June 2015 Global Macro Recap

“Human beings are a species splendid in their array of moral equipment, tragic in their propensity to misuse it, and pathetic in their constitutional ignorance of the misuse.”    — Robert Wright, The Moral Animal

Whether you view Greece’s / Europe’s actions and failures through a moral or political lens, the country’s debt spiral and the consequent economic reset lower was pre-ordained.  Simply put, Greece lied their way into the euro and will keep on lying on their way back out to either 1) the drachma or 2) mass debt forgiveness.  To be fair. Greece was enabled by the other ECB countries and institutions, the IMF, and the US so there is plenty of blame (and pain) to go around.  Sadly for us outsiders, there is a lot more negotiation gamesmanship and headlines to get through.  Meanwhile, the US has Puerto Rico whose governor just announced that it cannot service its $72 billion of debt.  Not good news when the Federal Reserve is considering raising rates slightly.  And China?  Its stock market is down 30% from its peak as we moved into early July and the Chinese government is trying everything to stop the panic – banning short selling, lowering margin for large company stocks, getting brokers and banks to pledge to buy stocks and prohibiting its social security fund from selling any equities (note that the social security fund is only $199 billion or so versus the much larger central reserve fund (over $4 trillion) so not the most important Chinese financial entity).  Only Japan seems quiet, but for how long is the question.  In the world of commodities, heavy US rains and hot European weather threatened grain crops which are either at the critical stage of harvest (winter wheat) or planting (soy).  Ukraine internecine war has restarted outside the headlines as has the conflict in Syria and Iraq against ISIL.  Oil-producing nations are maintaining high if not record output in their race for much-needed revenue.  Demand for metals, both precious and industrial, has been slack against plentiful supply.  With summer well underway, vacations are at high risk at being interrupted. 

 Grexit, Interrupted:  As June closed, the Greek government failed to pay its scheduled €1.6 billion principal repayment to the IMF and called for a referendum to give it greek euro payemntguidance on how to proceed in its negotiations.  Discussions ground to a halt mid-month as PM Tsipras engaged in some shuttle diplomacy (including a solicitation to Russia as one Orthodox nation to another) for money, which was not forthcoming.  Whether the issue was the combative Finance Minister Varoufakis or Syriza hard-liners or simple desperation, Tsipras came up empty-handed.  Meanwhile, deposits continued to flee Greece, forcing the European Central Bank to continually extend credit during the month to keep private banks solvent.  Estimates of the ECB capital lent to Greek banks is roughly €110 billion with deposits at the end of May at €130 million (€107 billion less than the €237 billion peak level last seen at September 2009).  This ECB money is not free – Greek banks have to pledge collateral against the ECB funds and the ECB demands extra collateral to insure it against loss (and actually in early July increased the collateral requirement).  With only €16 billion of equity (50-90% of which are book assets[1] not actual cash) and €80 billion of bad loans of the total €215 billion loans on their books, Greek banks are completely dependent on the ECB for cash to fund bank branches, ATMs and daily operations.  This lack of capital has forced Greek banks to limit cash withdrawals by citizens to €60 (tourists can still withdraw as much as before – as long as the machine has the bills to disburse!).  This is just like the 1920’s-style bank run all over again!

In terms of solutions, there are no good ones out there.  The IMF has estimated that Greece needs another €60 billion in new loans with a doubling of the maturity of the existing long-term ECB and EU debt from twenty years to forty years (their announcement was unclear but I assume that the IMF would be paid their €32 billion as per the current schedule).  Of course, Greek debt under this plan would still be an unsustainable 118% of GDP in 2030.  So more debt does not seem to be the answer.  Greece needs money so the debt will need to be written down.  However, the Troika dopension expenditures per GDP not wish to do that.  Therefore, a possible scenario could unfold as follows:  First, Greece simply will have to stop payments to the Troika (the IMF, ECB and EU) – most immediately €3.5 billion to the ECB and another €0.5 billion to the IMF in July to force the Troika to the bargaining table.  Just add it to the tab.  The €2 billion of t-bills due to Greek banks and private investors in July will have to be paid… why?  Because the Greeks may need those lenders to finance its government while it negotiates with the Troika a reduction of that €240 billion debt outstanding (which does not including private and ECB bank debt).  A second line of funding could be needed as the ECB increases collateral requirements on bank debt.  In this case, the Greek banks will have to raise the funds by taking the money from depositors, like in Cyprus.  Per the FT as of July 4th, the estimate is 30% of all deposits above €8,000 will be taken to replace the ECB capital.  There would also be losses in bank equity and debt, with possibility of bankruptcy.  Given the far-left, anti-finance politics of Syriza, I imagine that they would not stand in the way of this process.  Third, the Greek government will have to agree to cut expenditures or pay with non-tradable IOUs (a half-way currency).  Since pensioners represent a disproportionate cost to the government and the economy (see the WSJ graphic to the right), they are likely to get hit somehow, whether directly (which Syriza has pledged not to do) or via medical inflation or some other method.  With both sides hurting, only then will the debt likely be negotiated down (a haircut of €60 to 100 billion (25-40%) is a reasonable guess).

Note that there is still the high likelihood in my opinion of Greece leaving the euro altogether for a novo-drachma, which would devalue a large amount (20-50%) against the euro over some period (six to eighteen months perhaps).  The country does have €4 billion in gold that it could use that may offer some support.  The size of the devaluation will depend on the size of the Greek debt write off.  To get to this point could take a few months but the longer the Greeks ignore the scheduled repayments, the more likely it will happen.  The €46 billion in long-term debt held by banks, private investors and hedge funds will be a separate negotiation, but given it is trading at 57 cents per dollar of notional, it is already at default levels.  In that scenario, a debt negotiation would still take place as that would be an effective doubling of the Greek debt burden.

As a side note, the lenders deserve these losses in the tens of billions of euros for letting Greece join in the first place and the 2010 bailout – the IMF being the poster child of breaking its rules for political reasons.  Under normal conditions, the IMF is only supposed to lend up to 200% of a country’s IMF contribution quota but thanks to new rules in place since 2003, those restrictions were removed.  The IMF instead lent 1860% of the contribution quota – an enormous over-commitment.  The IMF also allows for members to delay payments due to “exceptional hardship” if it votes to do so.  Of course the IMF only lends to countries that are experiencing hardship so it is rather circular logic.  Meanwhile, Greek taxes for May missed the target by €1 billion – Greece is not able to pay anyone.  Perhaps that is why Standard and Poor’s lowered its rating to CCC minus from CCC in June, citing a euro exit by Greece at 50% probability.  On the other hand, Greece can stay part of the European Union so perhaps the ongoing grants and subsidies from that organization can be used to service its (reduced?) debt. 

Otherwise, Europe is just muddling through with borrowing costs moving quickly higher on the uncertainty in Greece.  German 10-year bonds were above +1% at the middle of the month though they ended the month at +0.75%.  Recall that two months ago, the rate fell to +0.05% annualized.  At the beginning of July, Sweden cut its overnight base rate further from -0.25% to -0.35% and increased its QE by roughly $5 billion.  Not sure why as the Swedish central bank stated that inflation is starting to pick up.  On the plus side, the IMF did raise the growth forecast for Spain in early June from +2.5% to +3.1% though it could be politically calculated as PM Rajoy is fending off a Syriza-style political party surge.  Meanwhile in France, the number of jobseekers increased to 3.55 million, a new all-time high which marks eighty months of job losses.  And while Greek banks were headlined in June for bad loans, Italian banks hit a new high of €191 billion in bad loans in April, a 15% increase from a year prior which is 10% of all its bank assets – which at least is better than the 37% for Greek bad loans!  Always good when you can deflect the attention to someone else!

Looking Good, Relatively At Least:  The World Bank did lower its June GDP growth forecast for the US by 0.5% to +2.7% for 2015 but that’s a lot better than the Eurozone’s +1.5% (revised upwards).  Q1 GDP was finalized at falling only -0.2% instead of the previous estimate of -0.7%.  The overall economic news is still verymonthly change in nonfarm payrollsmixed.  US household spending had its biggest increase in six years, building by +0.9% in May versus a +0.7% expectation.  The similar measure of retail sales had an increase of +1.2% in May, partially from a strong increase on gasoline (must be all those SUVs and trucks Americans are buying).  Job creation for May was solid at 280,000 positions versus the 225,000 expected, and as the graph on the right shows, it has been running in this general range for almost a year.  On the other hand, June was at the lower end of the range at +223,000 added to payrolls.  The unemployment rate fell slightly to 5.3% from 5.4%.  Durable goods orders for May fell -1.8%, more than forecasted (-1.0%) but for non-military, non-aircraft goods the orders increased +0.4%.  New home sales were good at +2.2%.  At the June Federal Reserve meeting, the key word was “gradual” to describe rate hikes – in fact, while 2015 projected rate hikes were unchanged, the 2016 and 2017 projected increases were lowered by half a percent or so, indicating lower rates and easy money for longer. 

Puerto Rico is finally having it Greek moment as its governor announced that its $73 billion in debt is unmanageable and has to be reduced by forgiveness.  On a per capita basis, this level is just under Greece’s.  Also like Greece, unemployment is very high (12.4% in May for Puerto Rico, versus 5.4% for the US in May (but much better than Greece’s 25.6%)).  At any rate, since Puerto Rico is a commonwealth (not a state), it cannot declare bankruptcy.  With a budget deficit totaling $52 billion over the next ten years, a default or restructuring should be in order.  Let the negotiations begin! 

Changing the Rules Midstream:  China, in case one has forgotten, is an authoritarian regime.  The government’s reaction to spike and subsequent collapse of its stock markets has been one of increasing desperation.  As usual, everything was fine on the shanghai composite chartway up – the Shanghai composite went from 3,235 on January 1st to 5,166 on June 12th or a 60% increase in under six months.  From that point to June 30th, it fell to 4,277 or 17% (and to 3,687 on July 3rd or 29% from the peak).  From the perspective of active market participant, it is normal for an over-extended market to make big moves like this.  In monetary terms, the losses from the peak are equal to about $3 trillion – about 1/3rd GDP.  Quite impressive but it underscores how irrational exuberance had flooded the market (spurred by leverage, of course).  The ironic aspect is that the market has been up on the perception of lower interest rates and QE efforts by the central bank to revive the economy.  Then on the way down, more liquidity was seen as the tonic.  The means were many:  a delay of IPOs which limits the number of shares, an increase of permitted leverage for “blue chip” stocks, pledges by brokers to buy stocks, a ban on selling by the social security investment fund (and large shareholders for six months) and the big-government favorite, calls to brokerages telling them not to short the market.  If anyone wants to hedge or engage in long-short strategies, too bad.  There have been suspicions of outright government buying but clearly not in sufficient amounts.  Lower interest rates and lower reserve requirements for banks announced at the end of June were expected to boost the market but have not stopped the panic. 

In economic news, China still is showing slowing statistics as May exports fell by -2.8% while imports plunged by -18.1%, led by lower oil imports (which appear to have picked up in June as China filled more of its strategic petroleum reserve). The most recent fixed asset investment figures grew at +11.4% (more slowly than expected) while retail sales at +10.1% (matched estimates) and industrial production pulled out a small beat at 6.1%.  Even the strong growth of the auto market has shown signs of weakness, with key luxury brands such as Volkswagen/Audi, BMW, and Jaguar Land Rover all showing year-to-date declines with the overall market growth slowing.

In a surprise result, Japan’s Q1 GDP was revised notably higher from +2.4% to +3.9% on stronger business investment and inventory build-up.  However, with Q2 GDP close to or below zero due to falling industrial output (e.g., May came in at -2.2%), short interest (bets that the stock market will fall) have increased to a record level.  There have been reports that the massive asset shift from domestic bonds to stocks (both domestic and foreign) and foreign bonds by Japan’s pension plan (the largest in the world) is substantially complete though there is still speculation that it may trail out to 2017.  In any case, there were net purchases of government bonds in May for the first time in seven months.  If the bulk of the transition is complete, then the Japanese market looks more precarious and successes claimed by Abenomics may fade quickly. 

The Cure for Low Prices is Low Prices:  It is too soon to call the end of the oil boom – OPEC agreed in their most recent meeting to keep production high and Saudi Arabia hit a record in May of 10.33 million barrels per day.  The International Energy Agency said that oil supplies were to grow “robustly” and outstrip demand this year.  Russia became the largest supplier to China for the first time in May at 930,000 barrels per day, beating Angola and Saudi Arabia.  Mexico’s state oil company Pemex announcedoil price vehicle sales discoveries of oil and gas in its offshore areas – hopefully reversing the steady decline in production over the last ten years. China’s production is set to grow 1.8% in 2015 to a new record and it is also giving $5 billion to Venezuela for crude oil production.  On the other hand, unemployment has doubled in Alberta, where the oil sands are.  The 40% decline in capital spending for 2015 underscores the drop in production.  Lower fuel prices have lit a fire under new vehicle sales, particularly of SUVs, minivans and light trucks (see right).  Of course if oil prices go back up soon, there will be some unhappy customers!  The shakeout was seen in many countries with Norway’s Statoil cutting as much as 2,000 additional positions having finished eliminating 2,300 jobs.  The two layoff programs combined would total about 15% of the workforce.  Brazil’s Petrobras announced a 37% decrease in capital spending both to help deal with its high debt load as well as asset sales to raise funds.  Iran sanction talks are dragging on past self-imposed deadlines.  Iran wants a deal so that it can almost double exports but we have to wait longer and longer it seems.  Finally, in a bit of uncertain news, Saudi Arabia opened up its $560 billion stock market to large foreign investors with more lenient requirements expected over the next few years.

Agriculture was the other big news item with strong spring/summer rains threatening the soy and corn planting and the wheat harvest.  While farmers said that they were going to plant a record 84.6 million acres of soy, the muddy fields have slowed down sufficiently that speculators wonder if the last 10% to be harvested will actually make it in the ground.  In grain stocks, stored corn still is the highest since 1988 but about 100 million bushels less than expected.  Soybeans also had decent stocks but less than forecasted.  In other food news, China seized 100,000 tonnes of smuggled frozen meat, some of which dated back to the 1970s.  Finally in metals news, Platinum is down 25% from the end of strikes last year with Amplats looking to cut 400 management jobs from its South African subsidiary.  The country’s government also said that 40% of its gold mines are loss making or barely breaking even.  Finally, China, the world’s largest gold producer had its representative, Bank of China joining the London Fix group that sets the gold auction prices twice daily.  A step towards internationalization!

Best of investing!

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.

[1] In the form of deferred tax credits due to previous losses.  This accounting entry only has value if the banks have actual profits as the credits can only be used to offset those profits.  Most accounting rules (e.g., in the US) require that these type of credits expire after a certain period and limit the usage of these credits in equity and solvency calculations.  Greece has been historically lenient in their accounting practices.