September 2014 Global Macro Recap

Global macro factors continued to reign in September, as can be seen in the strong rise in the US dollar which gained 3.8% against the Euro, 2.3% against Sterling and 5.3% against Yen.  Being a “safe haven” AKA “the best house on a bad street” does have its advantages – a need to invest those incoming dollars in our stock, bond and housing markets (easing the Federal Reserve’s QE exit and keeping the bull markets going) and a dampener on inflation (as imported goods (including oil) cost less in dollar terms).  We do expect US rates to be low for a long time to come… just perhaps higher than those in Europe and Japan given their worse economic conditions.  Europe still struggles despite their low rates – France is blowing through its budget deficit target and Germany’s vaunted industrial sector is showing strain.  On the plus side, Russia is quietly spiraling downward as the latest round of sanctions appear to be having an effect on its financial markets (the US dollar gained 6.7% versus the ruble, for example) and Russian companies need to refinance tens of billions of dollars by the end of 2014, consuming government currency reserves.  However, Ukrainians continue to be killed with impunity (imPutinity?), so the race against time continues.  China is likely to turn in a notably lower than standard 7.5% GDP growth number but I suspect that they will go for a “close miss” to keep market confidence going while acknowledging the growth downshift.  On the other hand, commodities are broadly lower which should be supportive of world economic growth.  

Fewer Treats Means More Tricks?  The Federal Reserve is still on track to eliminate QE in October, though with interest rates low for the foreseeable future, one cannot say that the US central bank is truly tightening. Unemployment down in Q3 of 2014 In the meantime, Q2 GDP annualized growth was revised upward to +4.6% from +4.2%.  The unemployment numbers are officially “good” with the headline rate at 5.9% and underemployment at double that level (11.8%).  Payrolls increased quite decently at 248,000 in September, pushing up the average for 2014 to 227,000 per month – the best since the 1990s.  New claims for unemployment continued their slow fall as well.  The income side of consumers is still troubling, with hourly wages down in September versus August and up less than 2% versus a year ago.  In fact, with the rich-poor divide ever wider, than goods inflation looks to be suppressed for a long time (per the Federal Reserve survey, the top 10% of families hold 75.3% of the wealth, up from 66.8% in 1989, while the bottom 90% conversely fell from 33.2% to 24.7%.  Median income for the top 10% increased between 2010 and 2013 while it fell for each bracket of the bottom 90%.  The US Census also released wealth/income figures that generally match these results).  Another way to consider wage-push inflation is to note that the median earnings for US workers have not changed since 1989).  Even if GDP growth is set to continue (higher consumer spending in July and August, increased consumer borrowing, mixed home sales and durable goods orders, and expanding factory indicators), this is the recovery that has left out almost everybody.

loans and leases at commercial banks increase in 2014One way to reverse this trend is if banks start making real loans to businesses and consumers, causing greater business expansion and wage increases.  Arguably this is what has happened in the San Francisco Bay Area, though the funding has come from venture capital rather than banks.  Fortunately, from the WSJ chart at left, in aggregate the Federal Reserve data shows that bank lending has increased year-on-year with the industry categories of debt (industrial loans, commercial real estate) displaying much stronger growth than their consumer counterparts.  Possibly slowing this growth are the Fed’s plans to increase bank reserve requirements for the largest institutions, particularly for those that rely on short-term funding (less than one year in maturity).  It took about six years to get some capital rules for “too big to fail” institutions and while they are still not yet effective, maybe our politicians are finally taking some steps.  Meanwhile, more municipalities are offering fifty year plus debt – at $14.3 billion in sales, that is up 60% since a year ago.  It may not be a lot of money in total but why not extend that maturity as long as possible? 

Europe’s Economic Soufflé:  The IMF recently warned that European GDP runs a 40% change in unemployment in 2014chance of deflating through the end of 2015 as recession risks loom.  As the graph from the Financial Times shows to the right, unemployment has stayed perniciously high after the crash in 2008 while the US is almost at the pre-crash level.  To combat this problem, Draghi began executing on the revived LTRO program (conveniently called the TLTRO).  However, it has fallen flat so far.  The first round of cheap bank financing to replace the expiring LTRO program had a poor start, as banks took only €83 billion of the €400 billion offered, mostly to Italy and Spain.  After all, why take four-year money when comparable government bonds are yielding flat to negative interest rates?  Banks are in the business of making money from money, not paying money for money.  Also, there is another round in December and more opportunities in 2015 and 2016 so there is plenty of time for banks to get funding if they want it.  In the meantime, Draghi cut interest rates fractionally (and moved ECB deposit rates to negative) and outlined plans to buy asset-backed securities like the Federal Reserve’s mortgage buying under QE (and also like those packaged loans that blew up in the crisis a few years ago).  Strangely, Draghi kept outlining buying plans all September without doing anything, leading market participants wondering if he would actually follow through on it or hope that the weaker Euro would revive his stumbling economies.  Some have questioned his ability to buy asset-backed securities as much of the ABS outstanding has already been pledged as collateral, so he may have to go for junk Greek and Cypriot debt or something more aggressive.  In the meantime, Eurozone government two-year debt is basically negative across the board (e.g., Ireland, France, Finland, Belgium, the Netherlands and Germany) and even ten-year debt is close to the 1% level (from Germany, of course).  No one needs help paying interest (if they can borrow).

However, in the real European economy, activity is faltering.  In August, German industry output fell 4.0% month-on-month and factory orders also reversed July’s gain, falling the most in a month since 2009 (-5.7%).  france's public debtMeanwhile France has dared the EU to stop it from blowing through its budget limits for 2015 and looks to delay abiding by EU targets for another two years which would be its third delay.  Hollande looks like he has no ideas on how to get out the morass that has kept French GDP growth marginally above zero, at best.  Best to pile on debt and hope to get out of office in time.  Ireland in the meantime is talking to the IMF about repaying a big piece (or all) of its €22.5 billion loan early given that it can re-finance at lower rates and thus cut its interest expense by an estimated €375 million per year.  The “austerity” that it went through is rapidly being put in the rear-view mirror as unemployment is below the EU average (though still high over 11%), a falling budget deficit (below France’s) and an annualized GDP growth of 8% in Q2.  At a 2013 debt-to-GDP of 123%, the Emerald Isle is not safe yet, but it showed that taking a relatively aggressive tack to cleaning up economic problems can pay off in terms of recovery speed.  PIIGS star Greece is still showing mixed signs as while it successfully sold €1.6 billion in government debt to private holders (60% more than targeted), it missed a troika deadline for reporting corrected budget deficit figures for the last two decades, which would outline the fraud that it engaged in to qualify for EU membership (remember those swaps with JPMorgan and Goldman Sachs that did not count as debt, but actually were?).  Additionally, Greece changed the accounting rules for its banks allowing them to use deferred tax assets as capital when calculating leverage ratios, which will help the Greek banks pass the upcoming ECB stress test.  Such non-cash assets will not help deal with the projected 40% non-performing loan ratio for 2015.  But who cares as long as the accounting “fits.”  Damage to Russian economy

Russia is still fighting its shadow war with Ukraine and is doing quite okay – at least holding onto territory taken by pro-Russian separatists.  European and American sanctions expanded and they are having a slow toll.  It may not be enough to help Ukraine get its territory back but anything that weakens Putin is the right move.  This winter will see a test as Russia is undoubtedly waiting for the weather to turn and use its natural gas exports to Europe as an economic club to force an end to trade restrictions.  They have already cut gas exports by 20% to Poland, Ukraine’s most likely ally, partially to prevent Poland from re-selling the natural gas to Ukraine.  However, the Russian financial markets are faltering – the government has a gold and foreign exchange reserve of $466 billion, down from $520 billion last October.  The most recent government bond auction in September raised a tiny $261 million at 9.4% for nine-year money.  The 2014 budget deficit is relatively modest (a few billion perhaps but the recent decline in oil prices by change that) so this is more of a 2015 issue.  A stalemate in Ukraine seems the situation for now as both sides play for time (for different reasons).

You Know the Chinese Economy Is in Trouble When…:  gambling revenues in Macau are at a five year low!  The latest numbers from China are not encouraging – only +6.9% growth in industrial production when a +9.0% number is the benchmark to reasonably real-estate downturn in 2014 Chinaexpect +7.5% GDP growth (see bar chart at left).  The decline in new housing prices is also worrying, though expected.  Sales have continued to fall, declining -8.9% in August.  Secondary statistics that analysts often look at since they are have less government “interpretation” paint the same picture:  electricity production down -2.2% in August, car sales grew less than in July (+5.3% versus +8.1%) and fixed asset investment and credit creation declined as well.  The short term solution is to try to stimulate mortgage lending – we know how well that worked in the US from the housing crisis!  Basically, the Chinese Central Bank is injecting $81 billion into banks in short-term money which in turn are supposed to lower interest rates and support easier mortgage terms.  Now the implied mortgage rate from Bank of China (one of the big four) is 4.6%, lower than the weighted average rate of 7.0% for all loans.  In addition, conditions on qualifying for first-time homebuyer credits are now easier (i.e., purchases of second homes can now be considered as first-timers!). 

There are a lot of distractions – a $10 billion fraud in trade finance is just the latest scandal – it is in addition to the $1 billion in potential losses from the Qingdao and Penglai port scandal we discussed previously.  The new crime covers thirteen provinces and cities with another eleven additional suspected locations.  Further corruption was uncovered as 162,629 former employees in central and provincial governments, state-controlled financial companies and universities were still drawing salary and benefits, despite no longer working.  A great retirement, if you can get it!  Finally, rumors surfaced towards the end of the month that China’s central banker, Zhou Xiaochuan, is under pressure and may be forced to resign.  It is unclear whether the markets will find his removal reassuring or a sign that Xi Jinping is further consolidating power and the senior cadres are still under close scrutiny and cautious. 

In Japan, the results of Abenomics are still coming in and so far are not good – unemployment is up (to a still low 3.8% officially), household spending fell for the fourth month in a row, industrial production was up only +0.2% when it fell the month prior by -0.9% and retail trade fell -0.5% when +0.3% was expected.  Q2 GDP was revised further down to -7.1% annualized (worst since Q1 2009) due to worse business spending (-5.1%) and consumer spending (-5.3% – worst quarterly result on record).  At least Abe is getting his inflation – CPI was up +3.4% year-on-year.  And also Japanese utilities are looking to increase their nuclear output which will allow them to turn off their oil-fired plants – talk about switching to clean from polluting, carbon-spewing energy!  The lower operating costs should be beneficial to factory output in 2015. 

Commodities A-Plenty!  After a few years of running out of everything (well, not really but prices acted that way!), the world is enjoying a sudden excess.  The US matched Saudi Arabia in terms of liquid petroleum production at 11.5 million barrels per day (a cheating figure that includes crude oil, ethane and propane) in June and August (though Saudi Arabia still has 2.5 million bpd in unused capacity just in case).  The Saudis have not responded by lowering production, but have instead lowered prices, particularly to Asia.  The US exported crude oil to South Korea in September from Alaska (oil exports from Alaska are not restricted by US law), and the Canadians are getting more oil from the US and thus are turning away European and African barrels.  In fact, US oil exports are the highest since the 1950s, surpassing the exports from OPEC’s smallest member (Ecuador).  On the demand side, European and Chinese oil consumption growth has stalled so that side of the equation is not helping.  A potential wrinkle to push prices down decisively is that Russian oil exploration is on hold since its American and European partners cannot do business there.  ExxonMobil had to halt Arctic drilling with Russia’s Rosneft due to the latest round of sanctions.  In an interesting twist, Shell is working with solar power to heat water to steam that can be injected into oilfields to prolong their production… green meets black! 

The other black energy, coal, continues its slide as can be seen from the FT on the right hard times for coal industryas Chinese demand continued its slide (recall the electricity generation fell -2.2% in August from the above).  Coal inventory in China is growing as miners are forced to stockpile their low-grade coal due to a government ban designed to improve air quality (finally!).  The new hydropower projects that were finished this summer (as well as expansion at the Three Gorges Dam) were enough to replace 370 cargos of coal (about 26 million tons).  Maybe they could further curb the countries CO2 emissions as well (see graph at right thanks to the FT)!

For other commodities influenced by China, the story is similar – iron ore demand was down (imports fell 9% in August), causing prices to fall by $10 to the lowest level since CO2 emissionsOctober 2009.  Cotton imports were also cut to the bare minimum under its trade treaties as the country’s reserves are at extreme highs.  Imports for 2014 are down 38% year-on-year through August.  A plan to cut state reserves by selling off the fluff is still being negotiated as any further collapse in cotton prices would crush many farmers.  Finally, apparently gold demand has fallen as the price of gold has floundered, as Chinese jewelry fabrication is down 22% for the first half of 2014.

In grains, the low stocks of soybeans are at almost the lowest level since 1973 but with a substantial global crop in play, price spikes have been well contained.  The World Bank said that international food prices were at a four-year low – 21% below their peak in 2012.  Recalling the stories blaming high food prices in the Middle East as one of the causes for the various revolutions, protests and unrest, we note that world soybean production is projected to be a record 311 million tonnes (10% higher than 2013) – and other foodstuffs are enjoying similar projected inventories.  Needless-to-say that this rise in availability will have a dramatic impact on the food-versus-fuel debate over ethanol and biodiesel… at least until next year.  Finally, we cannot ignore the impact that Ebola has had on the price of Cocoa as the country that produces 40% of the world’s supply (Ivory Coast) is right next to the outbreak.  Historically, the region has had many issues – civil wars, coups and export challenges – but the export of the valuable bean always had made it out of the country.  The initial run up of the contract for December delivery was about 10% but then it fell off, erasing all those gains after month-end.  Right now the market is speculating on the risk but it has not been realized yet.  If Ebola does become wide-spread, one could see a market downturn in a number of commodities as travel is restricted and demand falls.  This is not a prediction but a reminder that there are risks to what has been the initial reaction to the actual impact of the disease.

David Burkart, CFA
Coloma Capital Futures®, LLC
Special contributor to aiSource 

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