72 billion in debt, this is known as “a good start.”  The state of Illinois took the first step toward default as it failed to make a monthly payment to an escrow account for a December 15th payment.  It has time to make up the missing funds but this is the first step toward true payment default.  The basic problem is that the state does not have a budget – and as such even lottery winners are receiving IOUs instead of real cash per the Chicago Tribune.  Can you imagine struggling year after year, buying tickets on a dream, finally winning the lottery and only to be told that you cannot receive your lucky prize?  Heartbreaking!

Error on the Side of Weakness:  While one can credibly argue that the US is relatively overachieving, Europe still is showing on the underperforming side.  There are some pluses – Spain is seeking to pass an expansionary budget with tax cuts, higher salaries for public employees and more spending on education and military.  Debt-to-GDP is still high but is supposed to drop to 98% from 101% next year as the projected deficit is supposed to fall to within the EU guidelines.  With general elections expected this December, PM Rajoy is obviously looking to extend his leadership.  Switzerland avoided recession as Q2 GDP unexpectedly grew +0.2% instead of falling by that amount.  Tourism supported consumer spending, which was stronger than forecasted.  However, deflation of -1.3% is what pushed real GDP into positive territory.  Overall European unemployment declined to its lowest level in over three years to 10.9% in July from 11.1% in June.  The Q2 GDP number for the Eurozone increased a disappointing +0.3% for the quarter, missing analyst estimates, as France stagnated and Germany, Italy and the Netherlands all grew less than expected.  Greece posted a surprising +0.8% Q2 GDP growth rate but, like Switzerland, it was due to a deflationary adjustment of -1.5%.  A quirk of accounting.  Unsurprisingly, Eurozone industrial production fell in June by -0.4%, following a -0.2% decline in May and no growth in April.  So what is the result?  On September 3rd, ECB President Draghi announced a minor expansion of his QE plan to allow the purchase of a higher percentage of a particular bond than before, allowing the bank more flexibility and concentration of its purchases.  He also expanded the possible duration of the overall program and thus greater bond market manipulation.  For those wondering, German interest rates are still negative for three-year bonds.

Looking at our old nemesis Greece, there is a bailout deal in place though with conditions.  First, the deal:  Greece is going to receive €86 billion over three years as reforms are enacted with €26 billion up front to pay off the IMF and other current debts to the ECB and EU (AKA the Troika) and €10 billion to recapitalize banks (whacking the current equity holders).  Reforms are to include actually selling off assets as long-promised under the first reform packages, cutting off early retirement to lower pension expenses as well as some higher taxes.  The IMF’s involvement is still unknown.  Debt-to-GDP is supposed to peak in 2016 at 201% and then decline to 160% by 2022.  With Greek GDP expected to be down -2.3% in 2015 and still running a deficit, these ratios seem optimistic (as have all the previous forecasts).  However, the first asset sale was already announced with German firm Fraport-Slentel winning the lease rights to operate fourteen regional airports associated with tourist areas for €1.23 billion.  This the largest deal since the first bailout in 2010.  This capitulation by PM Tsipras to the Troika forced him to dissolve the government and call for elections on September 20th.  If he loses, then this bailout deal may collapse though the main opposition is the conservative New Democracy party which will likely also support the bailout.  However, neither party is expected to win a majority which may lead to further political uncertainty and a collapse of the bailout.  Of course, solving a debt crisis with more debt seems untenable so perhaps this result is best.  Hard to say.  

On the Eastern Front, the financial and physical war grinds on.  On the fiscal front, Ukraine secured a debt restructure with its largest creditors for a 20% write-off on $18Ukraine Inflation and GDPbillion and a four-year delay on $11.5 billion of principal payments.  There is a sweetener on the back end with a new proviso that states that creditors will receive up to 40% of the value of Ukraine’s annual GDP growth in excess of 4% for the years 2021 to 2040.  Russia’s $3 billion bond coming due in December is not under the agreement but this restructuring paves the way for a four-year $40 billion financial support program led by the IMF.  While it will add to the overall debt pile, there is a lot more potential with the Ukraine than with Greece so I welcome these developments.  Meanwhile, on the ground, fighting continues in the Russian-dominated eastern Ukraine where heavy weapons that were pulled back from the February ceasefire have been moved forward again by both sides.  200 Ukrainian soldiers have been killed and 2,000 wounded since the ceasefire was signed.  The front lines seem to be pretty static so far so the Russia’s desired land bridge to the Crimea remains elusive.  While the economic situation in Ukraine is bad, Russia too continues to suffer from low oil prices and renewed Western sanctions over the Ukraine fighting and kidnapping an Estonian (from Estonia) and sentencing him to 15 years in prison.  Q2 2015 GDP fell 4.2% versus Q2 2014 as industrial production (-5.0%), retail sales (-9.4%) and household income all suffered.  The ruble has moved from around 50 to the US dollar to 64 since the spring, adding to inflation.  With the IMF projecting negative GDP growth in 2016 as well, there the pressure on Putin will continue.

Massive Market Manipulation:  One cannot accuse the Chinese government of being too subtle as the leadership pulled out all the stops to reverse the 11.8% fall in the stock market – cutting interest rates further, lowering the reserve requirement for bank lending, devaluing the currency to spur exports by the largest one-day change since 1994, increasing required margin on equity futures contracts to index shorts, imposing punitive collateral requirements for foreign exchange forward trades, increasing the subsidized swap program for struggling municipal debts, directly buying stocks to an estimated total of $200 billion over the last two months, arresting eleven people by the end of August for alleged stock manipulation (i.e., selling shares) including a financial journalist for causing “panic and disorder” and punishing 200 more on “online rumormongering.”  With also the questionings and arrests of a number of human rights lawyers over the last few months, are we slipping back into the Cultural Revolution?  IsChina Labor Demand Index Mao’s Little Red Book to be carried by all?  Quashing dissent and repressing market activity is not the way to revive an economy in the modern age, not if Premier Xi expects innovation and technology to lead China this century. 

On the other hand, the economic statistics continue to look worrisome as labor demand contracted in July for the first time since 2012 per a FT proprietary index (see right), the official Purchasers Manager Index lost its bullish bias with a 49.7 print (below 50 means contracting factory orders), exports fell -8.3% versus a year ago July (an increase to the US was offset by declines to Europe and Japan), auto sales dropped -6.6% year-on-year (though Chinese brands increased), bad debt increased 22 basis points to 1.82% of assets during the first half of 2015, industrial production rose less than expected (+6.0% versus +6.6%) as did retail sales (+10.5%), oil demand fell (down -4% versus June), and electricity consumption fell 1.3% year-on-year in July (offsetting June’s gain).  Basically, Xi needed a big military parade to distract people from his lack of stewardship of the economy – and he got it.  Let us see what is next.

The rest of Asia continued to struggle under the Chinese deceleration with Japan’s industrial production falling -0.6% versus an expected gain of +0.1% and Q2 2015 GDP falling -0.4%, though slightly better than expectations.  Private consumption, business investment and net exports all fell as small wage increases did not translate into more retail spending.  Japan successfully restarted its first nuclear reactor since Fukushima disaster shut all nuclear plants four years ago.  As more reactors are restarted, PM Abe is looking to lower electrical costs by 20-30%, the amount of the increase since the 2011 mass shutdown.  A modern society needs cheap electricity and this process not only can revitalize Japan’s GDP at a crucial time but also lower pollution as the country can shut down the coal and crude oil plants that filled in during the interim. 

China consumer data

Plenty of Oil Post-Summer:  While oil prices staged a nice recovery at the end of the month (moving from $38 to over $49 per barrel), they have stabilized in the mid-$40s – still far away from the lofty $110s from last year.  Rumors of Saudi negotiations to increase crude oil prices, downward revisions in 2015 US oil production and the Saudi invasion of Yemen all sparked the turnaround.  Saudi production has declined slightly, going from 10.6 million barrels per day (mbpd) in June to 10.4 mbpd in July.  But with their budget deficits requiring them to raise ~$27 billion over the remaining months of the year (which does not cover all of the deficit mind you), it is unlikely to me that they would cut back unilaterally.  With OPEC and Russia coordinated, but that again is unlikely with cheating by Russia to deal with its own fiscal situation liable to scuttle the deal in the end.  As a side note, the drawdown in Saudi Arabia’s (and everyone else’s) sovereign wealth fund means a headwind for financial markets generally.  Another way to look at the impact on oil revenues, is a year ago OPEC members between them were collecting over $3 billion a day in revenues.  They are now collecting only $1.5 billion despite a 2 mbpd increase in production.  Not good if your budget depends on oil revenue!  And the view is not positive there – the US oil rig count rose all through August from 664 to 675 (though the count fell back to 662 for the week ending September 4th), Obama has the votes to ensure the Iranian nuclear deal passes the US Senate (though it may take two votes to make it happen), and China confirmed that it is indeed lending $5 billion to boost Venezuelan oil output which will be paid back in oil shipments (making the total lent $50 billion).  Venezuela currently sends about 700,000 bpd to China.  That means less Middle East oil demand by the Middle Kingdom – and with lower prices, greater negative price pressure on Russia and Gazprom’s oil pipeline project to China.

On the bullish side, the US government’s Energy Information Agency revised oil production lower for every month in 2015, causing a year-on-year projected decline in oil production for the year, not an increase.  Most of the changes were in Texas, not in the newer fields in North Dakota.  The change is due to deeper producer survey data, eliminating a number of EIA estimates.  This revelation supported the move higher at August month-end.  Layoffs are still being announced – ConocoPhillips announced further job cuts of 10% of its workforce to be added to the 5% reductions already made – but their impact on oil production and prices has not been fully felt.  However, US inventories at Cushing, Oklahoma, and the Gulf Coast (the key storage areas for US oil) still are a 33% combined higher than month-end August versus last year.  In addition, Canada’s largest refinery decided to no longer take US Bakken shale oil but is now importing Brent crudes from the Middle East – lightening the stress seen last year on oil-by-rail congestion.  In looking ahead, I still see the oil industry being burdened from high rates of production versus global demand for the next number of months.

In natural gas news, Italian oil producer Eni announced a “supergiant” field off the coast of Egypt so large that it eclipses Israel’s Leviathan discovery (30 trillion cubic feet potential versus 22 trillion) – basically 100% of Egypt’s natural gas needs for ten years.  The improved energy situation in Egypt comes at an opportune time to improve their fiscal situation.  In other Middle East news, Saudi Arabia, Bahrain and the UAE have all sent troops into Yemen to defeat the Shia forces supported by Iran.  Will it escalate the conflicts in Syria, amongst other places?  The Russians are building up an airbase in Syria to conduct flights against ISIS, Kurds and other rebel groups – more destruction for sure.  Will the US/Europe bomb that airbase?  Engage those planes?  Give surface-to-air missiles to rebel and Kurdish groups?  What if the Russians attack the US or Turkish planes?  Just when you thought the situation could not get messier, it steps up a notch.

In grains, US crops are still looking good – the condition of corn and soy are quite good versus the averages and the latest USDA figures show bumper crops.  Brazilian soy August shipments were reported at 5.5 million tons, up from 3.8 million last year, with a 13% increase year-on-year for the season as a whole.  China is still the destination of choice, taking 16.5% of Brazilian beans and almost 25% of Argentine beans.  With plenty of space available in US railroads due to fewer oil shipments, local grain can get to the market, unlike last few years.  Will farmers / silo operators panic?  There is a lot of on-farm storage but if next year is also a good crop then prices could get ugly.  In wheat, France, Europe’s largest grower, had a record year of 40 million tonnes versus 37.5 million last year on record yields.

Metals still look to be under pressure with Freeport-McMoRan cutting capitalChinese Aluminum Marketexpenditures for 2016 by 30% (from $5.6 billion to $4.0 billion) and is looking to cut its US workforce by 10%.  It is no better in aluminum where Chinese supply is out of control as the FT graphs tellingly show – and the pressure seems highly unlikely to fade without some major plant closures and layoffs – which in turn are highly unlikely in employment-sensitive China.   

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

Additional information sources:  BBC, Bloomberg, Deutsche Bank, The Economist, Financial Times, Fox Business, The Guardian, JP Morgan, PVM, Reuters, South Bay Research, Wall Street Journal and Zerohedge.