Saturday, May 16, 2015

Latest economic trends: U.S., Eurozone, China

This was recently presented to a major wealth management group in New York City.

Presentation

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Sunday, May 10, 2015

The biggest risk to US growth: further dollar rally

The biggest risk to US economic growth remains the possibility of an extended US dollar rally. The Fed rate hike expectations have been pushed out to December and many doubt that the Fed will hike right before the year end. That's because the hike will involve three rates: FF, IOER, and RRP and could be disruptive to money markets over the turn (year-end). That means if we don't get a hike in September, we may not see liftoff until 2016.



At least that's what the markets expect. But if the Fed unexpectedly hikes this summer, the impact on the markets could be severe. And the dollar is likely to rally further as a result.

We've seen what a strong dollar can do to US manufacturing employment.

Source: ISM, Investing.com

But there are other "unintended consequences". Consider for example US farming businesses and the banks that provide them credit. It's hard for US farmers to compete with Canadian, Australian, Ukrainian, and other foreign producers after those nations' currencies have been sharply devalued vs. the dollar. That's why grain prices, farms, and banks that lend to them are vulnerable to further US dollar strength.

Wheat futures (source: barchart)


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Crude rally about to sputter?

There is a distinct possibility that the recent oil rally is about to run out of steam. We have two potential issues on the horizon for crude markets:

1. The physical oil market seems to be facing challenges resulting in a disconnect from the futures market. We've seen this movie before, and it doesn't end well.
Reuters: - Tens of millions of barrels are struggling to find buyers in Europe with traders of West African, Azeri and North Sea crude blaming poor demand.

The deep disconnect between the oil futures and physical markets looks similar to the events of June 2014 when the physical market weakness became a precursor for a futures price crash.

"Being large physical buyers of crude we have a direct pulse of the market and feel immediately when it is well supplied, as is happening now," Dario Scaffardi, executive vice resident and general manager of independent Italian refiner Saras, told Reuters.

"In the short-term, futures prices do not necessarily reflect accurately the physical market."  (via @MarathonWealth, @GreekFire23)
2. While US oil rig count continues to decline (see chart), the recent price increases have been sufficient to bring some rigs back online. US oil production has stopped growing but so far it is not declining and remains significantly above last year's levels.
Bloomberg: - For the first time in five months, a rig in the Williston Basin, where North Dakota’s Bakken shale formation lies, sputtered back to life and started drilling for crude once again. And then one returned to the Permian Basin, the nation’s biggest oil play, field services contractor Baker Hughes Inc. said Friday.
Some forget that in the current price environment US firms are pushing rig efficiency to new levels and the cost curve is expected to shift lower.




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The Economist playing fast and loose with data

The Economist generally does a good job analyzing economic and financial data and synthesizing/discussing the results. But once in a while the authors try to pull a fast one on the readers.

Here is an example. In the chart below the author argues that the current US unemployment rate is abnormally low. Given how weak fixed investment (buildings, equipment, technology, vehicles etc.) has been, the unemployment rate should be higher than it is. Therefore, the argument goes, the low unemployment rate is not fully capturing the weakness in US labor markets.



While this conclusion may indeed be true, the argument is flawed. The analysis conveniently uses a period when this relationship between unemployment and fixed investment was strong - driven in part by a massive construction bubble in the US. The reality over the long run is that the relationship is rather tenuous. Here is 60 years of data, with the orange dot indicating where we are today. This goes to show that even the best financial media outfits will periodically try to cut corners.


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Energy market dislocation impacting the economy

We now see more evidence of the energy market dislocation impacting the economy. Here is the job cuts report from Challenger, Gray & Christmas showing a pickup in layoffs.

Source: Challenger, Gray & Christmas

Of course it's not just the energy sector that is being hit. As discussed before the impact on other areas in oil producing states is significant. Here is what's going on with construction jobs in Texas.




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China's falling interest rates

Expectations are building up that China's central bank will continue announcing further easing actions.



But it's not what the PBoC is saying that matters to the economy as much as what's actually going on in the short-term rates markets. And short-term rates continue to fall. This is a form of easing without the central bank announcements.

Overnight interbank rate (Source: SHIBOR)

Here is the 7-day repo rate - a fairly liquid short-term secured lending market in China.

Source: Chinamoney

Note that even the 1-year SHIBOR, to the extent it represents an actual lending rate, is falling (though remains elevated relative to inflation).

1-year interbank rate (Source: SHIBOR)

China's rates continue to decline and the PBoC will support this trend - with or without policy announcements.

On a related note, one of the reasons China needs to lower interest rates is to help the nation's strapped municipalities refinance their debt. Currently a great deal of the debt is structured using off balance sheet bank products and Beijing's goal is to shift to the muni market. That process however will take some time.

SourceL @Callum_Thomas, @prchovanec 


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Sunday, May 3, 2015

Sentiment shift on US inflation expectations

We seem to be undergoing a market sentiment change as fresh signs appear that US inflation has bottomed.

Commodity markets are firmer, particularly industrial metals. We've seen nickel prices moving up sharply a couple of days back (see chart). Here is aluminum and copper.




Commodity indices are still near multi-year lows but seem to have found a bottom - for now. Here is the CRB BLS Spot Index.

Source: barchart

Moreover, the components of the US Employment Cost Index seem to indicate improved wage growth as well stronger increases in starting salaries.

Source: Deutsche Bank

As a result we continue to see breakeven inflation expectations moving higher. The Eurozone has also seen an improvement in breakeven rates.



Perhaps the most telling sign that inflation sentiment has shifted is the record jump in inflation funds inflows (ETFs and mutual funds).

Source: Deutsche Bank

The dollar of course continues to pose risks to this change in investor views. Should we for example see a 300K new payrolls print from the labor department this Friday, all bets are off. The Fed will be back in play, the dollar rally will resume, and inflation expectations will dive again. Such an outcome with the jobs report seems unlikely but a resumption of the dollar rally remains a risk.

Source: barchart


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By insisting on a rate hike the Fed has "imported" some of the global slowdown

Economic data out of the United States remains lackluster. We now see more evidence that a strong dollar can be quite damaging to US growth, as manufacturing employment in the US unexpectedly shifts into contraction mode.

Source: ISM, Investing.com

With this miss in the Friday's ISM PMI report (which was generally weaker than consensus), the Bloomberg Economic Surprise index hit the lowest level since early 2009.

Source: @MktOutperform

Some argue that this economic soft patch is driven mostly by seasonal effects, as Americans increasingly tend to "hibernate" over the winter.

Source: Scotiabank

If so, will we see an improvement in Q2? There is quite a bit of debate around this topic, but so far a number of high-frequency indicators point to a softer than expected start to Q2. The ISM manufacturing report discussed above is one of them. Moreover, regional manufacturing inventory levels seem to support that data.

Source: @Not_Jim_Cramer

We also have the Atlanta Fed US GDP tracker - which correctly predicted poor GDP performance in Q1- pointing to growth that is substantially below the "blue chip" consensus.

Source: Atlanta Fed

Note that this model has been shown to be quite reliable in predicting the initial GDP releases in recent quarters.

Source: @Not_Jim_Cramer

The Fed officials seem to have gotten the message that it's not the slightly higher interest rates in and of themselves that would impede growth. While the US economy on its own can easily withstand higher short-term rates, it is the dollar's strength, driven by higher rate expectations, that could be damaging. The chart below shows the increased focus on the dollar.

Source: @M_McDonough

While the rest of the world is easing policy, the US central bank can't begin tightening without negative consequences. And the global monetary policy is in a rapid easing mode. Except for Brazil, Ukraine, and a couple of other nations that have been desperately trying to defend their currencies, we've had over 30 individual rate cuts by central banks globally this year alone.

There is another way to think about this effect. The chart below shows the global nominal GDP growth (measured in US dollars) - which is projected to decline in 2015 for the first time since 2009 (see write-up). By swimming against the world's monetary policy tide, the US risks "importing" some of that global slowdown. And that is indeed what the the Fed has done by telegraphing a hike this summer.

Guggenheim


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