Kiron Sarkar’s Weekly Report 10.18.14

Overview
Inflation in developed economies and a number of  emerging markets is falling sharply, mainly due to declines in food and, in particular, energy prices. The sharp decline in inflation increases the risks of deflation in the Eurozone (EZ) and further undermines the Bank of Japan’s (BoJ) 2.0% (excluding the  impact of the sales tax hike) inflation target.

Ignoring for the moment geopolitical issues, my concerns remain the EZ, Japan and China. However, Japan can and most likely will increase the size of its asset purchase programme, which will help in the short term, though I remain particularly bearish on Japan thereafter. China can implement a stimulus programme and the Central Bank (PBoC) can help in terms of an even more accommodative monetary policy, though, once again, its medium to longer term prospects look bleak. There are reports that the PBoC is to inject Yuan 200bn into the 20 largest national and regional banks in an attempt to avoid year end liquidity problems and to spur lending, having recently provided Yuan 500bn to the 5 largest banks. The problem, in the shorter term, is the EZ.

There is no doubt that the ECB (under Mr Draghi) has saved the EZ to date, but its policy options are increasingly becoming more limited, given the position of Germany and, in particular, the Bundesbank. Mr Draghi has admitted that, effectively, the only remaining option left is for the ECB to increase the size of its balance sheet, though  measures, such as a QE programme involving the purchase of EZ sovereign debt, are being opposed by Mr Weidmann of the Bundesbank. Indeed, Mr Weidmann is even opposed to purchases of covered bonds/asset backed securities, which the ECB is about to initiate. Whilst Mrs Merkel privately supports Mr Draghi, she will not say so openly for fear of alienating domestic public opinion, especially if her support for Mr Draghi is deemed to contradict the views of Mr Weidmann/the Bundesbank.

As a result, I have little, if any faith, that the EZ can act to preempt a crisis, the likelihood of which is increasing materially. The risks of negative growth in the EZ (and Germany) last Q is material – EZ Q2 GDP was revised marginally higher to +0.1 from zero previously, with Germany down -0.2%. Furthermore, the threat of deflation is rising.

France and Italy are pressing for tax cuts and increased spending, which will increase their budget deficits as a % of GDP. However, with debt to GDP at exceedingly high levels (over 130% in the case of Italy and approaching 100% for France), I continue to believe that yields on their debt look set to rise in coming months. Greek bond yields have soared recently (rising to above 9.0% during the week), as have yields of a number of EZ countries. Investors are seeking safe havens, with the German 10 year bond yield closing at 0.86%, having fallen to a record low earlier in the week.

Expectations of interest rate increases in the US and the UK are being pushed back. With declining inflation, the key will be whether wage and salary growth increase in the US and the UK, with data to date suggesting that growth, whilst improving, has been slower than expected. Bond yields have collapsed, with the 10 year US Treasury yielding just 2.19%, having traded well below 2.0% during the week. The market is now pricing a 50-50 chance of a rate hike by the FED next year. In the UK, it looks as if the 1st increase in interest rates has been pushed back to Q2 2015, from Q1 2015 previously. Sterling has declined recently, though the prospect that the UK will be the 1st major developed economy to raise rates, combined with better economic fundamentals, especially when compared with the EZ, should support the currency in coming months, in particular against the Euro.

Equity markets have taken a battering and, whilst oversold, I remain particularly worried that EZ economic data in coming months will be (much?) worse than expected. Admittedly, the sharp decline in oil prices will help, though the threat of deflation and negative growth looms. Geopolitical risks remain high.

As a result, the threat posed by the EZ remains elevated and I remain exceedingly cautious of equity markets. EPFR reports that investors sold a net US$5.7bn of European equities in the week ending 15th October, the largest on record. Furthermore, I continue to believe that the Euro will decline further.

On a positive note, it looks as if Mr Putin is desperate to reach an agreement over the Ukraine. Sanctions are having a material negative impact on the Russian economy, to a point where powerful factions in Russia are urging Mr Putin to do a deal. The problem is that the Ukrainian President Mr Poroshenko (who also wants to do a deal) does not have Parliamentary support to agree a deal, which will offer some concessions to pro-Russian separatists. However, Ukrainian Parliamentary elections are scheduled for 26th October and if Mr Poroshenko’s party can gain sufficient seats in Parliament, the prospects of a negotiated deal increase. In the interim, Mr Putin and Mr Poroshenko have agreed to enforce the Ukrainian ceasefire, which has been a total failure to date and remains problematical, as both Russia and Ukraine have difficulties in restraining their combatants. Mr Putin announced that he had reached an agreement with Mr Poroshenko on supplies of gas to the Ukraine over the coming winter.

US
The US small business optimism declined to 95.3 in September, from 96.1 in August. The hiring component declined for the 2nd consecutive month. Capex plans fell, whilst firms expecting higher sales also declined. However, the number of businesses believing that now was a good time to expand rose to the highest level since the recession began.

Total loans outstanding from commercial banks rose by +6.3% Y/Y in September, as lending standards ease gradually. Lending to commercial and industrial customers rose by +12.3%, though lending to consumers was up by just +3.9%. Money supply (M1) rose by +9.9% in August, though worryingly, velocity of money has continued to decline and is at 30 year lows.

Retail sales declined by -0.3% in September M/M, worse than the -0.1% decline expected and the increase of +0.6% in August. Retail sales, ex autos and fuel, were down -0.1%, as opposed to a rise of +0.4% expected and August’s increase of +0.5%.

Producer prices unexpectedly declined by -0.1% in September M/M  (+1.6% Y/Y, as opposed to +1.8% in August), lower than the rise of +0.1% expected and the unchanged level in August. It was the 1st decline in a year. Lower fuel costs was the main reason for the decline, though prices for services declined by -0.1%. With commodity, in particular energy prices, continuing to decline, a further fall in producer prices in October is likely.

The budget deficit for the year to 30th September came in at US$483.4bn, as compared with US$680.2bn a year earlier. The deficit, as a % of GDP, was 2.8%, the lowest since 2007. Revenues rose by +8.9%, whilst spending increased by +1.4%. However, the budget deficit is expected to increase in 2016, according to the Congressional Budget Office.

The Beige Book stated that reports from the 12 districts “generally described modest to moderate economic growth at a pace similar to that noted in the previous Beige Book”. Despite the weak September retail sales data (see above), the Beige Book stated that “retailers were relatively optimistic about the remainder of the year”. Wage growth remained modest generally, though “several” districts reported upward wage pressure for particular industries and occupations, such as construction and manufacturing. Indeed, in some areas, employees were leaving jobs for higher pay elsewhere.

Weekly jobless claims came in at 264k (the lowest since April 2000), lower than the 290k expected and the previous weeks 287k. Continuing claims came in at 2.389mn, slightly higher than the 2.38mn expected and the revised 2.282mn the previous week.

US September industrial production rose by +1.0% M/M, higher than the rise of +0.4% expected and the downwardly revised decline of -0.2% in August. It was the largest increase since November 2012. Capacity utilisation rose to 79.3%, from 78.8% in August and better than the rise to 79.0% expected.

The October Philly FED index came in at 20.7, higher than the 20.0 expected, though lower than September’s reading of 22.5. The employment and capex components were sharply lower, though the new orders component came in higher.

Mr Bullard, the Saint Louis FED President, suggested that the FED should consider delaying its plans to end its bond buying programme, which is scheduled to end this month. Mr Bullard is non-voting member of the FED, though his comments resulted in the US$ weakening. I find it hard to believe that the FED will change its plans, though the impact of his comments on the US$ just highlights the nervousness of markets.

US September housing starts rose by +6.3% M/M (+17.8% Y/Y) to an annualised rate of 1.02mn, up from 957k in August and marginally higher than the forecast of 1.0mn. Building permits rose by +1.5% to an annualised rate of 1.02mn, slightly lower than the forecast of 1.03mn. With mortgage rates lower, refi’s should rise as should housing sales.

The preliminary University of Michigan October consumer sentiment surprisingly rose to 86.4, the highest level since July 2007 and above both September’s reading of 84.6 and the forecast of 84.0. Even more promising, the expectations component rose to 78.4, the highest since October 2012 and above the forecast of 74.4. Better employment prospects, combined with cheaper petrol  prices, contributed to the rise in sentiment.

EU
It appears that the relationship between Mr Draghi and Mr Weidmann has deteriorated materially. There was a marked difference of opinion at the IMF meeting last week. Sources state that the working relationship between the 2 has “broken down” and that Mr Draghi has stopped informing Mr Weidmann about his plans in advance. The only good news is that Draghi retains the support of Mrs Merkel, though she will not express that publicly.
In addition, Mr Draghi stated that interest rates were now at the lower bound and that the ECB has just 1 instrument left, which is the size of its balance sheet.

S&P cut its outlook for France to negative from stable. They added that the budget deficit was deteriorating as growth declines. Finland was also downgraded, which leaves just Germany and Luxembourg as the 2 remaining AAA rated countries in the EZ.

German investor confidence, as measured by the ZEW  index, declined for the 10th month in October. The index of investor expectations declined to -3.6, down sharply from +6.9 in September and lower than the unchanged reading expected and the 1st negative and the lowest reading since November 2012. The current situations component slumped to +3.2, well below the reading of +15 expected and September’s +25.4. The President of the ZEW stated that the particularly weak reading suggests that negative growth for Germany in Q3 cannot be ruled out, though he did not expect  a long recession if Q3 was negative. The German economy ministry cut its 2014/15 GDP  forecasts to +1.2% and +1.3% respectively, down from +1.8% and +2.0% previously.

The Italian PM Mr Renzi announced tax cuts (E18bn), together with increased spending on unemployment benefits, education and research, which in total amounts to E36bn. Mr Renzi’s government claims that Italy’s budget deficit next year would go up to 2.9% of GDP, from 2.2%. The budget will require the approval of the European Commission (EC), who wants Italy to reduce its budget deficit. Both Italy and France are proposing more stimulus, together with more time to reduce their budget deficits. The EC is unlikely to approve the measures proposed by Italy, though I suspect Italy will go ahead regardless, as will France. I continue to believe that bond yields of countries such as Italy, France and even Spain will rise in coming months as the market focuses on larger deficits, slowing growth and higher overall debt levels.

German September CPI came in unchanged M/M (+0.8%  Y/Y) in line with expectations. French September CPI came in at -0.4% M/M (+0.3%  Y/Y), worse than the -0.3% expected and +0.4% in August. It was the lowest annual rate since October 2009. Spanish September CPI came in at +0.2% M/M (-0.2% Y/Y), higher than the +0.1% expected and August’s +0.2%. Italian CPI declined by -0.4% M/M (-0.2% Y/Y). The final EZ September CPI came in at +0.3% Y/Y, in line with the initial estimates. It was the lowest level since 2009.

EZ August industrial production came in at -1.8% M/M (-1.9% Y/Y), lower than the -1.6% expected and the +0.9% in July.

The Catalan region has cancelled its proposed referendum on independence from Spain, which was scheduled for the 9th November. However, it is to hold a “consultation of citizens” on that day, which will have no legal standing, though will indicate the wishes of the Catalan people. The Spanish Constitutional Courts issued a stay order on the proposed referendum.

Greece’s plan to exit its bailout earlier than expected (to avoid restrictions imposed by the Troika – the European Commission, ECB and IMF) has resulted in Greek bond yields rising sharply to well above 7.0%, deemed by the market as the danger level. It must be highly questionable as to whether Greece can finance themselves from international capital markets. However, the uncertainty has raised additional concerns not just over Greece but  the EZ and, in particular, the peripheral EZ countries.

UK CPI fell to +1.2% in September, down from +1.5% in August and lower than the forecast for a decline to +1.4%. It was a 5 year low. Core CPI came in at +1.5%, lower than the rate of +1.8% expected and +1.9% in August. Factory gate prices declined by -0.1% in September M/M and were down -0.4% Y/Y, the largest decline since 2009. Input prices fell by -7.4% Y/Y, lower than the decline of -6.7% expected, mainly due to lower oil prices.

The UK unemployment rate declined to 6.0% in the 3 months to August (6.1% forecast), down from 6.2% and a 6 year low. However, unemployment claims fell by 18.6k in September, less than the decline of 35k expected, which suggests that the improvement in employment is slowing. Earnings, excluding bonuses rose by +0.9% in the Q to August, up from +0.8% previously, though still below the September inflation rate of +1.2%.

The British retail consortium reported that sales declined by -2.1% in September, much worse than the increase of +1.0% expected and Augusts rise of +1.3%.

China
Chinese exports rose by +15.3% Y/Y in September, the largest increase since February 2013 and well above the forecast for a rise of +12.0% and the +9.4% increase in August. Imports rose by +7.0%, also much higher than the expected decline of -2.0%. The trade surplus came in at US$31bn. However, much of the gain was due to alleged exports to Hong Kong which surged by +34% Y/Y and overtook the US, suggesting that the export data may well have been inflated by capital inflows (to benefit from the Yuan’s appreciation) disguised as exports. Furthermore, an analysis of the import data suggests that the domestic economy remains weak.

September CPI came in at +1.6% Y/Y (+1.7% forecast), down from +2.0% in August and at the lowest level since January 2010. The decline was due to lower food and energy prices. Producer prices declined by -1.8% Y/Y, lower than the rate of -1.2% previously. The disinflationary trends are spreading.

Aggregate financing (the broadest measure of credit) came in at Yuan 1.05 tr in September, lower than the estimate of Yuan 1.15tr. M2 money supply grew by 12.9% Y/Y, slightly below the estimate of 13%. Forex reserves fell unexpectedly by -2.6% (US$103bn) in the Q3, down to US$3.89 tr, as opposed to an expected rise to US$4.01tr. It was the steepest decline on record, which suggests that there were some capital outflows in the Q, though the weaker Euro would have reduced the US$ value of China’s Euro holdings. Foreign direct investment rose by just +1.9% in September Y/Y.

Other
Reuters reports that Saudi Arabia has privately advised certain analysts and investors that it is comfortable with oil prices at much lower levels (below US$90 and perhaps as low as US$80) over the next 1 to 2 years. The change in policy is thought to be part of a plan to slow US production and to impact other OPEC producers, which will benefit the country in years to come. Reuters adds that OPEC is unlikely to hold an emergency meeting prior to the scheduled meeting for the 27th November. December Brent fell closed at US$86.16. The IEA reports that global oil consumption will rise by just 0.65mn bpd this year, just about half the increase it predicted in June this year and at the slowest rate since 2009. Consumption is expected to increase by 1.1 mn bpd next year to an average of 93.5mn bpd, down 300k bpd from the previous estimate. They add that OPEC is unlikely to cut production.

CRU, a leading consultancy, states that copper imports into China may drop by 25% next year, as a financial scandal in Qingdao in China, has resulted in tighter access to credit. CRU forecasts that copper imports may decline to 2.35mn tonnes, which would be the lowest level since 2008. A number of Chinese businesses have bought copper and used the metal as collateral for loans, rather than for industrial purposes. The global copper market is expected to show a small surplus next year, as opposed to the deficits in the previous 5 years, according to the International Copper
Study group.

Russia’s credit rating was cut by 1 notch to Baa2, from Baa1 and is now at the 2nd lowest investment grade level. Moody’s cited sluggish growth prospects, which have been worsened by the sanctions imposed as a result of the Ukrainian crisis, together with a reduction in its currency reserves. Russia has spent US$13bn this month to stop the freefall of the rouble, though the currency remains weak (it has fallen by 13% over the past 3 months) and the Central Bank has widened the trading bands.

Kiron Sarkar
18th October 2014