Tuesday, October 21, 2014

Last week's volatility and the economy

US consumers remain jittery. As expected, households actually paid attention to last week's market volatility and the Ebola fears. As many have pointed out, some of what we've heard last week was blown out of proportion. But any increased uncertainty, perceived or real, can have an immediate and a very real impact on the economy these days.

Source: Investing.com


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Monday, October 20, 2014

No hard-landing for China's economy for now

China's GDP growth is gradually slowing as expected - at least according to the official reports.


Growth is now at the lowest level since 2009, but so far the Bloomberg China GDP Tracker forecast of a sharp correction this quarter has not materialized.

Source: @M_McDonough

In fact, the nation's industrial production growth, which continues to decline, came in better than expected.



Fixed asset investment growth shows a similar slowing pattern - now growing at 16% per year.



Have the various hard-landing predictions (many focused on the worrisome credit expansion in China) been too draconian? From a number of recent indicators it seems that China's economic growth is gradually grinding lower - perhaps toward something like a 4% per annum in 2020 (see report). Unless of course China's official economic reports are completely flawed - which is always a possibility.

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Update on crude oil markets

Crude prices came under pressure again today. According to Reuters (from last week), the Saudis “will accept oil prices below $90 per barrel, and perhaps down to $80, for as long as a year or two”. Their goal is to shake out some of the high-cost competition (such as the US). The Saudis also do not want to choke off the economies of their customers by cutting production. Current production levels are likely to stay unchanged unless there is a significant price move to the downside from here. Spot crude is now holding right in the middle of the Saudis’ preferred range at around $85/bbl. Both OPEC and non-OPEC producers are not particularly happy with Saudi Arabia right now (particularly Russia, Iran and Venezuela) – these countries all want to see production cuts.

A significant difference remains in the demand profile between the international crude markets and those in the US. While both of the futures curves shifted sharply lower, the WTI curve, unlike Brent, remains in backwardation. It means that US crude oil market participants have an incentive to take oil out of storage rather than storing it. This indicates a more robust US spot crude demand than exists globally.

Source: Deutsche Bank




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Sunday, October 19, 2014

The good, the bad and the ugly of falling energy prices

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.
Source: barchart

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.
Merrill Lynch: - ... consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.
Source: Merrill Lynch

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Source: Scotiabank

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. - all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.

Source: @M_McDonough

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Source: CAZ Investments

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.



In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US - many funded via private capital (above) - are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation - even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Source: Credit Suisse

Rumors have been circulating of a number of energy (and related services) firms getting ready to "restructure". There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward - at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

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Friday, October 17, 2014

Big move for vol of vol

Staying with the volatility theme, the latest jump in VIX was clearly dwarfed by what we saw in 2008 or even in 2011. However that's not true for the volatility of VIX - the so-called "vol of vol". The CBOE's VVIX Index, "an indicator of the expected volatility of the 30-day forward price of the VIX" (see description), has been comparable to or higher than what we saw during those high stress periods. The possibility of VIX doubling or even tripling ("tail" risk) does not seem outside of the realm of possibilities these days - even from the current elevated levels. And traders are willing to pay a relatively high premium to be able to take advantage of such moves.



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Thursday, October 16, 2014

Implied vol dislocation

The recent spike in volatility has created a "dislocation" in US equity options markets. VIX, which is a measure of implied volatility for large cap shares is now higher than RVX - the small-cap equivalent. This is highly unusual, since small caps tend to be more volatile. Part of the issue is the outsized spike in the volatility of large energy shares due to the recent sell-off in crude oil.






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Convergence

The ECB can continue to argue that economic conditions in the Eurozone are nothing like those in Japan. The markets say otherwise ...





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Tuesday, October 14, 2014

Disinflation spreads to the UK

Italian consumer inflation remains in the negative territory (see chart), as the nation's economy struggles to grow. But Italy is not unique - the rest of the world is catching the Eurozone's disinflationary flu. China's latest CPI print for example came in below that of the US - something we haven't seen until recently (see chart).

The UK is also facing weakening inflation. Prices continue to fall at the wholesale level, with British firms still having little pricing power (see chart). It's difficult to raise prices when everything is marked down across the Channel. For the UK's consumers, inflation is now at the lowest level since the Great Recession - for both the headline and the core CPI.


It's difficult to see how the Bank of England can begin raising rates in such an environment - even with the housing market remaining strong (see chart). With oil prices collapsing, inflation is only going to move lower. Just as the case with the Fed (see post), the forward rates markets are pricing in an increasing delay in liftoff. The BoE is on hold at least until next summer as disinflation spreads to the UK.

Markets' expectations of the UK overnight rate (source: BoE)


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