Where's The World Economy Going?

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Includes: DIA, IWM, QQQ, SPY
by: Alvaro Martí

Summary

The world economy is facing major problems.

Recent European banks problems are concerning.

Central Banks have lost its ability to help the economy.

There's a big debt bubble.

Since my last WEO report in November 2015, in which I warned about the impact that would have a rates hike in the US and about commodities remaining flat, things has gone faster and worst than I expected. So, let's take a deeper look.

The highest impact was created by China, as the biggest emerging economy and engine of the world since 2008 has slowed its growth rates. Many people is worried about China as they think that they are going to enter a crisis, but that's not the problem, I'm not worried about that as probabilities are really low, but what worries me is the impact that this is having to the global economy.

China has devalued its currency in order to promote foreign investment and exports, but despite that they haven't been able to make its growth rates go up. That's not a major concern as China is dealing with two major forces, the first is that they will need more reforms of its political and economy as they are reaching, to say it in an easy way, a certain grade of economic maturity, so it's normal to slowdown its growth rates, and on the other hand they are dealing with a lower global demand, and, as they are a production country, they are suffering the consequences.

The problem is that, as they are 'a giant' their lower growth rates and as a consequence its lower demand for raw materials has pressed commodities prices down, creating big problems for other emerging markets that are dependent on commodities exports. That has also affected oil prices, as demand has been lower since last year, but for me, oil is a special case as it has also been affected by the OPEC price policies in order to retain market share. I'm going to talk about it later.

About the US I said in my last article that its economy was going to suffer a negative impact if the FED decided to hike rates. The rate hike that they conducted in December, despite being only a 0.25% increase strengthened the USD against other currencies such as the Euro, what's going to affect exports in the mid run and jointly with the high volatility that's going on in Forex its going to affect USD based companies with operations in other countries. That rates hike is also affecting man of the emerging economies as they are highly indebted in USD.

Despite having recently released a lower than 5% unemployment rates, we can see that wages has been flat since 2008 and that household income is even lower than in the 2007 peak. Inflation is also slowing, partly because of the low oil prices but there are also concerns about the manufacturing sector as its PMI is low and the housing sector is also slowing down.

In my opinion, the US economy is going to be negatively affected during this year by a weaker international trade and capital flows and as I previously said, by the USD strength. So in the mid term I think that the FED will need to reduce interest rates and even conduct a quantitative easing in order to support economic growth. I think (as I said in November 2015) that it was a huge mistake to hike rates in December.

In Europe things are even worst than in China or the US as inflation remains really low despite the expansive monetary policies conducted by the ECB. Despite flooding the market with Euros by purchasing debt and keeping interest rates near to zero, it seems that the ECB has lost its ability to control the European Union economy.

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Source: ECB

Germany released some economic data this week and, jointly with its banking system problems leaded by the Deutsche Bank (the biggest private bank of Germany and of the Eurozone) it seems that they are going to have and create problems for the whole European Union. Their exports and industrial production felt more than a 1% during the last quarter creating concerns about its economic recovery. Another negative signal was that they hadn't been able to reach its debt sales goal during the past three sales, so it seems that investors are losing its confidence in the historically known as the 'European engine'.

But the problems in Europe doesn't end here, Greece is the never ending story, there's anything new about them. The Italian banking system is also in trouble and the Italian central bank is conducting an operation to help its banks to clean its balance sheets of toxic assets in order to gain more liquidity. That, jointly with the fear of Deutsche Bank becoming a new Lehman Brothers (what would collapse the world banking system) is creating a high downside pressure on banks shares prices. But for me, the real problem is, that despite being a 'too big to fail', if the Deutsche Bank whole is as big as have been said, no one have the capacity to save it, because I think that if despite the expansive monetary policy conducted by the ECB they are having so much problems and the whole is as big as has been said, no one can't save them.

Another major factor for Europe is going to be the 'Brexit', as in my opinion, if the UK left the EU that's going to destabilize both economies and currencies, and, with a so weak situation that will be devastating.

About oil I expected in November prices to remain flat but not with as much volatility as has been seen until now. Prices has been low due to the OPEC production policies conducted to retain market share, what's creating pressure for economies like Russia and in my opinion is going to provoke a financial assets flood into the market as those countries have great reserves of it (I'm talking about Arabia Saudi for example) and they need not to cut government spending in order to keep social stability in its countries.

I'm also worried by the really high debt levels, as low interest rates during 7 years and a massive government debt issue have created a debt bubble. Some countries like China has increased its debt to a 200% of its GDP, USA have a higher than a 100% of its GDP debt levels, but what worries me is that some other economies are in similar levels and are not as strong as China or the US. Corporate debt has been also increased and I think that's only a matter of time that the bubble burst.

I think that a catalyst can be a burst in the oil sector debt, as it has become really high and many companies are going to default as I expect oil prices to remain low during this year. So at those levels there are really few companies able to resist as can be seen in the ROIC-WACC.

As a conclusion, I expect lower international trade, higher volatility and a decline in stocks markets (more than we have seen until now) due to the black clouds that are stalking the global economy.

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Source: Bloomberg

We can see that dividends cuts are near to 2009 and higher than 2008 levels and I expect those cuts to keep going on, specially in the oil industry, what's going to reduce stocks attractiveness.

I'm also really worried about the fact that central banks have lost its ability to mitigate a new crisis, as interest rates are near to zero and QE programs are being conducted right now in many countries.

With all that, I'm not saying that we're going to enter into a new recession, but probabilities are higher than last year and if that happens it would be worst than in 2008. On the other hand, despite recent falls, I expect stocks to fall near to a 10% more during this year if the thing doesn't become better and even more if more concerns appear. At those levels I think that it will be a good idea to pick some high quality stocks and wait.

The global economy is like a ship drifting without a captain due to the lack of an economic leader like China and the US has been in the past.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.