We were faced with an onslaught of bad economic data last week; although the markets doesn't seem to recognize bad as bad anymore (at least not subtle misses, which when compounded for weeks at ends across the entire spectrum from housing to retail sales has painted a rather poignant portrait of the global economy). I can summarize last week with one word: Confusion. As I watched the various asset classes trade, I saw instances of decoupling and recoupling, all within a day's session. How the market reacted to news releases (where most of the major releases were off expectations, so one would at least expect the market to be a little frizzled... but no) was sheer lunacy to me. It seems that everytime an event risk passed, the market was sanguinely hoping for another one to come... hardly moving an inch on the daily close. Things were way worse inside the FX complex where the Dollar was the buzzword for the week. From the way the Dollar was behaving, more QE (circa $700bn as estimated by MS over the weekend) seems to be imposing undercover. Yes, nothing much has changed over the past few weeks or months... but we have got new information. Specifically regarding global economic growth, the liquidity position Europe mired in, and various monetary policy stances.
About a month back, I posted about major economies reentering recessions. I said Europe was already in a recession while the world was precariously teetering.
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Today I can say with certainty that what I pontificated was indeed correct. Last week, preliminary Q1 '12 GDP America printed a dismal 2.2% on hopes that a 2.5% figure would materialize. Fat hope. Despite the extraordinary boost from good weather, growth was anemic in the first quarter. Do you reminisce the times where the market were effervescent over economic beats? All those unfortunately did not translate to above average economic growth and forecasts probably went ahead of themselves too. The quality of growth was shaky. A large portion of this 2.2% was from channel stuffing of inventory building. Firms have produced much more than they could have sold to consumers and this will lead to deflationary aftereffects as the inverse bottleneck of stock needs to be cleared (probably at lower end prices) before factory production resumes. So alot of this 2.2% of nominal growth came from producing stuff that went into the warehouse; I would read this as a bad sign because one should consequently expect the velocity on income to decrease as incomes are turned over at a reduced frequency due to excess inventories. This effect is analogous to a double blow where the excesses are removed (no growth) while in doing so, income velocity falls (slower growth).
|Instead, the Commerce Department said it was 2.2 percent, mainly because of government budget-cutting and a slowdown in business investment.|
There you go. Business investments or fix capital formations are strongly co-related to the business cycle which has incidentally turned negative. Investment has historically been strongly correlated to private expenditure (consumption, which constitutes just about 70% of GDP). Declining investments aren't present without a reason. You CANNOT say investments have declined due to cyclical factors. That would be an unadulterated farcical lie because everyone has acknowledged that the weather was very good; that should be a boost and not a laggard! Budget cutting is an excuse, or should I say nonsense. Austerity (reminder: overly used word and misunderstood) occurs over time, not within a quarter. The government didn't axe twice the number of civil jobs in Q1, so there is no formal explanation for that above statement by the commerce department. At the end of the day, we know, the man on the street, Joe sixpack feels the heat when he shops at the supermarket... when he fills up the tank of his gas guzzler... when he and 46.5mn Americans are surviving on government transfers (ie: foodstamps).
People forget that the onset of the great recession was due to a financial crisis, not a downturn of the business cycle. We went into a very deep recession with alot of private and public debt alike (much more than any past recessions). A recently browsed through a magnificent paper about how economies experiencing a financially induced recession took considerably longer to recover and start growing again. Growth was also below the long term averages due to natural deleveraging of private balance sheets (they also used complex mathematical models to map a recovery under certain conditions with varying debt loads). It should hence come as no surprise that nominal growth (forget real growth for now) has been agonizingly slow for America. Without the FED's previous operations of pump priming asset prices, growth would be zero or negative due to the absence of the virtuous cycle and the wealth effect of rising asset prices (read stock market but not housing market). Q1's weak growth exemplifies the unintended consequence of profligate fiscal spending on credit. Growth is weak because of debt. Period. America's debt to GDP currently stands at 101%. Federal debt outgrew output in Q1 and will continue to do so since the fiscal multiplier is lesser than 1 (it takes more than $1 of debt to produce $1 of wealth; so if debt becomes bad and is forgiven, wealth is destroyed).
Just today, Spanish Q1 /12 GDP printed -0.3%. Spain is quite literally hopeless since it is being attacked from every possible side (and soon to see riots on the streets as 25% of the population is unemployed and will never be employed when the nation is in such dire straits). We will await the growth figures of the rest of the periphery sovereigns as well as Germany and France. China will also be high on our watchlist for any slowdown of downside miss would probably spell disaster for the current political party (the situation is made tenser with the Bo Xilai saga) as China is still trying to find a balance on the seesaw of inflation and deflating her property bubble.
The number is 202 Million. Nope, not $202mn, but 202mn unemployed people for mother nature to awe at. 6.2%. This is the global unemployment figure. This is a mere estimate based on official government stats. We know the real number is always understated (courtesy of arcane government data fabrication). Sorry, but aren't we supposed to be roughly 3-4years into a recovery? If 202mn very frustrated and corzined people won't spark social disorder, nothing would. Hence the occupy movement, and the Arab Spring, and now the European Summer? One intriguing point to discuss is competitiveness and employment. The thesis is that a nation suffering from higher unemployment would see nominal wages decline relatively. This compression of wages would subsequently boost competitiveness. Take Spain for instance. Its 25% unemployment rate would have caused wanges to decline dramatically throughout 2011 and Q1 '12. Quite to contrary. Wages are almost still on par with that of Germany's and haven't declined as employment levels fell. To add icing to the cake, there are minimum wage policies in Europe. So there's a floor, which once reached would start the epic exponential curve of firing currently employed workers and a draconian wave of riots across all intoxicated nations. Not going to be pretty.
It somehow irritates me that I am 'forced' to write about this damned subject almost everytime I pen my macro thoughts. Monetary policy has become so powerful and so influential that the only thing the market trade on is expectations and realizations of monetary easing or the lack thereof. Be it the FED's QE, the ECB's LTRO, and the BoJ LSAP et al, global monetary stock has been increasing as central banks take turns to cover each other in each interlude. Yes, their efforts are a snafu. The end results are ludicrously skewed to making the rich richer and the poor poorer. It is important to understand where the money goes to. Had all these funds actually flowed into the tangible real economy? Hell freaking no. May I delight my fellow readers into looking at the chart below...
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Excess reserves held at the FED by these TBTFs have surged (this is what parabolic means). Austrians and most level headed folks who casually study the economy have tautologously exposed that this ruck of funds will cause (hyper)inflation. But this is contingent on the red line, the velocity of M2/MZM money (or the turnover rate of a dollar). Actually, one could use M2V as a leading indicator of economic performance. Velocity is very psychological and is a direct pathology into the average consumer's/business's mind. People spend more across the board when things are good (ie: real wealth is created and is being filtered down the pyramid). M2V has been falling for close to 6 years now and doesn't hint of halting. I cannot answer why; as I said it is a great psychological enigma of the human mind (perhaps there are unseen forces that are forbearing more ebullient behavior?).
And so the MMTers rejoice because they can claim to be right... that money printing isn't inflationary. Just they wait.
Childishness aside, Europe faces an almost insurmountable task: Raising capital. It isn't restricted to the governments. The banks need to comply with Basel III capital requirements and meet minimum standards on various coverage ratios (leverage coverage, net funding coverage, ect). Shortfalls need to be funded or else some guy in a black suit will pay a visit to the banks' HQs. The recently published BIS report on European Banks capital adequacy revealed a gaping hole in their capital structure. So back to what LTRO was purposed for; my inclination to believe that the inordinate €1018.74bn of fresh 3Y liquidity was really for funding capital shortfalls and not buying up distressed sovereign debt as many had hopped for. Italy and Spain were exceptions for the latter point; LTRO funds were actually transmitted through these debt securities before subsequently liquidated into cash. As ZH reported yesterday, short term deposits at the ECB which yields 25bps have surged once again to a near record level of €793.6. It seems that the 800 banks were willing to suffer a small negative yield of ~75bps to fund their capital shortfall.
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3 months ago, I wrote:
|Some are speculating that new revisions are impending. For those unfamiliar with Basel ad CAR, here's a quick synopsis of a very complex framework which has had 3 major revisions (Basel I, II & III). Under the Basel framework, banks have to maintain different types of capital for them to operate legally. The bank of international settlements (NASDAQ:BIS) appointed the Basel Community to set this core framework decades ago, which was then implemented and tailored to each country's requirements (this would be the responsibility of the respective central banks). Under Basel II, there were initial 3 tiers of capital. Tier 1 was the core capital which is made up of paid-up share capital, retained earnings, disclosed reserves (limit set), and lower-tier 1 (limit set). Tier 2 consists of 'subordinated' debt which included government debt (minimum of AA rating), disclosed reserves (above tier 1 limit), and lower-tier 2 (limit set). Tier 3 is negligible. All this forms total capital and must comply with capital adequacy ratio (NASDAQ:CAR) requirements. They are stacked against risk weighted assets (RWA). RWA is sub-divided into credit RWA and equity RWA. Different asset classes are allocated different risks factors and overall calculations can range from basic (simple-risk-weighted-method) to complex (IMM). Tier 1 CAR was 4% in Basel II and will be raised to 6% through 2012-2013. This timeline has been under pressure to be reduced so that the new CAR requirements can be fully implemented by 2012 at the latest. This is significant, and as always the main-stream media had talked minimally about this. If we focus on the European banks (even giants like DB, CA, UBS, SOCG...), they have not met CAR under Basel III yet. The problems are 2 fold. Their share prices have plunged (sharply reducing aggregate Tier 1 figures) and they hold alot of sovereign debt and relatively too little 'safe' debt. Although they (German and French banks) have been dumping risky sovereign debt, the counter parties were the sovereign banks. Italian and Spanish banks were the main private buyers of their government's debt in the secondary market. So their financial position is in short, totally screwed, again. The only ways these banks can meet the new CAR requirement in this short a time (they had initially been given a few years, this shows how hard it is to structure the correct concoction of capital), is to sell risky assets they have on their books and buy safe government debt (Bunds, Treasuries and nothing more). The second way is to retain much more if not all of their retained earnings (ie: not to pay dividends for a long time). The second way assumes they are profitable to begin with (and we know alot of them aren't). The first way is the way I think most of them will undertake. This would re-start/fuel the demented effect of falling prices of risky assets like stocks and commodities which reciprocates globally, leading to unnecessary fear and whatever the heck happens, this will be a steady process until they reach their requirements.|
Rhetoric is starting to catch up and for good reasons. The BIS's analyses reveal that there is a whopping shortfall of $1.2trn, of just about the size of the LTRO. Raising equity through rights issues is dreaded. However, there is a catch 22. It is known that banks which rely on central bank funding for more than 10% of net funded assets have performed poorly. The only way then is to repatriate assets. This was first highlighted by Deutsche Bank last weekend; the recent Euro strength despite the ECB/FED asset imbalance can be attributed to repatriation flows to the tune of hundreds of billions over a span of time. Further LTRO wouldn't help the banks to a great extent and it seems that the market understands this fact. Ambivalence in the European political soup may put pressure on Mario Draghi to conduct more easing; especially since the topic of austerity this and that has taken center stage recently.
We already know that central bank policies have grotesquely distorted the capital market's price discovery mechanisms and have led to severe mal-investments. Such policies have subordinated the free force of capitalism while bringing forth a swath of unintended consequences. Central bank policy has become the main transmission mechanism between the real economy and the financial economy. That is why we can have an ebullient equity market while the real economy lags. It wasn't such in the past but can it ever be reversed without some cataclysmic collapse? Can a narcissistic man on steroids not suffer from terrible aliments in his latter life? No and no. This very fact ensures that QE will be to infinity, as James Sinclair had coined this proverbial phrase. Once the music stops, the house of cards will collapse and the chairsatan's worst fears of a depression would ensure. There are smarter central banks who know that they are tasked with a crucial job of navigating a ship between the hellfire of inflation and the waterfall of a depression. There is little margin for error. It is common sense that when any chairman has steered his ship in such an acute angle in one direction that the ship's path cannot be corrected because of its sheer mass. One of my strongest themes for this year and the next would be inflation. My recent piece is a primer on my thesis that inflationary risks are grossly underpriced relative to deflationary risks. There is alot of room for prices to go straight up, and alot of paper money to be made.
What to Expect?
The problems in Europe aren't fixed. Spain is in deep trouble and that is likely the catalyst for risk to recouple back to reality. There is a slight chance Spain might be able to slip its way under the rug and slowly pay off its debts whilst its banks slowly write down underwater mortgages. That would take more than 5 years at today's pace of getting things done. Austerity (by raising taxes) doesn't work. Firewalls only bring some hope but doesn't solve the problem of too much debt. Firewall monies have to be repaid - so it is essentially a transference of who finances the sovereigns (private sector vs. governments/world). The IMF's war chest of charity money didn't help abate woes on a default/restructuring, because I am a strong believer that the latter two are the only way out of a death spiral. Meanwhile, I expect more backing and filling action in the European equity markets while waning equities and widening credit spreads of weaker financials. Remember that Spain was downgraded by S&P last week while the less known agency Egan Jones has already downgraded Spain twice in a week. Downgrades don't really matter anymore but serves as a confirmation that all is not well. I continue to believe there won't be further LTRO by the ECB mainly because the effects of the easing are not yet known. I'm watching sovereign yields and their respective CDS prices. Take note that Bunds have outperformed just about every major asset class over this 2 weeks; the 10s is yielding 1.66% as I type. Risk is definitely off in Europe. Portuguese yields have fallen rather precipitously but the quants over at ZH have attributed this to basis arbitrage where traders have bid up both the CDS and the underlying debt. They predict this compression of yields to loose momentum as the basis narrows and convexity kicks in towards the front of the curve. Again, Portugal is a tiny country and poses little material risk to Europe.
Across the Atlantic, April's NFP number is set to print this Friday. This is the key event risk not for what it is worth but for the market's expectations on the probability and size of more QE (it all boils down to the FED). I'm currently neutral regarding the FED's policy. I stick to my stance that there wouldn't be additional monetary easing till June when the Maturity Extension Program is resigned. The FED's holdings of treasuries creates a strong case for unsterilized easing (if it does print more) because it has almost exhausted its holdings of short date treasuries (3Y and below) to roll further back into the curve. At its current pace of asset swap, it has circa 2 more months of inventory after June. Operation twist will probably not be extended. I decline to prognosticate how American equities and treasuries will perform because I feel things are too ambiguous.
The RBA cut rates by 50bps earlier today on expectations for half of that. This is a negative shock for the Aussie carry. It seems that global central banks are un-torquing the liquidity spigot now that the ECB is more adamant to ease... and when the FED hasn't eased since June last year. The RBA's decision starkly illustrates weakening demand from China. I expect the FX carry complex to be unwound and the Yen (and probably the Dollar) to strengthen or hold steady. Carry risk would be off for a considerable period of time (50bps is alot of swap differential).
Gold has been consolidating for a few weeks now and looks poised to find escape velocity. I will be watching the volatilities on Gold.
Have a great month everyone!