Market mood was complacently buoyant for most of March, until fundamentals hit the last day. It was a strange end to the quarter, when normally the bulls in an up market make one final push to mark the books in their favor. In the news, we all have heard more about Cyprus than ever expected. The U.S. was generally quiet as Congress and the Administration decided to put off budget battles for another day and the media was deflated over the missing big collapse due to the sequester. Asia has China and Japan moving in opposite directions, with China trying to stem overheating, particularly in the real estate market, and Japan gearing up for an inflation push (which was actualized in April). The world of commodities is being challenged by the shifting inventory situations in Grains, Metals and Energy, and to a lesser extent, political-economic macro events. Weather and energy infrastructure build-out are the two main fundamental events that we expect will drive commodities this summer.
Cyprus, We Hardly Knew Thee: Or at least, the EU hardly knew how much of a problem it was going to be! Apparently, the European powers figured that an economy the size of Vermont could be solved in a jiff with the usual showering of money. Little did they guess that their decisions could shake the foundations of European banking. At least now we can switch from PIIGS to SIC PIG! As the dust starts to settle, the salient points are:
1.) The Cypriot banks bet heavily on Greek bonds and got hit with the 50%+ loss when the troika bailed out Greece and shoved losses on the bondholders. Big, risky, undiversified bets are a regular path to ruin, if not at first, then eventually.
2.) The banks funded these sour assets with about €68 billion in deposits, €40 billion in interbank and other liabilities, €2.7 billion in bonds and €15 billion in equity, effectively ensuring that losses were going to have to hit depositors since the ECB protected their banks from taking a haircut (they being on the other side of the interbank liabilities). By contrast, most banks in the United States and the rest of the world have bondholders as the largest portion of the capital structure (note they were also generally protected in the 2008 crisis). Therefore, hitting the depositors for the majority of the losses was the dictated solution. There is no “new paradigm” or “new template” here as the EU and IMF consistently acted to protect themselves and hit someone else (in this case Russian mobsters and Greek tax evaders). Funny that Russia did not save its depositors, though its banks have exposure to Cypriot businesses and banks, so the Russian government may have to bail their own institutions out instead.
3.) Note that Cyprus already gave its banks over €2 billion in equity of what it borrowed from Russia in 2011 – and its credit rating of CCC blocked it from tapping the usual capital markets. As it is, the €10 billion that the government will receive from the EU and IMF will still push its debt-to-GDP to 130%, and the resulting imposed austerity (by budget cuts and higher taxes totaling to about 3% of annual spending) will hamper its economy for years to come. The surviving major industry of tourism appears to be insufficient to support the government revenue base now that “financial services” has imploded. Turkey, who runs the northern portion of the island (yes there are two governments), also is looking to take advantage of the south’s woes to attract banking business and tourism money, further undermining hopes of recovery. Maybe the Chinese will come in and replace the Russians (Cyprus does offer residence permits for sale along with seaside resorts).
4. ) Everyone-for-one’s-self politics is blatantly apparent. Since the Cyprus situation was well known in the EU governments for over a year, there was a concerted effort to delay resolution until crisis, which represents the political instinct to try to avoid/defer bad news as opposed to a more technocratic, proactive approach to try to nip problems in the bud. Why push losses to bank depositors? German elections are coming up in September and Club Med bailouts are not popular with the German voters. Someone besides Uncle Fritz needs to pay. Other small banking nations have found themselves under the microscope: Latvia (obvious Russian mob destination), Slovenia (in the throes of a banking crisis already), Luxembourg (historic tax haven) and Malta (its financial sector is also eight times its GDP). Recall that even mighty Switzerland had to resort to extraordinary foreign exchange and capital requirement measures to shore up its banks and protect its independence – these little countries have to follow in the same footsteps.
Bunny Hop: A Little Step Back, A Little Jump Forward: The WSJ summed up the political scene with this headline: “Tired of Fights, Congress Passes Funding Bill.” In fact, I would describe the whole economy as “Tired.” The headline reminds us that even politicians get tired of fighting over the same ol’ stuff and can decide to pass sufficient appropriations to fund the government through the end of the fiscal year (September). There still are plenty of battles to come so figure this to be the calm before the storm. At least the sequester hit Congress’ offices as well as the rest of government – though not their salaries. Economic news was generally on the plus side with housing prices and retail sales moving up particularly, causing some economists to raise their forecasts for Q1 GDP from 1.7% annualized to 2.2% annualized. Seasonally adjusted retail sales were up 1.1% in February and the Commerce Department penciled in a 0.7% overall consumer spending growth. Housing starts, seasonally adjusted, and prices were also at strong levels – comparable to the four-year highs seen in the last few months.
Again we will question the sustainability of this positive housing trend given that investors not households are often significant portions of the buying – e.g., 22% of the home purchases in Orange County, California in Q3 2012 (most recent data available). Q4 2012 GDP final revision was moved upward to 0.4% annualized, up from the negative first reading and the +0.1% update. Obviously this is effectively zero still, so not cause for celebration. Unemployment shifted to a four-year low 7.7% at the end of February and 7.6% at the end of March. However, while there are jobs being created, the drop in labor force participation is what is driving these improvements in the unemployment rate – the numerator is growing slower than the denominator. Unemployment benefits are also shrinking in length due to shrinking budgets (including but not limited to the sequester) and the exhaustion of the funds set aside by previous years’ premiums. Mass job cuts are not over, as JC Penney announced plans to reduce its workforce by 2200 employees after a 25% drop in sales ($4 billion worth) in the year ending February 2013. A botched reform plan by former Apple store creator was blamed. Finally, March’s industrial activity as measured by the ISM is still listed as expanding, but the reading was notably below expectations. It was also artificially inflated by defense and aircraft orders, which are volatile and historically not lasting (especially the defense portion). U.S. auto sales (well, technically of pick-ups and SUVs) were up strongly, helping American and foreign automakers alike.
In California, a federal judge rejected attempts by bondholders to stave off the bankruptcy of the city of Stockton (again, not the first mention in these hallowed pages), which will permit the payment of its pension obligations (a $147 million shortfall) with a 80% haircut on its $125 million of pension bonds (the city owes $200 million in accrued principal and interest). Looks like the city council wanted to preserve their political status (and their own retirements). California also has started to work out the new costs under its health insurance exchanges with an estimate 3.4 million residents affected under their individual plans. The income dividing line is $94,200, with 2.1 million recipients below that should expect to receive subsidies, though many may see higher premiums due to the expansion of coverage. Covered California, the California agency charged with implementing the new health insurance marketplaces, estimates that individual premiums next year on average will go up 14% (9% of the increase due to rising health care costs not associated with the new law). As someone who pays their own premiums, eats healthily and exercises sixty minutes every weekday, I can hardly wait.
Asia Following the United States: Whether it is the Japanese version of QEternity or the mixed Chinese economic results, it all sounds strangely familiar. Japan officially kicked off its massive monetary stimulus with a goal of 2% inflation in two years by doubling the central bank’s purchase of bonds and doubling the asset base. To compare, the BOJ plans to increase the monetary base by the equivalent of $730 billion per year – way outstripping the $85 billion pledged by the U.S. Fed. The drop in the Yen alone should shove through that kind of inflation as high energy prices should soar higher. Of course Tokyo Electric Power Company also announced that it will not restart a pending nuclear power plant as planned as safety practices were deemed still insufficient. Looks like energy imports will continue their strong pace, though higher fuel costs from the weaker Yen do not sound like a cause for a stronger economy to me.
Like the United States, the Chinese economy shows some weakness but also some improvements. Manufacturing activity as measured by the PMI increased decently in both the government and HSBC surveys in March. February retail sales grew at a slower than 2012’s rate, though still double-digit. Housing prices picked up nicely but some of the increase may be pressured buying as the central government looks at implementing a 20% capital gains tax on home sales and other home-purchase restrictions. As one of the few ways to invest wealth, the property market is both a cause of speculative concern as well as a largely untapped revenue source for the government. Should there be a slowdown, do not grant yourself the illusion that the central bureaucracy will not tap wealth in the same thought that we saw in Cyprus and France. On the commodities side, there has been a slowdown in industrial metals demand since the Lunar New Year, with rumblings even before then. Steel production has risen to a new high but so have inventories. The now-recognized problem of air pollution will play its role too.
Life and Death in Commodities: Over in the Mediterranean, Israel began extracting from its first offshore natural gas field, which by itself, is expected to add one percent to the country’s GDP growth this year (+3.8%). This Tamar field is only the first, with larger Leviathan still untapped. Actually, at a cost of $3 billion and four years of development, it is the largest privately-funded infrastructure project in Israeli history, so Leviathan will truly be a monster undertaking. In an ironic twist, Cyprus also has large natural gas fields offshore, certainly plenty for energy self-sufficiency. Of course it does not have the funds available to exploit it and the economics still need to be proven out. Apparently they are not good enough to get the Russians involved.
In the U.S., the federal government’s Environmental Protection Agency (EPA) is moving forward to reduce the amount of sulfur in gasoline by one-third from 30 parts per million to 10. While critics claim that will increase prices by nine cents at the pump, administration studies place the additional cost at one cent. It seems that the ease of conversion would generally be doable as 90% of refiners already produce to that standard or can do so with modest improvements. The administration may use this to offset criticism from the likely approval of the Keystone XL pipeline which has drawn environmentalists’ ire. U.S. refining has also run into issues around the directive for adding corn ethanol to gasoline. Essentially, the law is that a certain amount of ethanol is required to be added to gasoline (technically RBOB which is the specification that is traded in our portfolios) – not a percentage of the gasoline you find at the pump, but actual gallons. The problem is that gasoline consumption has been declining for years and there is not enough demand to consume all those mandated gallons. The EPA has been unbending and forcing refiners to come up with reasons to buy the required ethanol, regardless if used or not. Furthermore, auto manufacturers will void their warranties if the percentage of ethanol included in gasoline is too large so the refineries cannot simply adjust the blend (such shifting to E15 or E85). Therefore, the costs of complying are expected to skyrocket so watch for more on this issue in the fall. And if there is a drought again this year, corn prices could reverse current weakness. Drought conditions as you can see below are still severe in important parts of the agricultural states, but have virtually disappeared in the eastern side of the country – a major improvement from late last year.
We may have a later start to planting but American and Canadian farmers are quite efficient so I am not particularly concerned with getting the crop in the ground. Cheaper grain prices will be welcome to Hostess Brands as the sale of its Twinkies unit has been approved with a target of getting these sweet nothings back on shelves by the end of summer. On the other hand, the USDA is considering buying 400,000 tons of sugar to prop up prices and keep sugar processors from defaulting on $862 million in government insurance programs. With the confectioners lobby claiming that this program has cost consumers $14 billion since inception in 2008, one has to question if the left hand of the government knows what the right is doing. Simply put, if the government was serious about people’s health (because, for example, more diabetics would drive up healthcare costs), it would stop this blatant corporate welfare. Better to spend that money on taking Michelle Obama gardens nationwide.
Electric car maker Fisker is looking at bankruptcy protection if efforts to find a buyer or strategic partner fall through before an April 22nd loan payment is due to the federal government. It is undisclosed what the exact amount due is, but the firm has $192 million outstanding from the Department of Energy. Two Chinese automakers have backed away as production is set to be U.S.-based. The firm has not built a car since July 2012 and readers may recall that its primary battery supplier A123 Systems was bought by Wanxiang Group after going bankrupt itself. Hopefully they have more assets than Solyndra. Rival Tesla at least made money for the first quarter in its ten-year history. Model S sedan deliveries topped forecasts and are on track for the 20,000 vehicle goal in 2013. Perhaps at least those U.S. taxpayer loans will be paid back.
David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource
Additional information sources: Bloomberg, Financial Times, New York Times, Wall Street Journal and Washington Post.
Disclaimer: Past performance is not indicative of future results. Futures trading involves substantial risk of loss. Coloma Capital Futures is registered with the NFA and CFTC under the 4.7 exemption. By no means is this newsletter offering any investment advice or suggesting to make any trade recommendations. Please consult an aiSource advisor prior to opening any managed futures accounts.