Category Archives: On the cover

On the cover

The Largest Financial Trade In History And Its Risk

Global Economy, On the cover, Sin categoría

This is a post by Daniel Morcillo, a special contributor, who reflects on some of the issues we have been discussing here since 2011 (the “sudden stop”, the end of the commodity supercycle, the deflationary nature of QE and the unpredictable impact on the world economy of the normalization  of monetary policy).

While the majority of media is now focused on the Hellenic, Hawks and Trump news, attention is lost upon a matter of greater concern to the world. Something the IMF and BIS analysts have been warning or a couple of years, which stands as the greatest trade seen in financial history. A trade that was originally thought to have been 1/3 of its actual size and which has been fuelled upon by Central Bank policy. I refer to the 9trn$ carry trade which has flowed into Emerging Markets and appears to be unwinding.

This call is not for a meltdown, but rather a global slowdown that could expose similarities with 2001 and deteriorate to 2008 levels in the worst case scenario.

This scenario is mostly based on a probable strong US$ throughout 2015-onward.

 

  • Central Bank stimulation strategy of easing monetary and fiscal policy (i.e. lower interest rates and more $ liquidity) creates and leads to US outflow of carry trades from $ to EM (1).
  • IMF in 2013-2014 warns of this carry trade and estimate it at 9trn$ (2015).
  • Devaluing currencies (“currency wars”) of the majority of world economies , the Developed Markets need/chase for yield (2), the Emerging Markets need (?) for credit , Central Banks policies (+others…) lead to a deflationary environment.
  • The misallocation of capital in an unwinding carry trade will make emerging markets more illiquid, spark volatility and moreover reflate the $.
  • The very possible scenario of a bull $ in an ending commodity super-cycle (see below) could be very harmful for global growth. Starting at EM and lagging at DM (US then EU).
  • Without knowing how these unintended consequences will exactly play out and when, the existing entrenched involvement of CB policy (e.g. FED hiking) could only attempt to cushion this probable scenario.
  • The peak for the global “expansion” cycle has been undoubtedly positioned by China, who has seen large sums of this $ denominated capital inflow start to roll out (3,4) . I remember pondering back in 2013 at the exuberant irrationality of the Chinese government building empty megacities in the middle of nowhere. Today 1st August 2015, Chinese PMI signals 50.00 (even the PMI number looks manipulated), the PBC along with the Shenzhen and Shangai Composite and their trajectory speak for themselves even though US Hedge Fund consensus still stands bullish. Back to the central scenario, it would be of no surprise to see the RMB unpeg from the $ in CHF/EUR style or GBP/DEM (c.1992) flair.
  • In this overall scenario, the situation of devaluing currencies vs a strong $ will inevitably lead to defaults, as the economic fundamentals of EM are stretched along with their voluminous $ denominated debt burdens.

“Significant emerging currency depreciation should cause investors to hesitate. Depreciation is a secondary form of “default”.” William H. Gross, 30th July 2015 (5)

  • For me, the focus now is to see who will be the highest beta debris (once again, based on fundamentals) of this carry trade unwind as well as too see if, when and how it plays out. With a focus on fundamental analysis it is also crucial to analyze capital allocation of this carry trade and its embedded liquidity.

As much as I like to quantify things as much as possible and prove through probability and historical back-testing, this is an unprecedented event in the history of financial markets. This is not only because of the magnitude of the stimulus but also due to the fundamental situation of each economy, market and the varied nature of concerning factors (such as CB policy) concerning each economy individually and as a conglomerate (EM & DM).  Depending on how you look at it; this is both a “This time it’s different” as well as the opposite.

This is more of an initially theoretical evaluation by connecting the dots of our global macro current situation which will be proven to be occurring through upcoming feed on world economic data. Regardless, current economic data does lead me to believe that this scenario which I have summarized above is increasingly likely, if not occurring now.

As an objective student of financial markets, I have to enforce that this is not a “doomsday” style global meltdown warning, but rather something I believe has to be on the eyes of market practitioners as it may fuel large sums of wealth destruction, slowing down global economic growth and lastly, at the same time aligning with the 3 standard-deviation historical average duration of the US economic expansion cycle of 83.64 months (or 7 years), before (statistically) we enter another recessionary cycle, led by the end of the commodity supper-cycle.

Further sources on the matter (cited above):

 

By Daniel Morcillo

 

Iran Agreement. Wrong and Dangerous

Global Economy, On the cover, Sin categoría,

“All war aims for impunity”, Michael Ignatieff

The agreement between Iran and the world’s great powers is a big political mistake paved with good intentions. It assumes that a government that has the explicit objective of the “total destruction of Israel” and that has not changed a whit its nuclear aspirations, will change. In fact, the agreement was celebrated by the Iranian news agency, since it is not a real change in its program.

“All nuclear power stations will continue their activity, Iran will continue to enrich uranium and the R&D on advanced centrifuges continues.”
Iran will keep 6,104 IR-1 centrifuges for 10 years. I am concerned that the Minister for Foreign Affairs, Javad Zarif, has confirmed that Tehran will begin to use their (IR-8) next-generation centrifuges, which enrich uranium up to 20 times faster than the current IR-1s.
The former Director of the CIA Michael Morell and a whole battery of geopolitical analysts have warned of the error of basing the agreement on the number of centrifuges and “verification”. “5,000 centrifugues is more than enough to build nuclear weapons, but not for an energy programme”.
According to the International Atomic Energy Agency, a nuclear bomb only needs 25 kilograms of enriched uranium U-235. And although it is more difficult to produce uranium 90% enriched, it is not much more complex than the 4-5% uranium required to generate electricity.
Limiting the number of centrifuges is not avoiding any risk. But it’s funny to put the nuclear program as an excuse to “diversify energy sources”. As if Iran could not diversify through natural gas, solar or wind power.
The support of Iran in the battle against the Islamic State has weighed more than the risk to Israel or the stability of the area. But the claim of the Obama Administration that verification alone will work -when only 25kg of enriched uranium can be enough to make a bomb- and leaving the region to solve its own problems are huge miatakes. And it puts Israel in danger.

The risk for stability and peace in the Middle East is huge… in exchange for a promise that “within eight years,” everything will change. It cannot be more naive.
Impact on the oil market… the only positive.
The agreement with Iran means an estimated increased investment in the country of $ 170 billion, primarily in oil and gas. The immediate impact will be to increase production in the short term between 500,000 barrels per day and a million in the medium term, being conservative. This means much more excess supply, as we mentioned many times in this column.

With the end of the embargo, the spare capacity of OPEC also doubles. In addition, investments in new oil infrastructure will help Iran to increase production above 4 million barrels per day and longer term probably to 6.5 million barrels per day.

Iran will have more than 20.8 billion dollars in annual added revenue in the short term, added to the aforementioned investments. Meanwhile, Saudi Arabia has already increased production to the historical record of 10.33 million barrels per day in May. Iraq, although not subject to quotas, also reached record levels.
The strategy of OPEC is still standing. Prove to the world that they are more competitive, flexible and reliable suppliers. Gain market share in an environment of excess of supply that they know is structural. And prove that they can win a price war against the US, Russia and renewables in an environment of low prices.
John Kerry and the negotiators know well that potential new geopolitical conflicts do not impact the “oil weapon” and with the US close to energy independence, they think that it is easy to leave the region to solve its problems without US support. Seems they have forgotten that there are more important things than cheap oil and reducing military presence in the region.
Obama says that the agreement is not based on trust but on verification. This reminds me of the scene in which Hans Blix told Kim Jong Il in the satirical film Team America that “if you don’t let us inspect your palaces we will send you a letter showing how angry we are”, seconds before being thrown into a pool of sharks by the North Korean dictator.
We may have cheap oil for a long time. But the risk to Israel, and by extension, Europe, is very high, and it is irresponsible for the world to appeal to the good will of those who want your destruction.

Greece Votes ‘No’. Risk On The Rise

Global Economy, On the cover, Sin categoría,

“Born to raise hell, we know how to do it and we do it real well”-Motorhead

The referendum in Greece ended with a win of the “no” against the proposals of the European Union.

But this is not the end. It’s the beginning.

For once, Greece’s prime minister Tsipras’ belief that this result will provide the country with more strength to negotiate was and is incorrect. If anything, the result brings the country one step closer to full intervention. Why?

As time passes, Greece is suffering not only from lack of funds to pay for public services and pensions, but its main industry, tourism, is also suffering, with a loss of more than 50,000 visitors in a week.

Greek banks are already requesting further liquidity from the ECB. It is not clear that support will remain indefinitely.

Greece is also facing bankrupcies in the private sector, where most companies are small shops and SMEs suffering from complete lack of credit.

Yes, as we explained last week in our call, this has been a political move, not one looking for the best financial deal.

Syriza has turned a problem of financing and liquidity into one of a possible failed state close to being intervened. While the Greek TV clings on to the “greater fool” theory of a possible Russian or Chinese aid, this has failed to materialize. Not only China and Russia face their own internal issues, but they are unlikely to come to the rescue of a country that sets lack of commitment to creditors at its core.

So, what now?

Don’t expect a quick solution. The EU is unlikely to bow down ahead of a large maturity in August.

Additionally, Greece’s vote is likely to cause shockwaves throughout Europe as we mentioned in last week’s call, with fringe parties making this vote a validation of their own aspirations.

More importantly, so far we have only seen the reaction of the ones that receive… Let’s wait for the answer of the ones that pay. The UK vote is coming soon, and it is unlikely that German, Finnish or Dutch citizens will feel happy to see their taxes raised to maintain Greece’s public spending and generous pensions.

Greece’s demands are simply impossible to grant. And what is most important is that, no matter what happens on a political level, investment and job creation will suffer after the country puts the word “uninvestable” at the door. Greeks are facing a prolongued period of recession and the very likely implementation of much harsher cuts than what they have voted against as the country moves to default and institutional implosion.

For investors there is a very relevant fact to remember. The monetary bazooka of the ECB cannot contain the perception of risk throughout other countries if the EU allows the victory of the message that default and lack of commitment is feasible. This is why the IMF and EU’s response has to be one of strength, or face slow implosion.
Low growth, lack of investment and poor job creation remain the central scenario. In the next months we have to add financial stability and the euro as a sustainable currency to the picture…again.

The referendum is not the end of the Greek drama. It is the beginning of the real drama.

 

-Daniel Lacalle

About the Author

Daniel Lacalle is an economist and fund manager, and author of ‘Life In The Financial Markets’ and ‘The Energy World Is Flat’ (Wiley).

The Greek Drama

Global Economy, On the cover, Sin categoría, ,

Contributor View written by Daniel Lacalle. Mr. Lacalle is an economist, fund manager and author of Life In The Financial Markets (Wiley) and The Energy World Is Flat (Wiley). You can follow him on Twitter at @dlacalle.

“You can check out any time you like but you can never leave.” -Hotel California

The Greek drama continues to unfold and puts pressure on European markets despite the fact that Draghi´s “monetary laughing gas” continues to pump €60bn per month into the slowly recovering European economy.

The call by the ruling party, the communist Syriza, for a referéndum in Greece, is the last episode of a soap opera that´s starting to be sadly comical.

For once, Syriza is calling a referéndum on State fiscal policy, something that the Greek constitution specifically forbids. It is simply a measure to try to make citizens forget the atrocious negotiating tactics of their government, who could have reached a benefitial agreement much earlier without putting the country on the verge of a bank run.

Additionally, the government is trying to show to the citizens that the Troika proposals are unacceptable when the difference between the document presented by Syriza and the EU´s suggestions are minimal (0.5% of GDP).

The real drama is that none of the measures announced will solve Greece´s real issues. No, it´s not the euro, or the austerity plans. It´s not the cost or maturity of debt. Greece pays less than 2.6% of GDP in interest and has 16.5 years of average maturity in its bonds. In fact, Greece already enjoys much better debt terms than any sovereign re-structuring seen in recent history.

Greece´s problem is not one of solidarity either. Greece has received the equivalent of 214% of its GDP in aid from the Eurozone, ten times more, relative to gross domestic product, than Germany after the Second World War.

Greece´s challenge is and has always been one of competitiveness and bureaucratic impediments to create businesses and jobs.

Greece ranks number 81 in the Global Competitiveness Index, compared to Spain (35), Portugal (36) or Italy (49). In fact it has the levels of competitiveness of Algeria or Iran, not of an OECD country. On top of that, Greece has one of the worst fiscal systems and limits job creation with a combination of agressive taxation on SMEs and high bureaucracy. Greece ranks among the poorest countries of the OECD in ease of doing business (Doing Business, World Bank) at number 61, well below Spain, Italy or Portugal.

Greece´s average annual déficit in the decade before it entered the euro was already 6%, and in the period it still grew significantly below the average of the EU countries and peripheral Europe.

Between 1976 and 2012 the number of civil servants multiplied by three while the private sector workforce grew just 25%. This, added to more than 70 loss-making public companies and a government spend to GDP figure that stands at 59%, and has averaged 49% since 2004, is the real Greek drama, and one that will not be solved easily.

One thing is sure, the Greek crisis will not finish by raising VAT – impacting consumption – and increasing taxes to businesses, nor making small adjustments to a pension system that remains outdated and miles away from those of other European countries. A new 12% “one-off” tax on companies generating profits of more than 500,000 euro will not help job creation and will likely incentivise more tax fraud.

The inefficacy of subsequent Greek governments and Troika proposals is that they never tackle competitiveness and help job creation, they simply dig the hole deeper raising taxes and allowing wasteful spend to go on.

From a market perspective the risk is undeniably contained, but not inexistent. Less than 15% of Greek debt is in the hands of private investors. Most of the country´s debt is in the IMF, ECB and EU countries’ hands. The most impacted by a Greek default would be Germany, which holds bonds of the hellenic republic equivalent to 2.4% of its GDP, and Spain, at 2.8% of GDP, small in relative terms.

Additionally, the ECB prints “one Greece” every three months.

However, the main risk for the Eurozone comes from a prolongued period of no-solutions. Not a Grexit but a “Gredrag,” dragging on for months with half baked attempts to sort the liquidity crisis.

This prolongued agony is unlikely to help investors´confidence. And it might raise questions of the possibility of similar illogical behavior from other fringe parties close to Syriza´s views in the Eurozone, particularly in Spain and France. Because behind this all what lies is an ideological agenda, not the best financial deal for the country. Syriza could be looking to do something similar to what Nestor Kirchner did in Argentina in 2005, cut ties with the IMF and agree to alternative financing with Venezuela at double the cost just for ideological reasons.

Greece exiting the euro remains a distant possibility, despite the headlines. The much publicised “Russian solution” forgets that Russia is not stupid and doesn´t lend at better terms or with easier conditions – think of Syria and Ukraine.

A Grexit would not solve Greece´s challenges, as the country spent decades unsuccesfully trying to solve structural imbalances before joining the euro with competitive devaluations and failed keynesian bets on public spending.

Greece doesn´t need to be a failed state. But governments seem to be inclined to prefer a bank-run and capital controls than to reduce unnecessary spending. The fact that Syriza´s first measure was to re-open the public TV network – undoubtedly a “priority” in a debt crisis- shows how little they care about the “social urgency”.

Greece should stay in the euro, open its economy to business, attract capital, privatize inefficient public sectors, incentivize high productivity sectors with tax deductions, and reduce wasteful spend, not feed the government machine with ever rising taxes to get a few crumbles left by the survivors of the disaster.

If not, in three years time we will be talking of the “Greek crisis” again.