May 2015 Global Macro Recap

The end of another month and still no resolution of the main issues of the day:  if/when will the US Federal Reserve raise rates, if/when will Greece default or stick EU governments with losses and if/when will China get its economy back on track.  As par for the course, the US economy gave mixed signals over its strength with an ugly negative revision for Q1 GDP but decent employment gains.  Greece does not have the money, nor political desire to find the money, to pay the Troika (IMF, EU and ECB) but the Troika does not want to nor in some cases legally supposed to take losses on the money it extended the recalcitrant Greek government.  Brinkmanship at its finest.  The first June payment to the IMF was delayed to the end of the month – and note, there is a grace period of a month before the IMF would officially call a missed payment “late.”  Furthermore, the €7.2 billion the Troika has promised to Greece would be gone by the end of August as that money would be needed to repay maturing debt (to the Troika).  Therefore, any “solution” would be temporary at best.  China is veering to indirect monetary stimulus by ordering banks to swap out existing municipal debt for new terms (at lower interest rates).  While the government has plenty of reserves in international bonds and other investments to clean up bad debts, redeeming those funds may unsettle markets.  More wait-and-see though any real drama is over a year out.  World oil production is still at very high levels though lower rig counts in the US are giving bulls some hope.  Geopolitical risk in the Middle East and Eastern Europe may also bid up prices.  ISIS and Putin benefit from higher commodities prices so their desire for disrupting world markets is quite tangible.  A deal to lift sanctions with Iran however could send energy prices into a tailspin as Persia has extra supply to bring on line in short order.

Feeling a Little Meh:  The US economy continues to send out uncertain  messages over its health.  The end of May saw the small increase for Q1 of +0.2% (versus +1.0% expected) be revised down to a -0.7% annualized levelUS GDP Growth on weaker-than-originally-forecasted net exports and lower inventory stockpiling.  The export result was blamed on the stronger US dollar which has weakened subsequently.  Automobile sales also have continued to hold up well.  Q2 expectations are still for a recovery from these transitory items (e.g., oil patch spending expected to stabilize, decent weather and no port strike) at an annualized rate of +2.7%, but we shall see.  Retail Sales were flat for April, slightly below expectations.  Factory output was unchanged in April versus March, with manufacturing held back by declines in oil and gas drilling and equipment.  Sales of previously owned homes (the majority of home sales) fell -3.3% in April though average prices increased +5.5% year-on-year (+8.9% for the median home) before seasonal adjustments. US factory activity stayed on the positive side per the Purchasing Managers Index but April’s Durable Goods Orders were down -0.5% (as expected).  US payrolls stayed on track with 223,000 hired in April, rebounding from March’s 85,000 level, and the unemployment rate ticked down to 5.4%.  Jobless claims stayed below the closely-watched 300,000 level for the 12th straight week, also showing continuing positive results. 

All-in-all, at this time, the Federal Reserve is under minimal pressure to raise rates even this summer, in my opinion.  They may still make a token move(s) in Public worker pensionthe fall or by the end of the year, but to my mind, that would be “optional.”  Supporting government debt and budgets is a priority for the Yellen Fed, especially with a major city like Chicago being downgraded to junk quality on its $8.9 billion in debt as Moody’s cut its rating over concerns about the city’s large and growing unfunded pension liabilities – the highest of any city both in per resident and as a percentage of the city government revenue (see left from The Economist).  With a budget deficit of $430 million for the coming fiscal year (plus an unbudgeted $500 million required pension contribution), there does not appear to be any easy budget solution either.  Moving up to the state level, Illinois has the same issues and is trying to cut transfer payments to Chicago (and other cities) to deal with its state-level deficits.  Will the domino effect come into play?  Sounds a bit like Greece.

Puerto Rico finally passed a tax-overhaul bill to stave off default but Moody’s still downgraded the island’s bonds deeper into junk territory.  Peter is being robbed to pay Paul but the situation is still unresolved.  Again, sounds a bit like Greece, doesn’t it?

Brazil continues to suffer, with unemployment at 6.4%, the highest in four years and inflation projected to end the year at 8.25%.  Brazilian ten-year bonds at 4.6% risk higher rates as the central bank looks to combat inflation.  The central government is looking to freeze spending and raise taxes to try to reduce its deficit and halt the spiral.  Perhaps a lesson for Greece?  Petrobras (the quasi-state oil company) at least is able to sell 100-year bonds yielding 8.45% which, while higher than Mexico, seems like a generously low rate given its $2 billion in losses recently due to corruption and fraud (and almost $10 billion in losses overall in 2014).

Spring Planting But Bitter Harvest:  Spring is seen as a time of renewal, shoots of new plants and fresh beginnings.  Certainly Draghi hopes his Q€ program will have that result.  Unfortunately, it still looks like the fruit will go sour on Greece and Ukraine.  General economic activity has been marginally positive, with an emphasis on the word “marginal.”

Greece has run out of money – it made its €750 million payment in May to the greek debt repaymentIMF by borrowing money from another account at the IMF.  How long can this farce continue?!  Now in June, there is €1.6 billion due to the IMF, some of which was supposed to be paid on the 5th.  However, as is permitted in IMF rules, Greece exercised its right to make all the payments at the end of the month, buying three weeks of grace.  Note that once Greece misses a payment, the IMF does not recognize that default until an official board meeting a month following.  Note the IMF has no real course of action apart from haranguing Greece or trying to find a greater fool different lender to give the money to Greece to pay the IMF back.  Separately, the ECB member countries then have to decide whether the IMF default will in turn cause their loans to be in default.  And the market has to decide what rate to charge for the treasury bills that Greece keeps rolling over.  However, given the size of the loans due in July and August to the ECB (see left from the Financial Times), Greece will be in default even if the IMF is paid.  Avoiding default will require new money from the Troika, which has about €7.2 billion in unreleased funds for Greece.  However, the release will only happen upon fiscal cuts and higher taxes by the Greek government, which it has resolutely refused to do.  And €7.2 billion only buys Greece about three or four months to September or so.  Therefore, a more comprehensive write-off or deferment by the Troika, deep cuts by the Greek government and/or a decision to kick the can down the road with more free money looks like the outcome in June (or later this summer).

Meanwhile, Russia’s allies in east Ukraine kicked off their summer campaign with attacks around the major city of Donetsk in their attempts to push west and south.  Certainly Russia is not intimidated by the extension or expansion of European sanctions.  Bloomberg did run an interesting article about the costs on the Russian budget as an independent think-tank in Moscow projected that the “black” AKA “secret” military spending has doubled since 2010 to about 21% of Russian spending or about $60 billion with a total military spend of about 34% or $84 billion (third globally after US and China and back to Soviet levels in the 1980s).  As a percentage, the US spends about 18% of its budget on the military and national security, though a much higher dollar figure ($615 billion per a US think-tank).  Ukraine meanwhile is trying to restructure its $23 billion debt burden (thank you Russian puppet former president Yanukovych for stealing billions).  Its finances may have stabilized with central bank reserves at roughly $10 billion, up from a low of $5.6 billion in February, but we shall see.

Q€ continued on its merry way with the big news being the scandal that a member of the ECB board told a closed-door hedge fund seminar that the bank was going to accelerate the summer’s buying in order to minimize liquidity risk during the slow vacation months.  Effectively being told to front-run the ECB and flip the bonds back to the bank for a quick profit, the attending hedge funds (and their friends undoubtedly) did just that (as well as selling Euros).  I guess central bank monetary policy is there to benefit those on the inside.  To quote my colleague Gary, just remember that it is only a conspiracy if you are not part of it.  Eurozone GDP gained +0.4% for Q1 (not annualized), mainly on consumer spending and a softer Euro helping exports.  EU employment also improved slightly amongst youth, and the overall rate declined slightly to 11.1% in April.  German Industrial Production fell in April -0.5% instead of rising the expected +0.4%.  Retail Sales came out separately for April and indicated an increase of +0.7%, which was seen as a solid figure. 

Still Struggling:  Japan put out a relatively strong Q1 GDP figure at +2.4% annualized (ahead of +1.6% expected) mainly due to heavy inventory builds and lower energy costs with the drop of the price of crude oil helping net exports.  Stripping out the inventory factor put the gain at only +0.4% (annualized), highlighting the dependency of that one factor.  March showed the first trade surplus in almost three years with exports up 8% and imports down 4%.  One can point to the weaker yen as helping the export side and lower oil prices aiding the import side.  With the inspections on the first nuclear power plant to restart to end by June 12th, we should see oil and natural gas demand slow further.

China’s macro indicators are still signaling “warning” as the OECD lowered the country’s GDP growth for 2015 from a +7.1% rate to +6.8% level as global growth was also lowered strongly from +3.7% to +3.1%, mainly due to revising the US number.  This weakness in the rest of the world implies that China’s export-led model will continue to struggle.  Overall trade in April fell -10.9% as exports fell -6.4% year-on-year, defying predictions that March’s -15% result would rebound.  Meanwhile, the cheap wages that have fueled this trade machine are slowly disappearing.  An indicator of this is the end of the growth of cheap workers migrating from the countryside to the city to fill factory jobs.  The annual migrant growth rate of 4% between 2005 and 2010 has slowed to 1.3% in 2014 and could contract in 2015.  Retail sales and Industrial Production came in at +10% and +5.9% respectively, slightly missing estimates.  Finally for you iPhone lovers, for the first time in six years, smartphone shipments in China declined year-on-year by -4.0% during Q1 2015. 

These figures translated into more bond defaults in the heavy industry and commodities space.  Coal importer Winsway Enterprises Holdings became the second Chinese firm this year to default on their US dollar denominated debt – they could not pay $13 million of interest on $309 million of notes due in 2016.  The first state-owned enterprise default also occurred when coke importer Baoding Tianwei Group could not pay its $14 million coupon.  A bottle supplier for Coke and Pepsi, Zhuhai Zhongfu Enterprise Co, was only able to repay $23 million of a $96 million principal payment after a bank consortium refused to lend it sufficient funds to roll over the debt.  Finally, Guangxi Nonferrous Metals Group, another state-owned firm, has $214 million of principal and interest due on June 13th but looks unable to make the payment.  China Credit Rating cut their assessment on the debt to junk level on the news.

Of course with all this bad news, the natural reaction of any central bank is to feed liquidity into the system.  China cut interest rates on May 10th with one-year lending rate lowered by -0.25% to 5.1% and the one-year deposit rate similarly cut to 2.2%.  For over-extended regional and municipal governments, the central bank ordered its dominant state banks to roll over insolvent government project loans, affecting about $3.5 trillion of debt.  In addition, it instituted a formal swap facilitation program to replace old loans at higher rates with new loans at lower rates, easing liquidity.  Jiangsu province and Xinjiang autonomous region replaced and increased their current debts for under 3.5% for up to ten years. Extend and pretend in the most direct and obvious fashion!  The central government has a lot of reserves so perhaps they can actually be successful at delaying any tough decisions for a long time… unlike Greece!

Black Bubbling Crude:  The fall in oil prices has not done anything to stop the production of oil – US production is up over a million barrels per day, OPEC production was up year-on-year in April, Brazil production is up 17% year-on-year for Q1 and Russia, Vietnam and Malaysia increased their net production byUS Crude exports about a half a million barrels.  US crude exports increased in April, exceeding OPEC members Libya and Ecuador (see right).  Iran exported a record 97 million barrels in May and there is no Iran deal yet.  US rigs keep falling and are now at 60% below the all-time high reached last October.  Saudi rigs on the other hand are at a 20-year high (see right).  With prices so low and production so high, who is buying?  China and India are, for certain.  China past the US in April as the world’s largest oil rigs in middle eastoil importer at 7.4 million barrels per day versus the U.S.’s 7.2 million.  As discussed before, the Chinese have a strategic reserve program that is still in early stages.  In addition, India, the fourth-largest consumer of crude oil, made its first crude oil purchase for its strategic reserve.  The US has started to see a small decline in its crude oil inventories, but they are still 30% higher than the last five years – and in line with seasonal draws and providing plenty for summer driving season. 

And it is not just oil that is plentiful – coal is so unloved that the second-largest miner east of the Mississippi, Patriot Coal, is set to go under and potentially 4,000 jobs with it.  Having filed for bankruptcy, the miner has to line up a strategic buyer or be forced to liquidate.  Meanwhile, the current version of the Chevy Volt has halted production as dealer inventory is enough for seven months, more than enough to cover dealers until the 2016 model year this fall.  If gasoline stays below $3.00 (currently $2.75 is the national average, a dollar below San Francisco, I may add), then electric cars will continue to suffer.

In other commodity news, bird flu has hit egg-laying flocks pretty hard – about 10% of the layers – with lesser hits to broilers (for eating), turkeys and ducks.  The cattle herd is slowly increasing on strong demand and good pasture – still expect $20 steaks at the butcher for this summer, however.  Some beef relief may come as China ended their embargo against Brazilian beef, which would shift demand from the US.  Grains are looking to generate bountiful crops this year and Russia has reduced its export duty on Wheat to help meet demand.  Finally, Ghana, the second-largest cocoa producer after Ivory Coast and responsible for 20% of the annual crop, has been facing bad weather and pests.  The West African country is projected to produce only 650,000 tonnes instead the recent four-year average of over 800,000 tonnes.

Finally per Reuters, Vietnam, the world’s top producer of Robusta beans used in blends and instant coffee, is devoting shifting land to pepper cultivation with prices of the spice rising eight times faster than those of coffee.  Prices in Vietnam, already the world’s largest producer and exporter of black pepper, have climbed 16 percent to 184,000 dong ($8.45) per kilogram since the start of 2014 as global output lagged demand, outpacing the 2 percent gain in coffee prices during the same period.  Stock up on that pepper!


Best of investing!

David Burkart, CFA

Additional information sources:  Bloomberg, The Economist, Financial Times, New York Times, Politico, South Bay Research, Wall Street Journal and Zerohedge.