June 2014 Global Macro Recap

Reflecting on June, one has a sense that the world’s economies and markets are starting to differentiate.  In the US, there was the nasty GDP downgrade from -1.0% to -2.9% for Q1 but with unemployment flirting with 6% and strong auto and factory news, one wonders if the bulls were right all along (at least until Q2 disappoints in some way).  Europe, however, is still skating on thin ice, with lackluster economic results, Ukrainian conflict and another grasp at central bank stimulus and phony GDP accounting as the best solutions that their elites can come up with.  Asia demonstrated that its emerging market status is still deserved, with precious and industrial metal fraud occurring in China, debt concerns and simmering tensions between China and its neighbors at the top of the list.  The Middle East appears to be avoiding the worst of the possible futures with radical ISIL Sunnis losing momentum as they hit the Shiite areas in Eastern Iraq as well as the direct confrontations in Libya between the eastern and western areas are slowly if unsteadily coming to a close and those oil fields are now re-opening.  The world of commodities is also breaking down via sectors, with agricultural products generally under selling pressure as global weather is being very cooperative and the oil markets are under less geopolitical stress.  On the other hand, meat is still in short supply versus global demand; as The Beef website (thebeefread.com) put it, “The cattle and beef industry is smack in the middle of discovering there is a great deal more inelasticity for beef demand than ever before believed… when markets defy those expectations, then many of the things we thought were true turn out to be, well a great deal less true.”  Hope you bought your steaks a few months ago, if not last year.

Whoops!  There Goes the Quarter!  A disappointing Q1 GDP figure of -1.0% was made notably worse with the June revision to -2.9%, the worst reading since Q1 2009.  It marked the largest downward revision in the Commerce Department’s history (albeit since only 1976).  The largest contributor to the -1.9% revision was the correction to health care spending assumptions, which fell instead of rose, accounting for 1.2% of the 1.9% swing.  Exports, business investment, inventory builds and consumer spending adjustments were responsible for the remainder.  But we simple consumers are not to mind these results as the government and market pundits said that everything was cold weather-related and hence good times are ahead.  Looking at the June unemployment rate of 6.1%, that is down from 6.3% and with the US having five consecutive months of payroll growth north of 200,000 jobs, the bulls have room to storm ahead.  It also gives the Federal Reserve room to continue to decrease the amount of money it is injecting into the economy – with another month of tapering in June, the monthly run-rate of Treasury debt purchases is now down to $35 billion (and an expected move to $25 billion at the Fed meeting scheduled for the end of July).  I view this removal of stimulus as welcome and that slightly higher interest rates would be desirable as the Fed money has gone primarily into asset growth and had not trickled down to the average citizen.  The better unemployment rate is great of course, but given that the labor market participation rate is still stalled out at 62.8%, right now the US economy is treading water, not moving forward.  The health care impact may or may not be a singular event – I think that it was a large enough structural change that we do not know the impact after only a few months of data.    This jury of one is still out.   

Disappointing US foreign trade was repeated the world over as global exports increased only 0.5% in Q1 (seasonally adjusted), with greater slowing growth in volumes and dollar value than expected.  Not a good time perhaps to hinge a country’s economic recovery on exports (China, UK, Europe, Japan, Australia, BRICs, etc.).  Back to the US, at least automobile sales continued to ramp in May with an 11% gain to make up for poor sales in January and February.  Even GM beat the trend with a 13% gain, despite its massive recalls.  The mileage efficiency gains over the last five years have been impressive, with University of Michigan’s average sales-weighted fuel-economy index increasing 20%, from 21 miles/gallon in January 2009 to over 25 in February 2014.  Ironically (or appropriately) enough, this improvement in mileage has resulted in a shortfall in gasoline taxes collected to fund the building and maintenance of federal highways and bridges.  The “Highway Trust Fund” (where Federal gasoline taxes are paid) is projected to run out this August after spending $45 billion this fiscal year and bringing in $33 billion in tax revenue.  No supplemental funding appears on the horizon given the divide in Congress – an early 2016 midterm campaign issue?   Meanwhile, renters continue to see their costs go up with an average twelve-month increase of 3.4% nationwide and up to double that in hot markets like San Francisco (+6.7%).  In looking at the graph above, recall that the inflation is not necessarily in the prices of goods (clothes, food, etc.) but in assets, with the private equity funds buying residential property looking for a return on their investment, causing a disconnect of the traditional link between incomes and housing prices (ignoring changes in interest rates).  Not a good sign, I would say. 

In Latin American bond news, Puerto Rico’s $14.4 billion in general obligation bonds were downgraded by Moody’s three levels from Ba2 to B2, deep into junk territory.  Standard & Poor’s rates the same bonds as AA-, nine level higher!  Puerto Rican utilities also had $46 billion in debt cut down to C-level ratings as the government passed legislation allowing for restructuring (i.e., losses) on $19 billion of those bonds.  Given the recent comments that we have made about Puerto Rico’s death-spiraling finances and lack of protection in bankruptcy court given its status as a US territory (not a state), this dire situation should be not be a surprise.  $73 billion in total debt is potentially on the line, though 8% interest on the general obligations will attract some yield hogs.  If you are looking for yield, Mexico is probably not your place as the central bank unexpectly lowered its benchmark lending rate by half a percent to a record low 3% in order to provide monetary stimulus.  Hopefully they can avoid the interest rate inanity of their northern neighbor.  No, the country for the risk-loving yield hog out there is Ecuador, who is back to the international bond markets after defaulting in 2008.  But hey, that was a long time ago.  Rated Caa from Moody’s and B by Standard & Poor’s, Ecuador sold $2 billion of bonds at 7.95% in June.  Given the country defaulted on $3.2 billion in bonds in 2008, has borrowed $11 billion from China in the meantime and selectively paid other debt, this seems like a “borrow from Peter to pay Paul” situation and so is not likely to end well for those lenders.  Of course, the big story is Argentina, who lost a critical judgment in June on defaulted debt on which it tried to avoid payment.  While not technically in default yet on its current debt, the deadline for paying interest and principal has passed and the thirty-day grace period has begun.  July’s commentary should have an interesting update on this chronic shirker.

Creative Destruction In Europe:  No, not the positive, clear-out-the-deadwood, Schumpeter-style creative destruction, but the wealth-destroying, deceptive-yet-imaginative kind.  Two items:  the ECB’s latest QE program and the redefinition of GDP.  The first is pretty straightforward:  in 2011/12, the ECB gave banks €1 trillion in three-year loans to do whatever they wanted.  The weak PIGS banks bought government bonds, thus bailing out country-level deficits.  The strong have been repaying the funds so currently about half (€500 billion) is outstanding and the rest is coming due December 2014 / January 2015.  Therefore the ECB needs to at least roll over the outstanding balances to keep the weak banks solvent, sovereign interest rates low and government deficits manageable.  To that end, Draghi, is offering €400 billion for two years with no strings attached and thus extending the maturity and allowing more to be borrowed if the money is put into approved loans (presumably to businesses and individuals as opposed to private equity and hedge funds).  He expects ultimately €1 trillion to be granted.  Unimaginatively, this program is called TLRTO (as opposed to LRTO for the first program).  In addition, he lowered the ECB deposit rate form 0%  to -0.1%, meaning that banks that leave cash at the ECB have to pay interest instead of receive it (AKA negative interest rates).  By discouraging the holding of cash (though someone has to hold it) and allowing ultra-cheap borrowing, Draghi is trying to turn up the inflation heat on the premise that price increases will get consumers and businesses buying.  Given Europe’s economic malaise, it has not worked so far and I doubt it will work this time. 

Deception number two is the artificial increases in country-level GDP by the European Union by including prostitution and drug dealing with the usual economic activity like farming, education, health care and manufacturing.  Why just these two crimes?  Why not murder-for-hire, human smuggling and unregulated gambling?  So why did the EU make this change to increase GDP?  Primarily to improve the macro-economic ratios of debt-to-GDP, deficit-to-GDP and other measures that are reported to the EU under the Maastricht Criteria.  These measures are supposed to be used by analysts to understand an economy’s ability to pay debt or to cover a deficit.  Last I checked, illegal activity is not taxed and therefore cannot support government debt nor cover a deficit.  In fact, to try to find illegal revenue, governments have to spend money on police and judges.  But EU countries have deficit limits otherwise they are penalized for budgetary misbehavior.  As of the end of 2013, countries past the 3% deficit limit include the PIGS and France (Italy was on the cusp).  With the new GDP methodology, European governments can maintain or increase their spending on these inflated GDP numbers and dig their holes deeper.  Who are they trying to fool?  Besides themselves?

Speaking of Russians, the conflict between them and Ukraine grinds on.  Ukraine has overcome their initial confusion and lack of leadership (helped by the election of the Chocolate King to the Presidency) to take back the military initiative, resulting in significant gains on the ground against separatist militia.  I expect, barring Russian intervention, the Ukraine will be mopping up the remnants by the time I write the commentary next month.  With Putin apparently backing off from direct involvement, the Russian financial markets had a collective sigh of relief, with the stock market back to the high of the year and two Russian banks successfully selling Euro-denominated bonds totaling €2 billion.  Ukraine and Russia are still haggling over pricing for natural gas and the deadline for a deal was mid-June.  Going forward, Ukraine will have to prepay for Russian gas.  With Europe reasonably supplied, there may be some energy alternatives for Ukraine, but at some point in the near future an agreement will be hammered out, likely in Russia’s favor.  Looking further, Putin has ill-advisedly created a Ukrainian national identity both by being their enemy to demonize as well as creating new heroes swathed in military glory by defending the (Ukrainian) Motherland.  The great game continues but Ukraine is wriggling their way out of Putin’s trap (with Europe’s money).


Fool’s Gold:  China’s May economic activity measures did generally well with retail sales increasing by +12.5%, fixed investment up by +17.2% and +8.8% in industrial production, all beating expectations.  Chinese officials were also relieved by a +7% rise in exports.  Not surprisingly, May also saw a 25% year-on-year increase in government spending on infrastructure, an aggressive acceleration from the 9.6% increase year-on-year for the first four months of the year.  China’s corporations need the cash flow as Standard & Poor’s reported that China has more non-financial corporate debt ($14.2 trillion) than any other country, passing the US ($13.1 trillion) by the end of 2013.  At the current pace, S&P expects Asian corporate borrowers to have more non-financial corporate debt than North America and Europe combined by 2016.  In regulatory updates, the Shanghai stock exchange approved the listing of a securitized block of small consumer bank loans totaling $423 million.  While credit-based securities like this one have been trading over the counter for a few years, this will be the first exchange listing of a collateralized loan obligation (CLO).  There is a great incentive for banks to grow this market as they can offload loans from their balance sheet, freeing up capacity to make new loans or upgrade the quality of their book.  Sound familiar to   us that lived through the US mortgage crisis?  The government also has relaxed the bank reserve requirements for some smaller lenders to try to promote more lending to small businesses and rural borrowers.  In summary, lots of leverage in the past begets more in the future.


Mega Meaty:  Before jumping into the energy markets, we tip our hats to Tyson Foods for “winning” the bidding war for Hillshire Brands with an $8.55 billion bid, topping the $7.7 billion offer by Pilgrim’s Pride.  One may recall that the initial prices were $6.4 billion, so we have come a long way from there.  While the Hillshire board of directors has until December 31st to formally make their decision, the break-up fee of $163 million should dissuade them.  Nice try Pilgrim’s (and their Brazilian owners); perhaps the discarded Pinnacle Foods will be of interest?  In other meat news, China announced an increase in their government stockpile of frozen pork.  Yes, China has a strategic pork reserve (SPR) designed to increase prices to help domestic producers.  Just like crude oil, the “other white meat” has a critical role in society.


Oil news came on two fronts:  the US and the Middle East.  In the US, production of shale oil finally allowed the country to surpass the previous peak set forty-four years ago in 1970.  Production of crude oil and related liquids was 11.27 million barrels per day in April 2014, placing the US as the number one extractor of all energy (crude oil and natural gas) and solidly in the top three in terms of oil alone (which includes Saudi Arabia and Russia).  There is so much of an ultra-light form of oil called condensate that the US government is allowing limited export of “minimally processed” condensate.  Pioneer Natural Resources received the first license, which permits export after running the condensate through a stabilizer unit, which is relatively inexpensive.  Given the relatively large percentage of shale oil that is condensate, this could be the opening in the door for broad oil export from the US.  However, the negative reaction by environmentalists and questions around the process has slowed the possibility of further expansion.  So we shall see how far it goes. 

Turning to the Middle East, Libya has gone from full confrontation just shy of direct warfare to grudging resolution with output projected to hit over 600,000 barrels per day as the 340,000 bpd El Sharara oilfield is resuming operations.  Production is still well below the 1.4 million bpd from a year ago and a number of wells and pumps have to be repaired or replaced.  Export terminals have also been subject to a number of protests and blockages but right now the ports are open.  Libyan crude is high quality and a number of European refineries are tuned to take this grade so hopefully this crisis is now behind us. 


The situation in Iraq is both more and less serious.  The armed conflict between Sunni, Shiite and Kurdish factions has more opportunity to do serious damage to the country and its structures.  With double the oil output than Libya, Iraq is a greater prize to those that can control its natural wealth.  ISIL with assistance by Sunni leaders chaffing under Shiite rule by Prime Minister Maliki has carved out the central-west portion of Iraq linked to the north-east area of Syria for their radical regime.  While their advance stalled out before reaching Baghdad and critical oil-producing areas of the Iraqi south, ISIL will likely be contending for the future of country for a number of months to come.  Their gains could be reversed with Iraq calling in help by the Iranians, Russians and Americans, as well as the Kurds have effectively blocked their northward progress.  Like with the Ukraine, Maliki’s forces may be able to retake ground.  However, given their past ineffectiveness and the fighting prowess of ISIL, I would not be surprised for the conflict to grind on for quite a while. 


To follow up on the South African update last month, the five-month strike by the platinum miners appears to be over at a cost of approximately $2 billion in lost revenues to mining companies, which would translate into $1 billion in lost wages.  The strike may be over but it will take months to regain full production.  The damage extends to a downgrade in South Africa’s sovereign debt rating by S&P from BBB to BBB- as GDP growth was reduced from +2.8% to +1.7% for 2014.  Looking ahead, the miners did receive some concessions but nowhere near their demands (such as a doubling of a minimum wage), raising the specter of future labor action despite the damaging loss of wages.  Production disruption is also happening in Indonesia as Newmont Mining halted gold and copper operations over the breakdown in negotiations with the government over export restrictions.  Indonesia has been banning raw metal ore exports to force companies to operate smelters / processors.  The decision has already affected the tin and nickel industries and with storage full, gold and copper look to be affected as well.  This means laid-off workers and hits to government revenues.  With the presidential elections in early July, this situation may not be resolved for a while. 


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

July 10, 2014


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