The US Federal Reserve played its merry games with the markets as it added supposed clarity around the “tapering” of its QE4ever program with the statement that it could reduce the buying level in the “next few meetings” – or it could reverse any cuts or actually increase their bond-buying program instead, as per their whim insightful secret analysis. Europe continued to muddle around though summer strike season is looming so expect some fireworks ahead. China’s headlines ranged from lowered GDP expectations to buying the US meatpacking brand, Smithfield. I am sure that Shuanghui International (China’s dominant pork and sausage processer) knows that improving their food sanitation takes more than rebranding (and we can debate the health value of “mechanically recovered meat” and “lean finely textured beef” some other time). Bon appétit!
Do As I Say, Not As I Do: It used to be so easy to invest during this cycle – don’t fight the Fed. Setting aside whether monetary easing has been beneficial historically to the stock market, the idea that free money may be not so freely given has given equities pause. Even though nothing has been done or committed to, the concept that a plan exists to ease back on the buying (let alone the maturation of the assets to let the balance sheet decline to pre-crisis levels) has given the market pause, upsetting the US Dollar, stocks, bonds (of course) and even perhaps commodities (looking at you Gold). My feeling is that anything done would be modest – a decline in the rate of buying from $0 billion to $20 billion per month and mostly of the mortgage side of the purchases (currently roughly split 50-50 with treasuries). Helping the Fed is the projected decline in the US budget deficit as forecasted by the Congressional Budget Office – with a strong improvement this fiscal year from $845 billion to $642 billion.
Note that we’re still piling up debts, just at a slower pace. Half ($105 billion) of the improvement came from higher tax receipts (at least partially linked to more-than-expected individuals and businesses booking gains last year under lower 2012 capital gains and payroll rates) and half ($95 billion) from the federal housing entities Fannie Mae and Freddie Mac cutting loss reserves, boosting earnings (though not cash flow). The repeatability of these gains is open to debate, and regardless, not to worry, the deficit is still projected to balloon higher after 2015 (see right). At least hitting the debt ceiling has been pushed off to September so we citizens can watch the political class fight over that issue along with next year’s budget all at the same time.
On the state and local level, California officially projected a $1.1 billion surplus for 2014 – a $19 billion improvement over 2013. I suspect that the Golden State needs a few more tech-IPOs to achieve that milestone but it does make for good headlines – as long as the state legislature does not pre-spend it. Turning to Illinois, politicians there again failed to create a compromise to address the country’s worst pension crisis – a deficit of $97 billion. At least the city of Chicago is making some touch choices with plans to phase out its 55% subsidy for 30,000 retirees’ by January 2017. Perhaps if corn and soy prices ramp higher the state will have the funds. Meanwhile the largest municipal bankruptcy ended, with Jefferson County, Alabama being forgiven $1.2 billion of debt (mostly hitting JPMorgan). A number of hedge funds that bought the debt at discounted values stand to make money and county residents will see a 7% increase in their sewer rates to support the debt going forward. Wall Street wins again! Meanwhile in Detroit, the state-appointed emergency city manager is finishing up his review and all indications are that he will put the city into bankruptcy and restructure $17 billion of liabilities. In April, Detroit had $64 million in cash but owed $226 million in payments. On the possible auction block are the masterpieces housed in the Detroit Institute of Arts, including works by Bronzino, Bruegel, Matisse and van Gogh. The DIA does not own the buildings or the objects – the city does. The top 38 pieces have been appraised to sell for $2.5 billion, not enough to cover the debt, but a sale would create a lot of breathing room. For those of you that are art supporters in San Francisco (disclosure: my wife and I contribute modestly), note that while the De Young and Legion of Honor seem to own their collections, the city owns the buildings and covers about 23% of their operating budgets. Hopefully San Francisco will not run into Detroit-sized trouble!
Signs of pre-crisis behavior have returned: synthetic CDOs (pools of credit default swaps) are being issued again in the chase for yield, loans with few, if any, covenants (investor protections) also have risen dramatically to 50% of the bond issuance market this year and margin debt (borrowing against brokerage accounts) has risen to the highest level ever – $384 billion – up 29% year-on-year and equal to 2.7% of the S&P 500 index. As points of comparison, the amount was 2.9% pre-crash and 2.3% post-crash (N.B., the pre-crash S&P 500 was worth a lot more than the post-crash value!!!). On an individual level, I just received in the mail the “opportunity” to attend a house-flipping seminar where I can learn “cutting-edge strategies” from two TV hosts. At least refreshments will be served. Finally, we know that we live in the modern world when a Twitter hoax can cut $200 billion from the stock market for a few minutes before the recovery upon learning that the news was fake (supposedly Obama was injured by a bomb blast at the White House). On the plus side, we know that we love iPhones so much that Apple can raise a record $17 billion in bonds to help pay for dividends and share repurchases without repatriating cash held overseas. Financial engineering at its finest.
Hitting the Brakes on the Drive to Austerity: With over-extended European governments unable to command growth while cutting their deficits, the European Commission decided just to focus on the commanding growth aspect instead. Deficit targets for Spain and France were pushed out two years and Netherland and Belgium out one year (Belgium thus avoiding fines for non-compliance), and Italy avoided budget monitoring by the EC. If you don’t like the rules, change them! In the meantime, Euro-zone unemployment hit a new record at 12.2% in April with analysts expecting higher numbers by the end of the year.
Retail sales remain tepid with even Germany’s dropping 0.4%. Euro-zone Q1 GDP fell -0.2% (annualized -0.9% for us Americans), which is better than last year’s -0.6%, though it marks the sixth consecutive quarter of economic contraction. France fell back into recession. Though recent German industrial activity picked up, the ISM reading for Euro-zone factory production was 48.3, indicating continued contraction since mid-2011 (though better than in March). Pan-Europe, companies wrote off €350 billion in bad debt last year, a 7% increase from 2011 and equal to 3% of outstanding receivables. An example is Tata Steel (2012 write-offs of €1.6 billion), which has particular issues with its UK division that employs 18,500 workers after cuts last year in its Port Talbot, Wales’ location. Time will tell whether further job cuts are on the table.
In country news, Greece actually picked up a rating improvement with Fitch (who?) increasing its assessment from CCC to B-… not great but a first step for a country whose debt is still expanding and expected to hit 180% of GDP next year (by Fitch’s own reckoning). Those Greece GDP warrants have grown in price from about €0.2 to €1.0 in the last twelve months – just as tasty as the bond gains as Greek debt went from 30% yields to under 10% in roughly the same timeframe. Perhaps the IMF did not really make that much of a mistake in its bailout – though its admissions that it fudged numbers and bent the rules would fit the panic mentality of the EU and its member politicians. As a current example, Spain hailed a drop in the registered unemployed as proof that their reforms are working. However, since the hiring was concentrated in the leisure industries which every year pick up in anticipation of summer vacations, one must discount this seasonal effect. More importantly, under new regulations, Spanish banks face a €10 billion shortfall in new capital against bad loans over the next few years. Another credit crunch appears to be in the offing as bankruptcy proceedings are estimated to increase 50% in 2013 versus 2012, cutting into current capital and reserves. Storied Fiat and related Fiat Industrial are gearing up to move their corporate headquarters to the US and UK respectively as their European market share continues to struggle. Per the FT, Fiat’s European capacity utilization is only 40%, well below the profitability benchmark of 80%. Alfa Romero, Maserati and Ferrari will undoubtedly still be made in Italy for branding purposes but one wonders about the rest of their factories. Still looking for ways to raise revenue from upper-bracket taxpayers, France unveiled plans to cut family planning subsidies to the wealthy, a break from the principle of universal child benefits. If this sounds similar to means-testing social security (except for young people) with all the political angst that would cause here in the US, I would say that would be a good comparison. In a last bit of positive news, Portugal successfully returned to the sovereign debt market, raising €3 billion in 10-year bonds at 5.67%, half the rate when Portugal was frozen out in 2011. Once again, investors are searching for yield!
Some Pork With That? As Shuanghui International looks to digest Smithfield Foods here in the United States, China seeks answers to the broader questions that face its economy. Sticking with food for a second, a recent study by the Food and Agricultural Organization of the United Nations noted that China is set to become even more dependent on imported grains, oilseeds and meat over the next ten years, with silage imports expected to double by 2022 and imports of soybeans to grow by 40% over the next ten years.
It should be of no surprise that the FT reported that food price increases, particularly from vegetables, were the main driver of inflation in April. However, GDP growth (actual and forecast), industrial production and electricity use are slowing, producer prices deflated accelerated and urban income grew less year-on-year than in 2012. Wages overall are rising but what is worrying is that they are growing faster than productivity and thus are a drag on export growth. Already Chinese firms are looking at relocating manufacturing abroad (hope our readers are familiar with outsourcing) with the FT reporting that Huajian (a leading shoemaker) is opening a multimillion dollar factory in Ethiopia, which has an established leather industry but requires Chinese technology and expertise. The wheel turns! On the speculative side, Chinese securities brokers are committing more capital to proprietary trading and other direct investment activity in a reversal to what is seen in the US and Europe. Regulators have cut the amount of reserve capital required, allowing brokers greater leverage. Two firms mentioned in the article, Citic doubled its profits from proprietary trading of equities in the first quarter of 2012 while Galaxy Securities expanded prop trading assets by 30% over the last two years, primarily in its bond book. In the housing market, Chinese properties continued their advance, with housing prices up 4.3% in April, year-on-year. The expansion of lending that began in the second half of 2012 is pointed to as a major contributor, with both developers and home-buyers having access to credit.
Looking at other countries, India GDP growth slowed for its fiscal year ending March 31 from 6.2% in 2012 to 5.0% in 2013, falling from its previous multiyear rate of over 9% annually. Lack of power generation is often cited, with a dramatic example last summer when blackouts affected 600 million people. At least their junk bond offerings are done successfully with Rolta India (a midsized engineering design software firm) raising $200 million with substantial US investor participation. Yield chasing! Korea too is having power shortages which are expected to impact manufacturing this summer as three of the country’s twenty-three nuclear reactors were found to have counterfeit parts and another seven are down for routine maintenance and are expected to come back on line in the early fall. At least manufacturing is buoying the Philippines as it further attracts outsourcing to its existing supplier base, relatively low-cost trained/educated labor and English-speaking citizens. Finally Japan is seeing a simulative bounce in its GDP, growing at 3.5% annualized, stronger than the 2.8% forecasted by a WSJ poll of economists. It is not the highest quarterly GDP growth by any means over the last few years, but a greater than expected acceleration. Certainly the weaker yen is helping exports and thus profits. Of course, for a country that imports basically all of its energy (i.e., expensive LNG), higher fuel costs will continue to drag on the economy. A weaker Yen I feel is likely as not only is the amount of QE4ever that the Japanese Central Bank is indicating (some estimates say 60% larger than the US’ – and Japan’s debt-to-GDP is over 200%), but the Japanese pension plan (similar to US’ social security) is looking to reduce its percentage of government bonds (from 67% to 60%) and reallocate to foreign bonds and Japanese and foreign equities. To my mind, increasing the supply of Yen and increased government buying of foreign assets sounds negative for their currency for quite awhile.
Meat Leads the Way: Shuanghui International reached an agreement to buy out Smithfield Foods for $7 billion, the largest Chinese takeover of an American firm to date. Shuanghui, implicated in tainted meat scandals in 2011, is looking for quality supply that it can market at home at a premium price while potentially looking to expand exports to the US. This is one of many recent cross-border deals recently – Japan’s Marubeni bought US grain-trader Gavilon, US’ ADM is taking over Australia’s GrainCorp and in 2009 Brazilian JBS bought US’ Pilgrim’s Pride. China continues to have livestock-related problems – in early June a fire at a poultry slaughterhouse killed at least 119 workers and the death toll from H7N9 bird flu stood at 37 at the end of May. To be fair, swine flu is hitting Venezuela (3 dead, 160 ill) and SARS has landed in Saudi Arabia (18 dead, 30 cases diagnosed) and France (one dead after visiting the UAE). Meanwhile beef prices hit a recent high in retail prices, with US retail prices for choice beef hitting $5.26 per pound – up 5% from last summer – and $4.20 in 2010. Looking ahead, there may be some relief in six to twelve months as grain planting progress has caught up well with corn reaching 91% on May 31st of the crop in the ground and southern crops already hitting four to five feet in height.
Rain has abated somewhat as the drought conditions have improved for the majority of the corn producing areas (see left – that vertical line almost perfectly demarks the corn belt on the right, versus the drought areas on the left). Soybeans too have made excellent progress and look ready to be in the ground in time for yields to stay strong. With the big USDA crop production report due Wednesday the 12th, we expect to see a substantial increase in end-of-year corn stocks – not a surplus for all time, of course, but a healthy one. If you are a coffee drinker, be advised that there are fungus concerns hurting Central American production of some of the rarest and most desired beans from Mexico to Panama. Arabica production is good thanks to Brazil’s bumper crop, but if you like Guatemalan coffees, expect a higher premium.
In conventional energy, the big news is the EU investigation on oil price manipulation by BP, Royal Dutch Shell, Statoil and Platts (an oil index publisher) as the three firms are considered to have influenced published prices on oil and biofuel products. The voluntary and selective price submission process of the Platts’ indices could have impacted everything from hedging contracts to tax rates. Coming after the LIBOR price manipulation scandal, this appears to be the next shoe to drop in market regulation and concern regarding the UK’s relatively lax standards (everyone still waiting for your MF Global margin trapped in London? I thought so). On the other side of the world but local to us in California, Kinder Morgan decided to halt its pipeline plan to connect Texas and the West Coast and let rail be the conduit of crude between the two markets. Interestingly, this would allow higher quality crude oil to be shipped into Californian refineries to better meet our high environmental standards and for us to ship out the lower quality crude we extract here for Gulf Coast refineries to mix with their shale oil. Mutual advantage via trade – economist David Ricardo would be proud! To round out the investigation calendar, the CFTC, the US commodities regulator, is probing over one million swaps related to energy and metal trades that allegedly should have been classified as futures and thus subject to position limits and other oversight. These markets are not so cozy now, are they? In natural gas news, Myanmar is finishing up two oil and natural gas pipelines that connect its ports in the Bay of Bengal with the Chinese interior, providing a shorter shipping route for Middle East energy to China. Capable of transporting 440 thousand barrels of oil a day and 12 billion cubic feet of natural gas per year (25% of China’s needs), the two pipelines avoid Indonesian and Taiwanese shipping lanes patrolled by the US navy and infested with pirates. Meanwhile, the United States has granted authorization to expand natural gas exports by allowing the conversion of an existing LNG import facility to allow for exports. $10 billion over the next five years is needed to create a 1.4 billion cubic feet a day in capacity and along with an earlier project at Sabine Pass, the Freeport project will be allow to export to non-free trade partners (i.e., Europe and Asia). In emerging market news, Petrobras issued an $11 billion bond deal, the largest in emerging market history (searching for yield!) as other Brazilian companies such as steelmaker Gerdau and construction firm Odebrecht take advantage of the demand to raise cheap debt. Finally, unsurprisingly, not just China is in the hacking business as Iran has been documented to infiltrate oil, gas and power companies’ control systems that could in theory lead to their commanding American oil and gas pipelines.
Reinhart and Rogoff Ettera: In follow up to last month’s commentary, the beleaguered economists Reinhart and Rogoff have published a supplement to their 2010 paper that came under fire on the impact of debt-to-GDP ratios in excess of 90%. There still is a drop-off in GDP growth but under the 2010 paper the effect is mild. The more recent work (which uses a larger data set and has not been under criticism) still shows a 1% drop in GDP growth generally when a country’s debt hits the 90% mark. Also the US Supreme Court unanimously ruled against farmer Vernon Bowman and in favor of Monsanto in the genetic seed case that allows Monsanto and other patent holders to prevent others to use products that “naturally” propagate, such as seed and genes (yes, you do not necessarily have control over your own genes). Therefore, Monsanto effectively controls the entire US grain market and thereby influences the prices of everything the world eats (including meat via feed and grain substitutes). Sounds like a Bond villain in real life to me.
David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource
June 12, 2013
Additional information sources: Bloomberg, Chicago Sun-Times, Chicago Tribune, Financial Times, New York Times, Wall Street Journal and Washington Post.