March 2014 Global Macro Recap

Putin getting Crimea is like a dog chasing a car and actually catching it… his teeth are gripping the bumper, but he has to somehow carry away the prize.  Rightfully, away from the stage of grand politics and egos, the markets are generally ignoring the Ukrainian situation – at least until there are meaningful sanctions or true economic disruptions to Ukraine and/or West Europe – Miley Cyrus and Justin Timberlake’s concert in Helsinki notwithstanding.  The US news was pretty quiet again with GDP and jobs as not great but good enough.  China is parceling out the bad news little by little and Europe saw the flight to quality with their stock market falling slightly (MSCI Europe -1.1%) but bonds rallying nicely.  If we believe Draghi, Europe is an “island of stability.”  Even Greece is making noises that it will no longer need aid (that is, after receiving the latest bailout tranche).  Meanwhile, I am starting to see advertisements for cash-out refi’s which you may remember was part of how we got into a bit of a mortgage mess a few years ago.  Ah, memories.


All Quiet on the Home Front:  To be direct, it was quite boring on the domestic front in the US as Congress did not really do much and the President was pre-occupied by foreign matters.  The US economy grew decently well at +2.6% in Q4 2013 per the final calculation – better than February’s estimate at +2.4% and worse than the survey of +2.7%.  Jobs data also looked pretty decent with non-farm payrolls increasing every month since December and positive revisions helped past months as well.  At roughly 200,000 jobs created last month, Yellen has political cover to continue tapering.  Bulls latched onto the numbers with the cry of the weather depressing the underlying strength of the economy, and thus more good times are to come.  More sober market participants point out that such a situation would drive Fed Chair Yellen to continue tapering (and claim victory in saving the economy with her buddy Ben Bernanke).  Which story the stock market likes better will be seen in the months ahead.  Car sales in March made up for lost ground from January and February with the first year-on-year increase since November 2013.  However, we are not out of the woods yet, as exemplified by office goods store Staples announcing the closing of 225 branches by 2015 – I have been personally affected as they just closed their store in downtown San Francisco a few blocks from the office.


In company and market news, the US Treasury announced its plans to reduce its ownership of Ally Financial, the GM subsidiary that was bailed out to the tune of $17 billion during the mortgage crisis.  sales of subprime auto bonds have surgedNow an independent firm, the government’s stake is set to go from 37% ownership to 17%, raising about $2.7 billion, which would put the cash collected more than the amount injected (though the expected taxpayer return would be about 3% per year, far below the stock market during that time).  The Federal Reserve also formally announced what everyone knew which was that big US banks have enjoyed lower costs of funds than smaller banks, enabling their continued growth and concentration of assets in the economy.  Nothing will be done about this of course.  Separately, the Fed stated that it has $53 billion in unrealized losses on its assets, despite QE’s low rates.  These losses are expected to amortize away to zero as the underlying bonds mature, barring any bankruptcy of the underlying holdings (not at all likely with the Treasuries, possible with the mortgage-backed securities), so all the Fed has to do is wait.  And wait it will.  The next meeting at the end of April will likely see another tapering given the employment numbers but expect market volatility as we approach the date.


With yields so low thanks to Federal Reserve policy, risk is being extended into subprime car loans (see chart at right from the Financial Times) with the story reported that investor demand is stronger than issuance.  Second-lien loans have also made a comeback, with $8.5 billion in sales in 2014 so far, more than double the rate in the same period of 2013.  And with the trend in reducing or effectively eliminating covenants along with higher leverage ratios for LBO deals, more risky debt is heading our way.  The second “rental” bond was priced in March, with the security backed by rental income from foreclosed homes.  non-financial and household debt as % of GDPThe talk about US business balance sheet strength is taken as gospel but recent US Census data shows that while US households have done something (enough?) about their debts, all the borrowing that we have been writing about the last few years has been slowly but steadily pushing up the leverage of companies as they have bought back shares.  There are caveats to this data as it does not necessarily account for overseas cash (which would be haircut by 30% or more if it ever was repatriated and fully taxed) nor off-balance sheet financing (special purpose vehicles, unfunded pension and medical liabilities and the like).  So something to keep in mind while the talking heads accentuate the positive at the expense of the negative. 


In government news, New Jersey restructured its pension payments by cutting $94 million from the amount due by the state, which will still total $2.25 billion, the largest contribution ever.  The Christie government will have contributed $5.3 billion over his time in office, double the $2.4 billion made the previous ten years, highlighting the end of the easy years in which governments could effectively ignore the full cost of employees by putting off their pension liabilities.  Basket case Puerto Rico raised $3.5 billion in a junk muni sales, postponing the risk of default by “a few months.”  Hopefully the investors will be able to fully enjoy their 8.7% yields (tax-free!) instead of a massive bankruptcy.  Once-darling Brazil of BRIC fame (Remember that acronym?  Who wants some Russian bonds?  Indian or Chinese stocks?) was downgraded by Standard and Poor’s to BBB-, one notch above junk.  Must have been related to that slowing economic growth that was mentioned last commentary.  At least Mexico can still raise money, with its first sterling 100-year bond, generating £1 billion sold at a 5.62% yield.  Good price for now, hopefully for that far into the future.


Workers of the world, unite! Пролетарии всех стран, соединяйтесь!  Putin and his cronies may long for the good old days, but we are seeing the final splintering of the Soviet empire as the nationalities most closely aligned with that system are repelled by Putin’s heavy hand.  The Poles, Balts and other nationalities have never been fully assimilated but the Ukrainians were historically linked to Russia.  This presumed kinship has been rudely shocked.  Besides the takeover of the Crimea, Russia has unilaterally increased the cost of natural gas by 80% and crude oil by 50% to Ukraine, obviously to try to break the economy.  The pressure is not necessarily one-sided as most of the food, fuel and goods that Crimea imports go through the Ukraine.  For a land bridge, Russia will have to actually invade.  Can it do so successfully?  Yes, as the quality and quantity of the Russian military is superior.  However for it to sustain its gains, it would need to fund them through the sale of natural gas and oil, logically to China and perhaps India.  Those logistics are not in place, so I do not see this step occurring at this time.  But Putin is thinking about it to be sure, and hopefully is Europe and the US.  In the meantime time, these countries have put in place a $14 billion bailout with an additional $13 billion available as first steps.  However, much more needs to be done on the ground, and another scare or two is likely before a new equilibrium is reached.  Recalling from the previous commentary, the short-term advantage is to Putin.  Longer-term is the opportunity for Ukraine. 


Draghi is the master of the verbal intervention, calling Europe an “island of stability” but he says he is ready with another round of quantitative easing if required (it is “data dependent”).  Certainly European bonds have benefited – Greek and Italian banks are raising debt and peripheral bond yields (e.g., Portugal, Ireland and Spain) are at new lows.  Five-year Spanish bonds are below US rates, Portuguese ten-year bonds are at four-year lows, and Irish debt costs hit the lowest point since the founding of the Euro (3.02% in mid-March for ten-year paper).  The troika have signed on the Greek bailout package, partially freeing the “final” €8.3 billion tranche from their bailout.  €6.3 billion will be paid in April to allow the repayment of a €9.3 billion bond due to the ECB (round-trip!) in May.  The final €1.8 billion or so from the €172 billion package is all that is left and is earmarked for June and July.  Separately, the IMF has €3.6 billion to approve but that is expected by mid-May.  Then Greece will supposedly be on her own to borrow money from the international financial community.  Greek banks started to borrow after the deal announcement, with Piraeus Bank amply raising €500 million as the first bank to do so.  The issue was six times oversubscribed, pays 5% for three years and is rated CCC/Caa1.  Piraeus Bank and Alpha Bank are also raising almost €3 billion in equity.  No room for the timid investor. 


No room in Italy either as UniCredit announced €14 billion in losses in 2013 as it took the big purge, wiping out a decade of profits due to bad loans.  Of course, its stock is trading at a two-year high.  Monte dei Paschi di Siena also a big loss and announced a plan to raise €3 billion in new capital.  DeutscheBank is offering €5 billion in “coco” bonds – bonds that convert to equity contingent on a loss of equity – and has plans for another €5 billion by the end of 2015.  Toxic waste has to be lurking on their balance sheet somewhere in order to need to raise that much money.  As a side note, Japan’s Mizuho also is offering $1.5 billion in equity-equivalent bonds – offering 4.6% for ten years but the value of the bonds becomes zero if the Japanese government determines the bank is insolvent (and what is the likelihood of that happening?  IHMO, infinitesimally close to zero).  But all is well – former Soviet republic Azerbaijan just raised $1.25 billion in its first international bond sale on the back of oil revenues and geographic proximity to European markets. 


China Submerging:  If you have not figured out that China is slowing down or at least needing to divert more of its surpluses to keeping running at the same pace, you have been keeping your head in the sand for the last many months.  The industrial gauge PMI has either slipped into contraction territory (the HSBC-Markit version which included more mid-sized firms) or missed expectations (the official PMI).  February exports fell -18.1% from a year earlier, badly missing the expected +7.5% increase.  In company news, Haixin Steel failed to pay back overdue bank loans as overcapacity killed their profits and asset sales did not raise enough money.  Zhejiang Zingrun Real Estate Company also failed on payments related to $556 million in debt held by 15 banks as assets are valued at $500 million (theoretically).  Construction materials manufacturer (sense a theme here?) Xuzhou Zhongsen Tonghao defaulted on their $29 million bond by missing interest payments, similar to Chaori Solar last month.  Shipbuilder Rongsheng that we wrote about a few months ago has asked bondholders to not ask for their money back as it deals with a $1.4 billion loss in 2013 and a reorganization of $1.6 billion of bank debt.  It needs to issue more debt to stay afloat (a HKD1 billion issue is planned this April) but any reprieve is temporary as it has HKD2.4 billion due in 2016.  Other shipbuilders and heavy industries eked out small profits on asset sales and corporate reorganizations (AKA engaging in accounting shenanigans).  On the banking side, bad loans caused $9.5 billion in writedowns at China’s five largest banks in 2013, double that of 2012.  A small rural bank (Jaingsu Sheyang Rural Commercial Bank) suffered a run in March as farmers panicked after local insurance co-operatives failed.  At least Daimler sold a RMB500 million bond to Chinese investors, allowing them to have some kind of diversification.  Perhaps China should take a page from Russia’s book and take back the territory that it lost under the Treaty of Aigun (230,000 square miles) in 1858 and the Treaty in Peking in 1860.  Hey Putin – remember that what is good for the goose is good for the gander.


Japan is about to face its first big economic test in a while as the sales tax increase (from 5% to 8%) took effect at the beginning of April.  Forecasters expect GDP growth at 4.1% in Q1 2014 but to fall off as the year progresses as buyers front-ran the tax increase.  Interestingly, sales of gold ingots ramped, with a national precious metals specialist reporting that sales were up 500% in March as customers looked to take advantage of buying before the tax increase.  In fact, the month was the busiest year in the firm’s 120-year history.  Mitsubishi UFJ’s gold ETF had an increase of 20% in its AUM from December 2012, despite the collapse of the gold price during that time.  Meanwhile, the Bank of Japan is almost completely financing the budget deficit, buying 90% of the government bonds.  Over 80% of its assets are in JGBs (the US Fed is about 55% in government treasuries) with an average maturity at eight years – and the deficits will continue with social security and debt service payments alone consuming tax revenues in 2015 means the rest has to be financed.  Historically, these kinds of ratios have led to inflation, severe deficit reduction and/or default by governments.  None have gotten out of the trap unscathed.  None.  Not a question of if, but a question of when. 


Dr. Copper Not Welcome In China:  For those of you outside the commodities complex, copper is said to have a Ph.D. in economics as its sensitivity to construction and industrial activity is to be reflected in it its price.  And, given its price collapse from $7,800 to $6,400 (over the last twelve months) due to a flood of inventory in China (bonded warehouse copper stocks almost doubled from 5,500 tonnes to almost 9,500 tonnes), Dr. Copper is not happy.  And the price of copper acting as collateral (anecdotally pledged multiple times to many lenders) falling is feeding directly into the unwind of financing discussed above.  China has the money to protect the big lenders and firms (as in too connected to fail) but the cost will be slower growth like it has been in this country and elsewhere.  Agricultural news saw two large mergers – Fyffes and Chiquita remerged after thirty years and will control about 1/7th of the banana market which Cargill (the largest private company in the US per Forbes) is joining with Brazil’s Copersucar to propel Cargill back into the sugar business where it backed away from after major losses in 2012.  Accessing 1/3 of Brazil’s sugar, the JV looks to marry Cargill’s distribution with Copersucar’s production.  Bad news if you are addicted to caramelized bananas.  China also was the center of an important agricultural merger with Chinese food importer Cofco taking over Dutch trading house Nidera for about $1.3 billion.  As China becomes more dependent on foreign sources for grains and other foodstuffs, they are looking to build and buy that expertise. 


Crude oil is caught up in the Russian-Ukraine shenanigans for very little reason.  Ukraine is a major grain exporter and close to key markets in the Middle East but the Crimea is just a big rock with a great military base, not possessing arable land nor a key civilian port.  Ukraine is not a big oil exporter – yes some major Russian pipelines go through the Ukraine, but they are running at partial flow rates and alternatives exist further north through Belarus. natural gas imports from russia as % of total imports As mentioned earlier Russia does not want a shooting war until perhaps the alternative pipelines to India and China are built, which will take several years.  That said, Russia does supply Europe with 31% of their natural gas, though the dependencies are skewed to its neighbors which receive over 75% of their natural gas from Russia to as low as France and Netherlands which are under 15%.  Anytime Russia wants revenge stemming from WWII to Germany (36%), Austria (71%) and Romania (86%), it can squeeze them.  Just not yet, strategically.  For the record, despite what any politician says, US-sourced LNG is completely inadequate to do anything about it.  What the US can do, and did, was remind Russia and the world that it has almost 700 million barrels of crude oil in its strategic petroleum reserve by performing a “test sale” of the same sour crude that Russia commonly exports.  The shale and Canadian oil sand resources offer a strategic option to supply friends if needed (similar actually to what happened during WWII when the US produced about 60% of world oil).  And don’t think that industrial pollution is only a Chinese phenomenon as petroleum coke, a fine black powder blown from open storage barges, coats neighborhoods and lungs in Chicago.  A byproduct from Canadian oil sands refining and sold as fuel in emerging markets with lower environmental standards, the coke detritus is expected to triple as BP’s Whiting, Indiana refinery’s new coker will allow it to shift cheap Canadian tar sand production from 20% of its feedstock to 80%.  The Chicago terminals are owned by the appropriately-named Koch brothers, and litigation is ongoing.


Invest wisely!


David Burkart, CFA  

Coloma Capital Futures®, LLC

 Special contributor to aiSource


Additional information sources:  Bloomberg, Financial Times, South Bay Research, United ICAP, and Wall Street Journal.