The world ambled through summer – no one wanted to rock the boat until the kids are back in school and adults go back to work. The US continued its good-news / bad-news cycle that seems to make for low volatility markets but with an underlying sense of unease. Q2 GDP growth was finalized at +1.1% (a touch lower) but Q3 GDP expected growth is holding at a strong +3.5% per the Atlanta Fed. Other economic indicators are mixed as well. The Presidential electoral process remained full of pre-school antics with more to come at the first debate at the end of September. Puerto Rico is a mess and the ballyhooed Federal Oversight Committee is still being formed – they will not make any recommendations until after the election is over as unpopular items like spending cuts or credit write-downs are likely to be part of the package. The UK put up some positive post-Brexit numbers to everyone’s surprise. It is still early days but we wish them well with their EU negotiations. Scrutiny over the ECB’s bond-buying plan (Q€) increased given the rapid decline of available bonds to purchase as well as appearances of corporate favoritism. Greece’s financial situation and Spain’s political situation also are still lurking as issues. Russia made more invasion / aggression noises at the Ukraine. More investors became worried over China’s debt situation as global trade continued to falter. Korea allowed one of its largest shipping companies to go under, forcing creditors to seize assets and stranding cargos. In a state-supported and guided economy like Korea, this is a notable turn in government policy. Finally, OPEC and Russia are looking at trying to put together a production freeze agreement at the end of September to support oil prices. Saudi Arabia is looking ahead to its IPO of Saudi Aramco and all of the producers desperately need oil profits to manage their social and military spending. With record production and inventories, an agreement may falter quickly and US shale oil would also step in with any price increases. Grains, livestock and metals all seem to be well-supplied with only softs (coffee, sugar, cocoa) still fighting off some adverse weather. All the major central banks meet this month – we expect status quo or further dovishness as outcomes.
No August Surprise: Janet Yellen may have spoken in tones that sparked rate risk chatter, but the Federal Reserve will not do anything before the election. There may be some wild notions posted before their meeting on September 21st, but best to look past the noise to other parts of the world. Q2 GDP came in slightly lower at +1.1% – disappointing from the first number announced last month but still higher than Q4 2015 and Q1 2016. With the Fed forecasting +3.5% for Q3, there is still optimism to hit some of the bigger levels last seen in 2014. Payrolls for August missed expectations at +151,000 versus +180,000 but the unemployment rate stayed low at 4.9%. Underemployment also moved to lower levels (9.7%), albeit not much different from the beginning of the year. US job openings pushed higher on a total level as well as on an openings per hire basis. Federal Reserve figures on wage growth looked promising as year-on-year average hourly earnings moved to +2.6% in July, the highest level of 2016. Some more figures: July industrial production was up +0.7%, an uptick from June’s +0.4%. Orders for business equipment as well as factory orders also climbed to mark their best improvements for the year. July retail sales, on the other hand, failed to improve as while automobile sales were positive, non-auto sales slipped -0.3%. However, with gasoline retail sales down due to lower prices, this result may not be so bad. Existing home sales (seasonally adjusted) fell for the first time since February with the blame put on lower inventory. Closings were relatively quick as properties were on the market on average for 36 days in July, compared with 42 one year ago. Finally, the Congressional Budget Office projected higher deficits and debt to GDP than last year’s forecast, essentially driven by an aging population requiring more health care and retirement spending while contributing less to GDP (i.e., lower productivity). While we do not expect any lasting impact from the election, either from the result or from the Fed’s review of the economy, there should be a jitter or two along the way.
One possible disruption could be from Puerto Rico, which is just looking worse and worse – exhibit A are the three state pension plans which are estimated to have $2 billion in assets to cover $45 billion in future liabilities. Adding insult to injury, $1 billion of the assets have been lent to plan members for mortgages and “cultural travel” so retrievable assets are even lower. Recall also that $70 billion of government debt is also outstanding. Given the general poverty of the island, reduced payments would have a severe effect on at the individual level, but cuts seem to be in the cards. The oversight board that is supposed to magically make everything alright has been named by President Obama but is considered to be creditor friendly by the market. A chair has not been designated and time will be needed to deliberate and gather facts. Anything that will eventually happen will not occur until next year, in my opinion. Further south, President Rousseff was impeached and the Brazilian stock market roared its approval (YTD, it is up +37% and up +67% in USD terms!) despite a troubled GDP. Hard times are still ahead on low commodities prices. At least the Olympics went off reasonably well (though PM Abe of Japan stole the show with his Mario Brothers act!). Argentina is still struggling with lower GDP and higher unemployment (hitting 9.3% in Q2), though inflation is under control and that is a clear success. We continue to wish President Macri every success in turning the country around.
You Must Be Talking About Europe: …when the area grows at a +0.3% rate over the second quarter (not annualized) and it is considered a success. Germany grew at +0.4%, twice the rate expected but about half the rate of Q1. …when Spain’s debt-to-GDP ratio reaches the highest level in a century at just over 100% of GDP and its ten-year bond rate is at a record low 0.9%. …when even France can dip its unemployment rate to under 10% to 9.9% despite the lackluster GDP growth. The Eurozone unemployment rate is still slightly above 10% however, at a five-year low. …when Spain still does not have a government despite two more parliamentary votes. New elections will likely be held around Christmas 2016 if a new government is not formed by the end of October. …when Italy’s Prime Minster Renzi will undergo a personal referendum in October or November on his performance – and it could go either way, leaving Italy rudderless into the new year … when ECB monetary policy seems to be completely out of whack with reality as so little qualified German debt is available (only 35%), that the ECB will have to start to overweight Italian and Spanish bonds – which are at least positive yielding! Or continue to load up on corporate debts – note those bonds that are eligible for ECB purchase are trading 25 basis points better than those that are not. Picking corporate winners is the ECB way. No major changes were expected in ECB policy when they met on September 8th and that is what happened. An extension of QE from March to September 2017, expansion of qualified assets or other measures were considered too much at this stage. …when Greece’s latest bail out is held up and may be scaled back as the promised reforms from earlier this summer have fallen well short of promised. …when France’s year-on-year July industrial production figures fell much more than forecasts (-1.3% versus -0.4%). …and when the UK defies short-term Brexit expectations with better than expected numbers (for now at least) in retail sales (see left) and manufacturing PMI when it came in at 53.3 for August, against expectations of 49 and a five-point increase from July’s 48.3 reading. The Bank of England meets on September 15th and while may loosen, it could just as easily hold off.
You also know you are talking about Europe when Russia creates trumped-up Ukrainian “incursion” evidence in their latest attempt to rile up the region and distract its population. At least it is understandable that Turkey’s Erdoğan turned around and made nice with Putin – 57% of Turkey’s natural gas comes from Russia. Besides, regional tyrants have to stick together (though who will replace Uzbek thug Islam Karimov, ruler for 25 years?). Finally, you know that you are talking about Europe when some of the biggest banks in Europe have capital shortfalls per the latest ECB stress test that are bigger than their market capitalization – looking at you Deutschebank. Not easy being European when events are heading in the wrong direction.
…Or Talking About Asia: China has many resources but their slow shift away from export-led industrialization to a consumer-led balanced economy is still a difficult one. Global trade is not making it any easier with exports falling by a worse-than-expected -4.4% and likewise imports by -12.5% in July compared to a year ago. However, fuel exports hit a record and crude oil imports also increased but a subsequent change in tax enforcement may halt this trend. The overall trade balance in US Dollar terms is close to monthly highs. Foreign exchange reserves have stopped falling after the splurge from late last year to early this year as policymakers shifted from outright stimulus to bank support and regulatory adjustment. Looking at the economy further, July’s numbers came up short – industrial production rose +6.0% in July from a year earlier, less than the projected +6.2% gain, retail sales climbed +10.2% last month versus the estimate for +10.5% and fixed-asset investment increased +8.1% in the first seven months of the year, compared with a projection for +8.9% growth. Hong Kong retail sales year-on-year remained in negative territory but appear to have flat-lined. The official Chinese PMI gauge reached its highest level in 2 years – 50.4 in August was up from July’s 49.9, showing some expansion of manufacturing activity.
Chinese banks are looking now to build up their equity capital to cover bad loans while the rest of the world seeks yield. The ratio of non-performing to total loans held steady in Q2 for the first time in three years, but that was due to the denominator increasing by 15.7%, implying that the non-performing loan numerator increased by a like percentage or a higher yuan amount. To quote Bloomberg, “[the figure for nonperforming loans rose] in the second quarter to 1.44 trillion yuan ($217 billion). To put it another way, there were more nonperforming loans in China at the end of June than Vietnam’s entire 2015 GDP.” In addition, there are unofficial nonperforming loans called “special mention loans” which are loans that are expected to go bad but have not yet (technically). This amount also increased, to 3.32 trillion yuan ($500 billion). And then there are the loans at the provincial level. Typically we hear about how deep in debt provinces and municipalities are, but in a twist, Shanxi province has had to extend the maturity of 400 billion yuan ($60 billion) of loans it made to its coal mining businesses in a bid to keep those dying businesses afloat just a little longer. To put these numbers in perspective, the seven largest coal groups in Shanxi have 1.18 trillion yuan in debt – equal to the provincial GDP. The comparison is not completely fair but it gives a sense of the magnitudes under concern. As they say, a billion here and a billion there and soon you are talking about real money.
Japan’s economy missed GDP growth expectations for Q2 with an increase of only +0.2% on an annualized basis, far short of the +0.7% number projected by economists. A stimulus package was duly unveiled, but as is the norm, a big headline number of ¥28.1 trillion ($277 billion) translated into ¥6.2 trillion ($61 billion) of new planned spending with ¥4.6 trillion ($45 billion) or 0.9% of GDP to be spent in the current fiscal year. It is something but underwhelming. Global trade hit Japan too in July as exports fell 14% on an annual basis for the 10th consecutive monthly fall. Industrial production fell more than expected (see graph above right) though unemployment also fell to 3.0%. That low figure unfortunately hides a lackluster full-time employment trend versus strong part-time employment. Similar to the US, employment gains are primarily amongst the old (see left), and in Japan, primarily with women as men increase the ranks of the long-term unemployed. Also like the US, the Bank of Japan is reviewing monetary options this month on September 21st, though the BOJ is expected to act: to lower rates further or have some other expansion of its QE policy. Can monetary policy overcome an aging population? I do not think so but the Japanese government is trying everything. Finally Korea gave up financial support of the world’s seventh-largest container shipping company, Hanjin Shipping, and allowed it to proceed into bankruptcy. Amongst other things, Hanjin handles 40% of Samsung’s exports and 20% of LG’s. Right now creditors are swarming over their vessels, tying up $14 billion in freight in various ports around the world. While overall shipping capacity is still plentiful, this event will further snarl global trade.
An Age of Plenty: Oil production and supplies are still at highs no matter how one measures it. To update the US storage, the amount in above-ground storage continued to rise counter-seasonally, beating expectations (see graph to the immediate left). US crude oil stocks rose by a bigger-than-expected 2.5 million barrels as refineries trimmed runs by 1% and at 523 million barrels are 16% above the year ago level and 27.4% above the five-year average. Yes a recent hurricane did cut into imports for the first week of September, but that is just a small interruption. US production is still off of its highs (see right), but the US drilling rig count continues its rise off the low from to 374 on July 29th to 407 on September 2nd. OPEC output hit a record 33.5 million barrels per day, with Saudi Arabia hitting a record 10.67 million barrels per day in July and a possible 10.9 million barrels per day in August. Iran and Iraq are producing incrementally more, with Iraqi successes against ISIL liberating oil fields and refineries, indicating futures increases. Nigeria came to a tentative cease-fire with its rebels, allowing repairs and a limited oil production increase. Even Libya is beginning to export crude oil again with its first cargo from Ras Lanuf since December 2014 and a second one up for charter. Russia’s Rosneft, the world’s top listed oil producer by output, said crude oil production was 4.11 million barrels per day in the second quarter, up +0.5% quarter-on-quarter. Another demonstration of low oil prices and a lack of enthusiasm for drilling is that the US’ Bureau of Ocean Energy Management sold 140,000 acres of oil and gas exploration leases in the Western Gulf of Mexico for a total of $18 million – the lowest bid for the region ever. Finally, a new massive (25.5 billion barrel estimated) deepwater field was found off the coast of Newfoundland, Canada, which is a long way from producing but will struggle to gain interest at the $45 per barrel pricing we see these days. OPEC is meeting on September 26th to the 28th to consider again an output freeze but with Iran refusing to limit production and contradictory language by Russia and Saudi Arabia, we doubt that it will occur. More theater.
Looking ahead, China is still building out its Strategic Petroleum Reserve but the current capacity is close to filling and more needs to be built before its goal of 90 days of supply is reached. Meanwhile the sum of diesel, gasoline and kerosene exports surged to a record – tripling the monthly average volume of 2015. Independent refiners shipped excess fuel abroad, further challenging global refinery margins. US gasoline usage reached a record in July but it is not enough to soak up the volumes produced – and driving season is almost over. The volume of gasoline supplied to domestic consumers averaged 9.7 million barrels per day (bpd), an increase of 273,000 bpd compared with the same month in 2015. However, as one can see to the right, we are well supplied. People can afford those SUVs. Natural gas did have a demand pull at the end of July as some extra heat cut into the seasonal build cycle. Texas in particular set a peak electricity demand record. More natural gas plants in operation this year as coal and nuclear plants went off-line also shifted demand for the commodity. Inventories are still above the five-year average however. Japan is restarting its fifth nuclear reactor after the Fukushima disaster in 2011 as it weans itself off oil and coal plants. The process will remain slow due to protests and lawsuits.
In grains, we see strong if not record supplies in all the row crops. Wheat prices are at ten-year lows as harvests in Russia (to be the largest wheat exporter this year), Ukraine (5% increase over last year), Australia (largest in five years), Canada (second largest in twenty-five years) and the US all contribute to record production of 743 million tonnes (up 1% from last year). The USDA is projecting record corn (15.15 billion bushels) and soy (4.06 billion bushels) crops, though with what we feel are over-aggressive yield numbers. Even reduced, the crop will be quite impressive. Russia is also projecting a record corn crop. Meanwhile China’s soy imports in July fell 18% year-on-year – as a buyer of 60% of the world’s traded soybeans, this is a big deal, though China did front-load its purchases earlier this year. US crop conditions remained at superior levels with both corn and soy dramatically above averages and last year. Finally, US farmers are rebuilding their livestock inventories, with hogs at record levels. Apart from softs (coffee, sugar, cocoa), we see ample supplies of commodities available over the next several months.
In market news, John Corzine and co-defendants settled with regards to their involvement in the MF Global collapse as insurers will pay $132 million to make up losses. He bet with other people’s money, destroyed one of the largest firms in the business and walked away. Though he had better stay out of Chicago! Finally, Hong Kong’s stock exchange is looking to list RMB-denominated metals futures at smaller notional values than the LME. We will see if this can capture some of that wild commodity trading seen on the mainland!
Best of investing!
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.