Wednesday, March 4, 2015

An update on Brazil's flagging economy

Posted by Walter

Brazil's economic uncertainty continues to worsen. While growth projections for all the BRICS have been lowered, for the first time in years Brazil's economy is now expected to contract in 2015.

Source: Bloomberg, @M_McDonough

We can see the impending recession reflected in the nation's inverted government bond yield curve.

The fiscal situation has worsened materially. As the Economist recently pointed out, wage growth of public sector employees is unsustainable.

Source: @sobata416,

The government is now forced to undertake significant austerity measures which will hit the economy hard. Years of mismanagement have come home to roost. With fiscal risks on the rise, the nation's sovereign CDS remains elevated.

Source: @HedgeForMoney

The Brazilian real hit new lows not seen in over a decade, as the economy struggles. Furthermore the Petrobras scandal as well as its potential impact on state banks (who are massively exposed to the firm's credit risk) weigh on the currency.


As the currency depreciates, the nation's dollar denominated debt is becoming increasingly burdensome.

Source: @sobata416,

Some may remember this headline from 2013.

Source: Bloomberg, May, 2013

That $11 billion was 24.5 billion reais in 2013 and now it's 32.8 billion. The company's liabilities have increased by a third while the assets have been hurt by weaker energy prices.

In response to the currency weakness Brazil's central bank hiked rates to the highest level since 2009 to stabilize the currency and fight rising inflation. This will further dampen credit demand and accelerate the recession.  Now all we need is for the Fed to hike rates. That will put more downward pressure on the real and force Brazil's rates even higher. As it is the 10-year government bond yield is already above 12.75%.

It's important to point out that given its significance to the global economy, Brazil's problems can spread way beyond its borders. The Petrobras scandal for example has shaken other Latin American debt markets (see story). The currency weakness in Brazil is now pressuring some international commodity markets. The nation's growers of sugar, oranges, etc. can dump commodities at lower dollar prices and still come out ahead in domestic currency terms. As a result orange juice and sugar futures have fallen sharply (May-15 contracts shown below). A number of other commodity markets will be impacted as well.

Source: barchart


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Monday, March 2, 2015

The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB,

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics


Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.
RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.
Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.


But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.


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Sunday, March 1, 2015

China's rate cut insufficient: investors expect more PBoC stimulus and yuan devaluation

Posted by Walter

China's central bank followed up with a second rate cut this year. While many believe this is a step in the right direction, the move alone will do little to reduce high real rates and tight effective monetary policy.

Source: TradingEconomics

In fact money market rates in China have been rising. Here are the overnight and the 1-week SHIBOR (interbank) rates for example.


At the same time inflation has been moving lower, with CPI hitting 0.8% YoY in the last report.

This results in real rates that are are multi-year highs (chart below) in a slowing economy. The situation in the repo markets is similar. The effective monetary policy is just too tight and these real rates are not sustainable - many more cuts will be needed.

Source: @georgemagnus1

The PBoC pointed out that the reason for the cut was to achieve "real interest rate levels suitable for fundamental trends in economic growth, prices and employment". Market participants and economists remain a skeptical.
Deutsche Bank: - The rate cut is not enough to stabilize the economy. We believe growth will continue to weaken in March and Q1 GDP will drop to 6.8% (consensus 7.2%). The key issue is whether the central government will loosen fiscal policy significantly and quickly enough to offset the slide of fiscal spending on local government side. We do not see signal of such easing yet. Without meaningful pickup of fiscal spending, growth momentum will likely weaken further.
Source: @georgemagnus1, IMF

The expectations are that a whole series of cuts could be coming as China's growth slows further. That's why just as the short-term rates rose recently, markets view these rates falling significantly in the longer term. The rate swap curve has become even more inverted over the past month.

With recent talk of a US rate hike in 2015, this puts the Fed and the PBoC on a diverging policy trajectories. That exerts further downward pressure on the yuan which now trades at the lowest levels since 2012. The chart below shows USD appreciating against CNY.

Source: barchart

Many now believe that Beijing will soon let the USD/CNY peg go. With rate cuts alone insufficient to stabilize growth, weaker currency may be just the medicine China's economy needs.


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Sunday, February 22, 2015

Market expectations of the first Fed rate hike seem unrealistic

Posted by Walter

The Fed Funds futures continue to point to the first Fed rate hike in late Q3/early Q4 of 2015.

The debate is now focused on whether this timing is unrealistic. To be sure, whether we have a hike in September of 2015 or in January of 2016 will have little direct impact on near-term growth. But could an earlier hike exacerbate disinfaltionary pressures in the United States and globally?

Some argue that the weakness in inflation has been driven by energy markets and once we have some stability in that sector, price growth will speed up again. However we are also seeing signs of slowing inflation in the "core" measures:

Core CPI:

Core PPI:

Moreover, this slowdown is coming from a variety of sectors - for example healthcare:

Source: Credit Suisse

Therefore even if we see some gradual increases in energy prices (which may take some time), inflation measures may remain significantly below the Fed's target for a while. So what could prompt the Fed to act in the next few months? Some argue it will be wage pressures.

While we've had a number of forward looking indicators pointing to higher wage growth ahead, we haven't seen that trend in the official figures thus far. Americans are certainly working longer hours, but the pay per hour continues to grow at 2% per year. That in no way constitutes wage pressures - at least not yet.

One of the arguments for higher wages going forward is poor productivity growth in the US. Companies will be forced to hire more people and pay them more - the argument goes - in order to compensate for difficulties they are having in achieving growth with their existing workers (via technological and process improvements, etc.). Perhaps.

Source: Evergreen GaveKal

But even if we see a modest improvement in wage growth in the next few months, the FOMC remains concerned about pushing the dollar higher and destabilizing global economic conditions - the equivalent of another "taper tantrum". For example, it's important to keep in mind that the Greece situation is likely to resurface again in 4 months or earlier.
The FOMC: - ... the increase in the foreign exchange value of the dollar was expected to be a persistent source of restraint on U.S. net exports, and a few participants pointed to the risk that the dollar could appreciate further. In addition, the slowdown of growth in China was noted as a factor restraining economic expansion in a number of countries, and several continuing risks to the international economic outlook were cited, including global disinflationary pressure, tensions in the Middle East and Ukraine, and financial uncertainty in Greece.
And for those who still believe that the Fed is too domestically focused, just take a look at what occupies a good chunk of Janet Yellen's time these days.

Source: WSJ

At this point we would need to see a major shift in domestic wages and inflation indicators as well as a more stable international economic picture in order for this dovish FOMC to move on rates. The expected rate hike in the next 6-7 months indeed seems unrealistic.


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Diverging developments in oil markets vs. energy shares

Posted by Walter

Let's take a look at the recent developments in the US energy markets and the seemingly contradictory reaction by equity investors.

First of all, while we continue to see significant declines in the US rig count (both oil and gas),  ...

Source: Banker Hughes

... American crude oil production remains at record levels and still rising. It's going to take time for this momentum to turn.

Source: EIA

Part of the reason is the increasing productivity of new rigs in the US.

Source: EIA

Moreover, outside the US some major oil producing nations such as Russia and Iraq - desperate for hard currency - will maximize production in the months to come. Global production will therefore continue to rise.

The second key development has been a relatively steep crude oil futures curve (contango).

Source: barchart

This is encouraging crude investors to store oil. The arb involves buying spot crude, simultaneously selling forward, and storing for delivery at a future date (Profit = Forward Price - Spot Price - Storage Cost - Financing Cost). If the arb persists, the trade can be rolled. That's why this past week we saw the largest spike in volume of crude in storage.


Moreover, the absolute levels of crude in storage are now at the highest level in some 80 years.

Source; EIA

As a result, analysts expect Cushing, OK (the WTI crude delivery/storage hub) to run out of storage soon.

Source: @jenrossa

Crude in storage is on the rise outside the US as well. As an example, Iran just launched a huge floating oil storage unit in the Persian Gulf (built by Samsung). This facility stores 2.2 million barrels of crude.

Tehran Times

The most important development in 2014 of course was the historic shift in the crude oil production cost curve, capping crude prices at $75-$80/bbl for some years to come.

Business Insider: @themoneygame

Now, with these production fundamentals in place, rapidly growing amounts of crude in storage, and longer-term prices capped way below milti-year averages, why are energy firms' shares still relatively expensive? For example, over the past couple of years spot crude oil is down 45%, while the energy component of the S&P500 is up 2%.

And forward P/E ratios are more than double the historical averages - these are some of the most expensive large cap shares in the market.

Equity markets seem to be betting on a quick decline in production and sufficient recovery in crude prices to return the energy industry to stronger profitability in the nearterm. There is also the view that some energy firms will remain resilient due to their midstream operations - storage, transport, and refining. And we've all heard talk of consolidation and M&A activity in the space which may also support share prices (see story). A number of analysts have turned constructive on the sector.

Source: Goldman Sachs

Furthermore, from the technical perspective many portfolio managers have been heavily underweight the energy sector for months and some believe that the eventual rebalancing will drive up share prices.

These are all solid arguments. However given the current lofty valuations, if we don't see a major improvement in crude prices in the next few months, energy shares may take another leg down. One can see this nervousness in the credit markets as HY energy credits remain near historical wides to the rest of the market (chart below). For those who wish to jump in at these levels, be prepared for significant volatility and deleveraging in the energy sector.

Source: Credit Suisse


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