Category Archives: On the cover

On the cover

Is the US dollar the new “gold”?

Global Economy, On the cover, Sin categoría

@dlacalle_IA

The wake up call that Trump and the rise of interest rates have meant for global asset classes should not go unnoticed. Above all, the implications on cost of debt. No one can say we had not been warned, but many states and investors preferred to think that the Federal Reserve would continue to play the monetary laughing gas game to perpetuate imbalances that have been accumulated for sixteen years.

The central bank led madness brought an accumulation of more than $ 11 trillion in negative-yield bonds, more than $ 4.3 trillion in the Eurozone. And now a small rise in inflation rates could create a potential losses exceeding a trillion dollars . Since October, the number of bonds with negative rates has fallen by more than 20%.

The vacuum effect I commented on this video yesterday  makes the strong dollar and a small rise in interest rates absord liquiodity from all over the world and into the US. Capital flight out of commodities and emerging markets into the US.

In China several companies have been forced to cancel relevant bond issues due to volatility. Shandong Iron and Steel, Hesteel Group and Wanhua Industrial cancelled their issues in an environment where investors demanded much higher rates. It is normal, if the US 10-year bond rises to a required yield of 2.5-2.6%, no one in their right mind would accept risk in countries and areas of high volatility whose differential with that US bond does not outweigh the risk.

The strength of the dollar and the slight rise in US rates has led the Chinese sovereign 10-year bond yield to 16-month highs. In two days they have suffered the biggest price drop for eight years in the five and ten year bonds, leading the Chinese regulator to halt trading in futures due to some capital outflows.

Such a rise in rates and an increase in risk would not be a huge problem – after all, they are still very low rates with 3.5% in the 10-year bond – if China had not embarked on the brutal orgy of debt.  In the past 12 months, China has accumulated more debt than the US, Japan and the Eurozone combined, and has “stabilized” its slowdown with a monstrous increase in the money supply (M2) of an 11 , 4% for a GDP growth of 6.2% with a worrisome housing bubble. Total credit granted has increased since the start of the year from 246.8% to 265% of GDP, seven months after the Chinese government announced measures to “contain” excess borrowing.

The global implications of this Chinese risk are important. Those who argue that all this cannot continue to happen, because China accumulates more than 1.2 trillion dollars of US bonds are wrong. First, because China has been reducing its US bond portfolio for years and has the lowest figure since 2013. Today, it is not China, but Japan, who holds the title of largest US foreign lender. Second, because – contrary to popular belief – the main buyer of US bonds is not China, but the Americans themselves and US investment funds. If China were to dispose of its entire US bond portfolio, the US market would absorb it in just over two weeks.

The China-US issue is important because it leads to a spiral in which the world’s old growth engine is in evident slowdown and faces the serious problem of losing a significant part of the more than $250 billion annual trade surplus with the US if they both enter a commercial war.

But how does it affect Europe? Of course, it starts by showing how unsustainably low rates were, and sending yields higher. German investors themselves have reduced their sovereign bond holdings by more than $ 2.8 billion this month, and that dominating effect should be a wake up call to countries that think that financing themselves at 1.5% is timely and guaranteed.

. It is a small relief for banks drowned by negative rates, but not a lifeline because in Europe, the problems of overcapacity and lack of productivity remain.

. The devaluation of the euro, yen, and yuan against the dollar is likely to show again that the Keynesian dogma that a weak currency leads to more exports is simply incorrect.

. Emerging markets, used to huge liquidity inflows and low rates, receiving more than 10 years of large amounts of US dollars to finance long-term local currency projects, will continue to suffer from “the sudden stop” and capital outflows.

The US dollar has become the new gold in the face of mounting evidence that the “beggar thy neighbour” policy and drowning structural problems in liquidity is coming to a close. And if, as I hope, in a few months we will see two hawks as new appointments in the Federal Reserve, capital flights to the US will be even greater. Let´s see.

There are many who think that the US economy will not accept a strong dollar. Allow me to doubt it. The US only exports 12.6% of GDP and less than 30% of the profits of the S & P 500 come from exports. Praying to the mantra of monetary expansion and devaluation will not work if the US economic policy with the new administration is aimed at strengthening the domestic market, increase disposable income for the middle and lower classes, and end the perverse incentives created by years of failed demand-side policies (read the poor legacy of the Federal Reserve )

The greatest mistake that can be made by the European Union in the face of this uncertain scenario is to try to tackle it with expansive measures. After decades of industrial plans, fiscal expansion, monetary stimulus and ultra-low rates, growth is still poor … and will not be solved by seeking further imbalances.

We could be waking up from a model based on unicorns of Keynesian multipliers to a new global paradigm where the largest and most powerful economy conducts supply-side policies. Ignoring that this option even exists shows us how hypnotized we are with the mirage of growth by decree and the nonexistent wealth by monetary expansion. But, at the very least, we should be prepared for the growing possibility that the placebo effect of monetary laughing gas is over.

Daniel Lacalle is an economist and author of Life In The Financial Markets and The Energy World Is Flat (Wiley)

 

This article was originally published in Spanish by @elespanol

The Fed´s More Than Questionable Legacy

Global Economy, On the cover, Sin categoría

@dlacalle_IA

Yesterday, Janet Yellen, Chairman of the Federal Reserve, announced an increase in interest rates of 25bps, the second time in a decade, and expecting three more rate hikes in 2017. At a continued rate of +25 bps per year, it will take the US nearly 10 more years to get back to a 3% Fed funds rate.

Let us remember what was promised to support the massive stimulus plan:

The White House predicted an average growth in the economy of 4-4.5 percent, unemployment would drop to 5 percent, and the budget deficit would shrink to a mere 3.5 percent of GDP.

During the Obama administration and the massive expansionary poilicies of three QEs and ultra-low rates, economic growth was a mere average of 1.4%, 2.1% if we exclude 2009. That compares to an average 3.5% with Reagan, 3.9% with Clinton and 2.1% with Bush Jr (average annual GDP growth).

The recovery growth gap compared to other recoveries since 196o has been set at $1.67 trillion. That means the weakest recovery in recent history, as well as an economic growth that has stalled at almost half of the promise. Average The Federal Reserve expects 1.9% growth for 2016 going to 2% in 2018, the weakest relative to potential and previous recoveries.

All of this is after a massive $4.7 trillion monetary stimulus and $10 trillion in new debt (a fiscal deficit increase of $13 trillion at State, local and Federal level). Public debt ballooned from 48% to 75% of GDP. Average annual deficit was 5.2% and for 2016 it is expected to be 3.2%.

Quantitative easing was launched under four premises. Provide liquidity to reduce the risk of contagion after the financial crisis, add jobs, inflation and growth.

Its first objective was clear and worked. Unfortunately it went from solving a problem of liquidity to creating the largest bubble in financial history. High yield bonds at the lowest interest rate seen in 35 years, and stocks at all-time highs, exceeding fundamental valuations and real earnings growth.

But job creation was a success. Was it not?. 4.6% unemployment! 9.3 million jobs created. Being good, and to deny it is ridiculous, employment figures are far from what is expected of the world´s leading economy after a $ 24.7 trillion fiscal and monetary stimulus. Under Reagan 12.6 million jobs were created. Under Clinton, 21 million. Even with the massive crisis, Bush Jr saw 5.7 million in job creation.

On the one hand, more than 11 million people are out of the labor force, leaving the labour participation rate at 1978 levels, and it is completely false to say that it is explained by demographics. The US has a similar demographics as the UK and labor force participation is almost ten points lower. In addition, labour force participation rate has fallen in almost all segments of age (very important between 25 and 54 years).

In October 2016 425,000 workers left the labour force, the highest level of the historical series, reaching a total of 94.6 million working age Americans that are not participating in the system or looking for a job. That shows a labour participation rate of 62.8%, not seen since 1978. In addition, the number of US citizens who supplement their income with food stamps has doubled from 20 million to more than 40.

Temporary employment stands at 18.2% (less than 35 hours per week), ie considered recessionary levels. In times of growth, the US has always had a 16.6% lower temporary rate. In the recession of 2001 it was 17% and in 2008 the maximum was 20%. With the biggest stimulus in history, it has only been reduced slightly to 18.2% even with the aforementioned poor labour participation.

Since 2009, doubling the debt, the average household income in the US has fallen in all segments (the median of $ 55,000 to $ 54,000 and the poorest segment from $ 13,000 to $ 12,000) and real wages continue to be at 2008 levels.

To top it all, in the last five years, the US annual productivity growth has been 0.6% on average, the poorest since 1978.

Inflation expectations have also been consistenly revised down throughout the period. In fact inflation expectations have only come down until the recent uptick in October, and still stand below the 2.8%-3%.

What is more interesting is that QE has been disinflationary as money velocity has collapsed and capacity utilization remains poor, at 75%. The massive creation of money has gone to create huge inflation in financial assets and disinflation in the real economy, laying the grounds for one of the most dramatic imbalances between asset classes and industry and consumption seen since the 70s.

The argument against all this is that “it would have been worse” and that the crisis was too big. None of them work, and sound more like excuses as other presidents lived through deep crises as well. But those excuses don´t stack up against the fact that the US created more than half of all the money supply in its history in the past eight years and has seen the longest period with ultra-low rates.

In summary, the Federal Reserve´s policy has generated results that range from disappointing -liquidity- to complete failure -jobs, growth and inflation- but leaves behind a massive bubble in financial assets that will not be easily sorted. Raising rates so slowly only perpetuates the bubble.

No wonder Americans have decided to vote for Trump´s promised supply side policies.

 

Daniel Lacalle is a PhD in Economics and author of Life In The Financial Markets and The Energy World Is Flat (Wiley)

OPEC-non OPEC deal. US shale wins

Energy, Global Economy, On the cover

@dlacalle_IA

Over the weekend OPEC and non-OPEC countries delivered the first coalition cut pledge in 15 years with 11 non-OPEC countries agreeing to cut output by 0.56 mbpd. This is on top of the pledge from OPEC to lower output by 1.2mbpd as well.

Russia 300k, Mexico 100k, Oman 40k, Kazakhstan 20k, Azerbaijan 35k the bulk of the cuts.

One of the big problems of this agreement is the alternative of the devil. That by which a decision is likely to have negative or very negative consequences.

The main beneficiary will be the shale in the US, immediately taking the opportunity to increase volumes. US rigcount surged 27 units to 624 on the week ending on the 9th december, up 220 since May 27 and the biggest increase since 2014.

Additionally, the image of producers acting to harm consumers will accelerate substitution -electric vehicles, efficiency measures- from importers.

Then there is the issue of compliance.

OPEC has a notorious history of non compliance with supply cuts. Members tend to cheat on quotas and, as prices rise, volumes pick up again.

But let´s remember that this “deal” comes after OPEC increased production from 30mbpd to 33.6mbpd. That is, it´s a deal to cut just a part of the increase, to 32.5mbpd.

I have been invited four times the annual meeting of OPEC in Vienna and I have seen many myths spread by the media. Let us remember for a moment why OPEC agreements do not happen easily.

  • OPEC is only 30% of global production of crude oil and liquids. Their ability to influence is declining in a global market where additional barrels come from countries where production decisions are not state orders, but business decisions of thousands of private companies -Canada, US, North Sea-.
  • OPEC countries do not value their position based on price, but on market share. For that reason, Iran or Iraq are unwilling to reduce their production until they respectively reach pre-sanctions and pre-war market share.
  • OPEC countries do not provide hard quotas. Therefore, decisions to reduce production are always left to the discretion of each country, which tends to exceed its production limit.
  • Freezing production knowing that the substitution will come -at least partially- from US barrels has zero impact on the market balance, but has a very important negative effect on producers’ image with customers.

Let us remember that the most “optimistic” see a market balance in 2H2017 after this cut pledge, so there is a strong risk that it may not happen at all.

Even after these cuts -if they happen-, oversupply in the market exceeds 500kbpd and spare capacity is higher than 2.6mbpd. Meanwhile, the IEA has revised up estimates of US production by c500kbpd. It could go as high as 1mbpd in less than a year.

Dallas Federal Reserve President Robert Kaplan estimates that US oil production has potential to top 11mbpd in less than two years and most market participants, including the IEA, see a very likely short-term increase increase to 9mbpd from current 8.6mbpd. Continental Resources CEO Harold Ramm goes as far as to say that US shale producers could increase output to 20mbpd.

This oversupply is also evident in the huge amount of oil stored on ships, already at the same levels of 2008, about eight million barrels.

 

OPEC will only succeed if demand strengthens and oil producers make it clear that they are much more flexible and competitive than other alternatives. If they fall into the trap of a pointless cut, substitution and technology will accelerate the process of stripping oil of its crown as king of primary energy sources.

 

Daniel Lacalle is an economist and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

This article was originally published in Spanish by @elespanol