Again the US stood by quietly next to Europe given the relative lack of news in the States versus EU. The US (apart from Puerto Rico) is quietly moving ahead economically, not too fast and not too slow. Jobless claims are low and the GDP figures are good enough to cause people to wonder if the Federal Reserve will actually raise interest rates. While Yellen may have signaled in July that the Federal Reserve will do something by the end of the year, she and the board have a lot of latitude to do nothing. The only certainty is that without a meeting in August, Fed watchers can take their vacations. Europe on the other hand has a deal with Greece in the sense that Greece said it wanted to stay in. What that means financially is unknown since Greece cannot pay its debts nor cut its deficit. More loans from Germany then? At least the IMF knows what it wants – out! In Asia meanwhile, the Chinese government decided that lower stock prices are a form of betrayal and accelerated its efforts to halting the slide. They were successful (temporarily at least), though at the cost of their reputation (though I am sure only temporarily given market’s short memory). The capricious nature of the Chinese government intervention along with the slowdown of their economy despite the shrill insistence of 7% growth weighed on commodity prices – particularly in energy, grains and metals. High production, ample inventories and good weather gave a bearish tone to the fundamentals as well.
A New Countdown: In an attempt to engage in real democracy Greece held a referendum at the end of June where the Greek people said “no” to the bailout terms of the Troika but a few days later PM Tsipras instead said “yes” to basically those same terms. Pointless, though I suppose it did buy Tsipras some time and “good effort” sympathy. With the “yes” to more debt and austerity, Greece was granted a stay of execution, Euro-style. What does that mean? More Euros in the form of a bridge loan (€7 billion for three months) to cover the IMF and ECB loans in arrears from June and July, more negotiation between the Troika and Greeks to set terms of a new bailout (with estimates ranging from €50 billion to €85 billion) and time for the Greek government to pass needed legislation associated with the bailout. There are many points of possible failure – Tsipras’ government may fall and new elections will be required, the government may not pass needed legislation (opposition within Syriza is high), the Troika may insist on unreachable terms, the European governments may not ratify the agreed terms and simply the dire economic situation may overwhelm any hopes of a plausible arrangement. By the end of July, some of these issues are apparently resolved for the time being – Tsipras is still PM, the IMF is quite unlikely to contribute to the new program (or distribute another €16 billion under the old program), some additional taxes and government layoffs were passed, the Greek banks have not failed yet (thanks to the ECB) and the big issues (i.e., Greece’s failed privatization program, pension and government salary reform, VAT taxation reform/increases and non-payment of €5 billion to private creditors) are still in play. With the next big loan repayment due on August 20th of €3.2 billion to the ECB (as well as an additional €1.8 billion due to the IMF and other creditors), the deal deadline is ticking down. I do not know if an agreement will be reached or will more time be arranged so that politicians can take some kind of summer holiday. I will only note that the basic issue still needs to be addressed: since Greece cannot repay its current debts, will the EU/ECB/IMF write down their loans or not. Otherwise, all this drama is just pretend. It has generated one tangible benefit: S&P upgraded its Greek sovereign credit rating from CCC- to CCC+ as there is less than a 50% chance the country will leave the Euro.
Greek banks are an important piece of the puzzle as deposits fled the country, forcing the ECB to step in with a cumulative €130 billion in emergency funding to keep them solvent. With branches closed for three weeks until July 20th and strict withdrawal amounts enforced (was €60 per day!), the Greek banks teetered on a knife’s edge. With the lifting of many capital controls, the talk is that the Greek banks have to raise more capital – perhaps as much as €25 billion on top of the €31 billion they have on their books. The real challenge lies on the asset side of the balance sheet as we can see on the left. The first item is the investment securities of roughly €75 billion, which are largely Greek government bonds, which would be highly vulnerable to write-down risk (and guaranteed write-down if Greece leaves the Euro for the Drachma). The second larger source of uncertainty are the loans to customers. Non-performing loans are currently estimated at €90 billion (40% of the total) and are expected to head higher with updated figures. There is supposedly €55 billion of provisions and collateral, but in a declining economic environment, that offset is not very likely to be worth 100 cents on the Euro. Some assets can be sold (e.g., foreign branches) but the amounts are small and sales would take time, which may not be available.
The other hot fiscal crisis is over Ukraine’s $70 billion debt as the beleaguered country struggles to make payments – it almost missed a $120 million interest deadline on July 24th and has $1 billion principal due in each of September and October before a more substantial $3.5 billion due in December (with $3 billion to its Russian enemy). Between a war and an economy down 23% from the beginning of 2012, Ukraine is desperately trying to negotiate its payments. In terms of war news, over 100 Ukrainian soldiers officially have been killed since the Minsk “peace agreement” signed in February and a former PM Mykola Azarov (allegedly bankrolled by Russia) is calling for the overthrow of the current government. The “good” news is that the eastern Ukraine and Crimea which is controlled by Russia is reportedly spiraling into a mess, costing roughly $6 billion per year between budget subsidies and infrastructure rebuilding. While a relatively small portion of the overall Russian budget, the corruption and poverty has not made this (yet?) into a long-term win for Putin.
Europe overall is doing just okay – some economies are doing well (e.g., the UK grew +0.7% in Q2 for the quarter (so higher than the US on an annualized basis) and Spain had its best quarter since 2007 by growing 1.0%). Spain actually showed a good improvement in their jobless rate which fell from 23.8% to 22.4% and youth unemployment fell below 50% for the first time since 2011. Unemployment overall stayed steady at 11.1%. Obviously this recovery has a long way to go and is fragile but sounds promising. Other pan-Europe news is more negative with PMIs lower than expected (though still showing expansion), record high government debt levels (average of 92.9% of GDP up from 92.0% at the end of Q1) and the latest industrial production numbers were a decline of -0.4% versus an expected +0.2% in May. German exports are still moving along with a +1.7% in May versus an expected -0.8%. Car registrations for the first half of 2015 were up 8.2% with auto companies’ profits following. Even Peugeot, which needed a €3 billion rescue package from Chinese carmaker Dongfeng and the French government, pulled in a €571 million profit in 1H15.
In terms of items to watch in the months ahead, there are four. First, Italy is putting up its post office as the first offering in its €12 billion privatization scheme. Demand for that listing should be monitored. However, it still will not stop PM Renzi from asking for fiscal relief from the EU to run a higher budget deficit over the next three years. The Bulgarian and Romanian branches of Greek banks received additional support from the ECB separately as the central banks in those countries have also faced minor runs and crises. Note that if those branches collapse, then the Greek parents would lose critical assets, damaging (perhaps critically) their solvency. Third, the Austrian high court blocked an attempt by the Carpathian province to avoid €890 million of the €10 billion it guaranteed for Heta… money it does not have but looks like it will have to contribute €7.6 billion. Given that the province has an annual revenue of only €2.3 billion, it cannot meet that obligation. Who pays and when is still being fought over as the EU rules governing this circumstance have never been tested. Finally, the upcoming election to watch is Portugal’s on October 4th as it will be a test whether a Syriza-style party can be elected. Right now the answer is no, but with the uncertainty in Greece, there could be an upset.
Summertime Cruisin’: It may be time to hit the beach in the US while one can – the Federal Reserve is still engaged in the doublespeak of whether it will or will not raise rates. Given the effectively zero rates now, any increase of 0.25% or so will be trivial in terms of affecting the real economy. Those that are overly levered in the markets may experience a hiccup or two but it should still be at the margin – if there is an increase. At this rate of hyper-dovishness, there is a very good chance that there will be nothing done this year. In terms of GDP expectations, Q2 2015 looked good enough at +2.3% annualized but the revision upward for Q1 from -0.2% to +0.6% is more important. The US may miss the lowered IMF forecast of +3.3% for 2015 but a good second half may be enough to push Janet Yellen over the edge. Personal spending accelerated by growing from +1.8% in Q1 to +2.9% pace in Q2, though retail sales fell slightly in June. US car sales in June stood at 1.48 million, the highest for June since 2006 – cheap gasoline (apart from California!) is spurring demand. Durable goods orders excluding military and aircraft were up +0.9% in June, reversing May’s decline of -0.4%. Jobless claims fell to the lowest level in 41 years indicating good employment levels though wages grew at the slowest pace for a quarter since 1982. Unemployment for July stayed flat at a quite low 5.3% as job additions topped 200,000 and June’s number was revised upwards. In terms of bigger problems looming, the trustees of the US social security pension and disability system noted that the disability account will run out of money in 2016, trigger a 20% decrease in benefits assuming no changes in the amount paid to the disabled (which has been increasing) and the tax base. Combining the pension and disability funds will stave off the inevitable, but that will be difficult to pass in the current Congress, I believe. The pension fund and the medical fund (Medicare) are still projected to run out of money in 2030 or later, assuming a 5.1% GDP growth rate annually. If the US stays at the current lower GDP growth of 2.7%, then the funds could start to run out up to ten years earlier (2020 or so). Obviously there are a lot of variables here but the next President will certainly face these issues after their election in 2016.
In banking news, the Federal Reserve is requiring the eight leading US banks to hold an additional $200 billion in capital to be phased in starting in 2016 and being fully “topped up” by 2019. As systematically important banks, they are being held to a higher standard than regional or community institutions. Fortunately, all but one of the banks are on track to meeting these requirements – the outlier is JP Morgan which will have to raise an additional $12.5 billion – about twice its annual dividend. Very doable. Puerto Rico decided to not make a $58 million payment on a “moral obligation” bond – unlike the typical general obligation municipal bond, this type of bond has no legal obligation to repay. Though technically not a default, it should raise questions in investors’ minds. A bigger red flag should be an announcement in early August stating that the Puerto Rican government had “temporarily” stopped its regular $92 million monthly contribution into a fund that is used to make payments on $13 billion of debt. A small amount is due from that fund on September 1st ($5 million) that is easily met, but a bigger $370 million is due on January 1st next year. Will that trigger the real default? Who dares invests to find out?
Banning Selling Does Not Equate to New Buying: As commented on last month, the Chinese government pulled out all the stops to halt the markets’ precipitous fall from 5,166 on June 12th in the Shanghai Composite down to the low of 3,507 on July 8th for a fall of 32% after its 60% increase the first half or so of the year. The market closed the month at 3,663 or just off the low. The short term conclusion is that the investigations into short sellers (or any sellers for that matter), outright buying with up to $209 billion by the China Securities Finance Corporation (a government entity) and suspended trading in 505 companies on the Shanghai and Shenzhen exchanges (18% of total issues) still by the end of the month have stopped the bleeding for now. The first takeaway is that the market is broken and too dependent on government intervention to maintain itself – it is not a market based on fundamentals. Also the government buying is done with borrowed money so there is still leverage in the system (the CSFC reportedly has $483 billion available to it from the Chinese central bank) and no plan for an exit. Finally, with all the talk of the tens of millions of new retail investors, their estimated share of market value is 5% of the total – 21% of all individuals with money in the market had $1,600 or less in their account and 69% held less than $16,000. The real value therefore lies in the big firms and individuals that opened multiple accounts under different names to disguise their trading and perhaps they are the ones that the Chinese government is trying to shield from losses. I can only conclude that MSCI must be very relieved that they did not expand China’s weight in their indices which are the industry standard for investment managers all over the world.
Officially, Chinese GDP grew at a 7% annualized rate in Q2 2015 with better-than-estimated retail sales (+10.6%), industrial production (+6.8%) and fixed asset investment year-to-date (+11.4%). However, one can clearly see the declining rates ofgrowth in the graph to the right. There is some evidence that real estate is recovering as property sales in floor-area terms grew 16% in June, the fasted monthly growth since 2013. China’s preliminary PMI from Caixin Media (formerly the HSBC gauge) fell to 48.2 for July, down from 49.4 in June and matched a 15 month low showing that there is still indications of industrial production slowdown. China’s official July Manufacturing PMI hit 50.0, a five-month low, which is lower than expectations. More concerning is the decline in Chinese employment growth which crossed over to negative territory for the first time in fifty years (see left) and a decline in Chinese car sales year-over-year to -3.4% in June. Foreign car makers were not immune with reported Chinese sales flator down. On the employment side, Foxconn, the Taiwanese manufacturing group responsible for assembling Apple’s iPhones and iPads, is looking to India to expand, with plans to build ten to twelve factories employing one million people citing high wage costs in China. With the volume of world trade down by -1.2% in May, the global slowdown does not indicate that China (or anyone) can easily grow their way out of their economic malaise. July exports fell more than expected (-8.3 year-on-year versus -1.5%) and the related trade surplus fell to $43 billion, off from a high of over $60 billion in February. Domestically, China’s June new-home prices stopped declining in less than half of the 70 largest cities (just barely) with twenty-seven increases versus only in three cities last month.
Other Asian countries have caught the Chinese cold – Singapore’s GDP fell by -4.6% in Q2, led by a -14% drop in manufacturing and non-oil exports to China (-4.3% in May). Japan’s central bank lowered its GDP growth projection to +1.7% for the fiscal year (which ends in April 2016), down 0.2%. Industrial production fell 2.2% in May while service activity fell 0.7%. Despite the mining slowdown, Australia still is expected to grow below-trend, at +2.5% GDP for 2015.
Fill ‘Er Up! The world has a lot of oil – and looks to increase production even more! The first headline is the Iran deal, which will end sanctions by the UN, US and Europe, allow free oil exports by Iran, direct investment by the rest of the world in Iran and release about $80 billion in assets around the world – if the terms are ratified by the various countries and the up-front nuclear reductions occur and ongoing inspections come up clean. Based on how desperate the world is to find any prop to their economies, the terms will be ratified with the US as a possible exception. To implement the cutting of the number of centrifuges it operates, reducing its nuclear inventory and providing access to scientists and documents, Iran can speed that up or drag it out but is expected to be done in six to twelve months. The $80 billion is also offset due to $55 billion in debts in arrears to various energy companies when the Iranian government expropriated the energy industry after the revolution. I would expect those claims to be vigorously pursued and most of the money will not be available until those debts are settled. However, if the terms to the lifting of sanctions are quickly implemented, then the estimates are that Iran will be able to increase oil exports by 60% in a twelve-month period following – that would be late 2016 / early 2017. Iran has already started to deliver crude that was in storage – a two million barrel ship left for Shanghai in mid-July – but exports at this time will be few given that sanctions are still technically in place. It was also revealed that most of the forty million barrels in storage is actually condensate (a very light form of crude oil sort of close to gasoline which trades at a discount) and fuel oil – not the crude oil that many were expecting. The takeaway here is that there may be only limited incremental oil export supply at this time but much more to come in 2016. The main beneficiaries are likely Turkey and Europe as they are reasonably close to Iran’s oil and gas – and would be alternatives to Russia. Obviously the energy companies that are familiar with the geology and can negotiate reasonable production sharing agreements (big caveat) will profit.
Meanwhile Saudi Arabia set a new production record of 10.564 million barrels per day, a level not seen last since 1980. Iraq also increased production in June. Libya is still exporting small amounts of crude oil even. The latest OPEC forecast has production increasing by 1.7 million barrels per day over the second half of 2015 and the amount of oil in storage to increase by 700 hundred million barrels – equal to eight days of demand coverage – and reaching the highest level of global stocks ever. 2016 is projected to be higher at another 1.3 million barrels a day added in production and more surplus, pushing those numbers even higher. As the graph on the right shows, the US is doing its part with the forecasted slowdown in 2015 to be recovered by the end of 2016. The US has already begun adding oil drilling rigs, marking a reversal of the declines since late last year. Re-fracking technology in the US is increasing initial output by 30% as well, extending its competitive advantage over higher-cost producers like Brazil deepwater. US oil stocks are still at record high levels though lower than the peak due to the usual decline over the summer driving season. US gasoline demand is about 3% higher for the same period last year as automobile and truck sales have increased into summer. China also has seen increased gasoline consumption though a recent drop in passenger car sales may limit further growth. On the other hand, China has increased its diesel exports to the highest levels last seen in 1999 as the local market cannot absorb all the production – and in direct competition with the new Saudi refinery and threatening the US refinery exports.
The projection of low oil prices ($47.12 at the end of July, though hitting $43 at the time of this writing on August 11th) for the next number of quarters have cause the oil companies to start layoffs in earnest, with Shell cutting 6,500 positions (including some firings already announced) out of a workforce of 94,000, Chevron making redundant 1,500 workers (2% of its workforce) and Italy’s largest oil and gas contractor Saipem announced layoffs of 8,800 by 2017. Overall, it is estimated that 70,000 energy positions have been eliminated since last summer.
In agriculture news, grains were hit by warm weather that dried up all the rain-soaked fields. US crop conditions continue to be excellent (see corn graph on the next page) with soy conditions also better than the five year average (though not as good as 2014. There has been a turn in sentiment in August that fields have gotten too dry, reversing some of July’s losses but for now we are skeptical. South Africa and Europe are legitimately being hit hard by heat but the harvest in Brazil is moving at a good pace. All eyes are on the August USDA report on the 12th. China is continuing to sell off its massive cotton reserves and, in the US, milk production hit a monthly record in May (18.4 billion pounds) and is on pace for an annual record of 208.7 billion pounds. There is so much milk being produced that there are also record amounts of it being dumped (31% more than last year. In protein news, there were no new cases of avian flu reported with the last case cited the week of June 14th. Australia signed the first trade deal to export feeder and slaughter cattle to China, worth an estimated $1 to 1.5 billion.
Finally in miscellaneous news, China updated its gold reserves for the first time in six years to show a 57% increase since 2009, disappointing market watchers but placing them in the #5 spot ahead of Russia. The big difference between China and Russia is that the Chinese have plenty of capacity to buy more! It should be considered as reliable as other Chinese government statistics. We also note that 2015 is projected to be the hottest on record (at least through May) – it is not the hottest in the US but in Europe, along the Equator and South Africa there are record warm temperatures. Open-outcry trading in many commodities and foreign exchange ended in July at the Chicago Mercantile Exchange. There are still pits full of screaming traders but in about half the size of the original floor. Shed a tear for Billy Ray Valentine, Louis Winthorpe III and the Duke Brothers.
David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource
Additional information sources: Bloomberg, The Economist, Financial Times, New York Times, Politico, South Bay Research, Wall Street Journal and ZeroHedge.