The mood of the markets turned a bit on edge in February as January’s giddiness subsided. This is not to say that results soured – the S&P 500 continued its bull run, although on lighter volume. But apart from approaching the psychological milestones of the previous highs, the real economy continued to drag. Americans debated the budget sequestration which came into effect on March 1st, the world debated the possible “currency war” actions of the Japanese and the Europeans debated which tune to fiddle while Rome burned. In the end, sufficiently nothing happened. Or alternatively, something very important is maybe just starting to happen – the fits and starts of the political and social process to deal with the excess of the 2008 financial crisis and its aftermath which has led to even more excesses. This is very slow and uncertain but one can see glimpses of it in the US budget debates, the Italian election results (or lack thereof) and current Chinese and Japanese financial plans which are being drafted now as well. Gradually (even leisurely) there is a refocusing away from financial solutions (though there is still QEternity and central banker jawboning) and toward real economic solutions (i.e., political decisions on spending, taxes, investment and consumption). When will this re-prioritization occur, how much will each segment of society pay and whether will it happen soon enough are the fundamental questions.
Why Can’t We All Just Get Along: February was set up to be a busy month in Washington DC as members of both parties at first looked ready to battle over the sequestration, but in the end, they found it easier to just say a lot but do nothing. Everyone found something to love and hate about it – making (relatively) high defense cuts, protecting (the vast majority of) entitlement spending and avoiding tax increases (this time). Just to be clear, this Congressional action is not an actual cut in overall spending, but lowering the increase for the current fiscal year from about $100 billion to $15 billion. In Washington parlance, this is known as “bending the cost curve.” In addition, this spending does not include the $59 billion of additional Hurricane Sandy aid passed separately. Also, whatever 2013 GDP effect it has (estimated at -0.25% when the Sandy legislation is included), the approximate $160 billion in tax increases that began in January (actually a reversion to previously higher tax rates) will overwhelm the sequestration’s effect. Of course, count on politicians to muddy the waters as best they can, blaming the growth slowdown on the other party’s position on taxes or spending.
Meanwhile, in the here-and-now, the economic news is mixed. Q4 2012 GDP was revised to a just barely positive number, only sufficient to postpone an official recession countdown. Housing continued to count as a positive, with sales of previously owned homes higher year-on-year and home inventory for sale lower year-on-year. Recall from previous commentaries that hedge funds, investors and overseas buyers are distorting these numbers and they are seasonally adjusted. I know that in our condo building of 68 units, a sale occurred last month and one is pending, so I can attest that inventory is moving in San Francisco. My colleague Gary can attest to it too as he just finished buying a home on the Peninsula. However, I say that we need to wait for the key selling season to kick in during the summer before welcoming the return of housing. The investor boom in residential real estate has picked over the bargains long ago, leaving the market fully valued. Stories are circulating about developers succumbing to the same temptations as banks did during the housing bubble, overlooking bad credit and luring stretched borrowers to pricier homes. If so, someone will have to take the fall. A similar story is in automobiles. US sales continue to improve (again seasonally adjusted) as the American fleet ages though the increase in taxes and government spending cuts could slow this rate of replacement. Climbing gas prices (as they usually do at this time of year) may hurt consumer spending, but may also spur purchases of trade-ins to more efficient vehicles. Unfortunately, this trend would translate into higher purchases of small cars (with lower margins) over more-profitable SUVs.
The related uptick in US factory production should be noted, with improvements in both overall activity and new orders. Increased consumer spending appears to be more bifurcated between higher wealth in the top earning households buoyed by housing values and a rising stock market and those struggling to make ends meet via food stamps (48 million participants or 15% of the population – was 8% on average between 1970 and 2000) and social security disability (11 million or one per every 16 workers nowadays versus one per every 32 workers in 1992). This is not a successful story for society, at least for the long term. When a memo from Wal-Mart is leaked that warns of a “total disaster” in projected February sales, it is not because a wealthier populace has moved to buying their goods at boutiques. It demonstrates their thin wallets. And do not look to the banks for help as JP Morgan announced 17,000 jobs to be cut over the next two years (7% of headcount), mostly coming from their residential mortgage business and closing branches.
Zone of Splendiferous Decay: Europe continued its gentle erosion as EU officials projected that the Eurozone economy would shrink again in 2013 by 0.3% with joblessness increasing further to 12.2%. Eurozone GDP for 2012 Q4 fell by 0.6% with Germany falling by that amount, France down 0.3% and Italy -0.9%.
Austerity is blamed, whether on the lower spending or higher taxes, but to choose the other way would not avoid social unrest, and perhaps not even postpone it. However, the political costs are mounting. The Netherlands chose to defer cuts until 2014 despite missing their 2013 budget commitment to the EU. France also asked for more time on its deficit targets after its government forecasted a large miss in 2013 due to cutting its GDP growth from +0.8% to zero. Bulgaria’s government resigned after days of nationwide protests and riots over budget cuts, rising electricity costs and corruption charges. Greek unions struck over the pay, pension and staffing cuts negotiated with the EU and IMF as part of the Greek perpetual debt restructuring. Spain is expected to miss its deficit target, which will impact its government’s agreement to receive on extra EU funding (unless ignored with a wink-wink). UK deficits and weak economy caused Moody’s to cut its top credit rating of the country one level from AAA, the first primary rating agency to do so (see right). Italy’s government received a blow against austerity as its EU-favored technocrat Mario Monti was decisively defeated by receiving only 10% of the vote. However, the voters split their preference amongst many feuding parties, so it is unknown who will govern, let alone for how long and can they get anything done in the meantime. Italian bonds issued that week were well bought but at higher interest rates than at the beginning of the year (e.g., the 10-year tranche yielded 4.8% but similar bonds were paying 4.1% in mid-January).
There are a few positive notes – first European Banks paid back more LTRO funds to the ECB – another €75 billion in February to bring the total paid back to 20% of the original €1.02 trillion lent. While the liquidity crisis for the well-established banks seems to have passed, it is still a central problem for many of the shaky PIIGS-based organizations. Portugal enjoyed a nice surge in exports, increasing 5.8% in 2012, with the trade deficit falling by 1/3rd. Finally, foreign investment in Greek stocks has pushed its equity market 33% in 2012, making it the best performing EU market last year. Some Greek companies have been able to issue debt and rumors of private equity interest have appeared. Risk-on?
Achieving Growth: China has committed itself to a 7.5% GDP growth rate for 2013 so everyone has the 8% penciled in. So how will it accomplish it? In a time of re-shoring production back to the United States and higher technological barriers to innovation, there is always land confiscation, shadow debt and idea theft. Local governments are at the heart of the first two, trying to maintain their power and keep unemployment down via construction. The graphic on the right shows the inequity of treatment to a sample farmer and the dependency of the system on his exploitation (the local government made the difference between the 9 Yuan ($1.43) per square meter they paid and the 640 Yuan ($102.04) charged to the developer).
One wonders how much longer can this part of the economy sustain itself, especially since the central government is further reining in real estate speculation. To that end, the central government will increase on March 1st the effective taxes on capital gains from home sales to 20% and increase the down payments on second-home purchases, which are often 60% of the price. “60 Minutes” had an interesting segment on ghost cities and real estate speculation that is worth the time.1 All this empty growth means that there is internal debt that has to be serviced or written off. Debt metrics such as private debt to GDP and the growth of private debt versus GDP growth over a number of years are at similar or higher levels than what was seen in Japan in 1989, Korea in 1997, US in 2007 and Spain in 2008. Total private and public debt is estimated at 200% of GDP – below the US at 350% and Japan at 500% to be fair. In 2007, the ratio of incremental debt to economic growth was about one-to-one. In 2012, it was closer to three-to-one. Does China have plenty of reserves in the form of foreign bonds? Sure – as long as one recalls that selling those bonds will increase those countries’ interest rates (like, maybe, the US?) and create demand for the Yuan versus the other currencies, likely hurting China’s exchange rate and thus its trade position. Finally, on swiping intellectual property, the PBS NewsHour had a notable segment featuring a US security company’s exposure of hacking by China’s People’s Liberation Army.2 The target was not the US government but 141 companies’ data on strategic planning, financial information, and product development. While this economic espionage was also practiced by the Soviets, they had limited capacity to translate this information into new products or competitive advantages. China’s manufacturing abilities, however, allow for implementation not just observation. At least they were willing to co-introduce with the United States new sanctions against North Korea after that country “test” exploded a nuclear bomb in February.
Black Gold and Other Stories: It is official; the oil shale boom has reached such a fevered pitch that US oil output broke seven million barrels per day, the first time in over twenty years. Oil imports are on track to hit 25-year lows in 2014, though the percentage of oil imports from the Middle East increased. For the politically minded, does this situation then make us more or less dependent on foreign oil? Keep in mind that high-quality shale oil is crowding out the similar high-grade African crudes, and that Saudi Arabia is a co-owner of the largest US refinery which is just starting full operations at the end of the current maintenance season. The US trade gap is going the opposite way of Japan, ironically spurred also by trends in energy resources and policy. Not only is the US importing less unrefined crude oil, petroleum and product exports hit a record high. In December, the US trade deficit fell 21%, though the whole 2012 decline is a less impressive 3.5%, primarily on lower imports from Europe and China. China is the world’s largest oil importer as of December 2012, importing 6.12 million barrels per day versus the US’ 5.98 that month. We wonder then when China will get going on their shale boom. Chevron is now involved in Australia, which is estimated to have the world’s fifth-largest shale gas reserves, and China and Japan are ready markets. Finally, the recent death of Hugo Chavez adds some potential uncertainty to the oil markets as Venezuela is a key oil exporter to and gasoline importer from the US, but more on this in the next commentary.
Also heading overseas is US coal. While one may think it is going to China and India (both prodigious coal consumers), it actually steams for the UK, Netherlands and Italy. Just like with Japan, those countries have to import energy and find that natural gas is three to five times more than US prices, making coal highly competitiveunlike here. For how long is the question as US coal exports face the same environmental headwinds over there.
European alternatives are dwindling with their phase-out of nuclear power and lack of new natural gas plants. Belgium is one example. They have seven nuclear reactors producing 50-60% of domestic electricity, two of which are currently down for maintenance but two others are scheduled to be shut by 2015. Building a natural gas plant in time is certainly doable but red tape could snarl such a project.
The Other Red Meat: While pork has enjoyed its rebranding, we at Coloma feel that horse is overdue for its proper place at the American dining table. Many Europeans eat horse, and you can find horse sushi in Japan. Horse has higher concentrations of iron, B12 and omega-3 fatty acids than beef – so real nutritional benefits! Separately, February was a strange month full of space rocks – both one that thankfully stayed in its solar rotation to return in 2046 and another that gave us a spectacular show streaking across the sky before it smashed into Russia. Just like the movies!
David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource
Additional information sources: Bloomberg, Financial Times, Hussmanfunds.com, KQED, New York Times, Wall Street Journal and Washington Post.