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The challenges of Europe

Global Economy, Interviews, Media, On the cover, Sin categoría, ,

Here is my interview on CNBC discussing the risk of complacency, lack of reform, governments intervention and debt in Europe.

We have started to see signs of optimism in Europe supported by a macroeconomic environment that, far from being attractive, is showing some encouraging data. But the fragility of the recovery is still high.

  • Industrial production indices are approaching expansive levels.
  • Corporate margins are improving, quietly, thanks to exports and cost control.
  • Private debt has been reduced to 2006 levels.
  • Financing costs for small and medium enterprises, including Spain and Italy, have fallen to two-year lows.Gas imports have increased for the first time since 2008, which is very relevant to industrial activity.
European Recovery

European Recovery

(Courtesy Morgan Stanley, SocGen)

All these elements themselves should not lead us to be overly optimistic, but neither should be ignored.

Recovery is extremely weak since, at the same time, countries persist in tax rises and attacks on disposable income that depress consumption. And if we don’t see an improvement of consumption, all other variables are simply smoke.

Unemployment and consumption are the two great scourges of Europe. With all the government support and a highly interventionist state, unemployment in France has reached three million people. In Spain, above 5.8 million, it has  shown a moderate slowdown in job losses. But job creation is only going to happen when consumption recovers, and that will not happen in an environment where disposable income is curtailed and taxes destroy families and SMEs. The fiscal burden in the European Union is already about 40%.

Threatening to raise taxes on big business now is another huge mistake. They’ve been a pillar of internationalization and growth, and thanks to them we now have global multinationals, employing tens of thousands. But these strategic moves cost a great effort in debt and weak balance sheets.The cleaning of such balance sheets has not been completed in full, despite cost savings and divestitures, and to raise taxes is a dangerous move that creates more harm than good. Because these large corporations are also big employers, generate the bulk of private investment in the countries, and their social security contributions are one of the main guarantees of the financial sustainability of the welfare systems. Further tax changes would also delay the entry of foreign capital until conditions are stable and attractive.

The European Union has warned France that it can not go higher in its tax burden. Unfortunately, as always, tax hikes delay the recovery and do not generate the desired revenues.

The tax increases are not helping consumer or employment, but also do not improve the borrowing countries. Keep in mind that at the end of 2013 the debt to GDP in the euro area might exceed the current 90.6% by at least 1%, and that the state deficits continues to rise above 4%. In this environment of low interest rates and moderate risk premiums, there seems to be little problem, but low interest rates and strong bond demand do not last forever.

But the relative calm in Europe can not mask the huge debt problem across the eurozone, and should be used to prepare a challenging winter.

European countries, and peripherals in particular are going to have to face excessive deficit budgets, and three risks :

  • Italian debt ratios that are much higher than expected.The financing needs of the public sector in 2013 already almost double the figure of 2012.
  • A current account deficit in France of nearly 60 billion in 2013, and a debt to GDP that is on its way to 100% in a short period of time (currently 91.7%).
  • A deficit in Spain that, despite the recovery, is exceeding all targets at 6.7%.

So why be optimistic?

Since the problem can be short-term financing and that Germany and the paying countries will continue to press for the much needed structural reforms, it is likely that, as I have commented in CNBC a few times, the European Central Bank might conduct another liquidity injection (LTRO) to help the financial system to face the risk of higher interest rates and possible bumps in the huge portfolio of government debt that banks accumulate. Only in Spain, more than 213.6 billion. European banks accumulate up to 20% of Europe’s sovereign debt and that weight is monitored constantly by the European Central Bank.

But, like other liquidity injections, the problem will be generated if it is used to give another kick to the can and take this slight recovery as an opportunity to increase tax pressure and delay the reform of governments that spend between 10 and 50 billion more than they collect structurally. Because then we will find the same problem as in previous periods of slight improvements: the bureaucratic machine crushes the recovery.

Read further: http://www.cnbc.com/id/101544281

The Chinese Slowdown Impact On Commodities

Energy, Global Economy, On the cover, Sin categoría, , , ,

China slowdown 1

29/03/14 Confidential

“China’s economic restructuring has made pre-2008 paradigms out of date and off the mark” Hanfeng Wang

I have had the pleasure of giving a masters degree on commodities at UNED, and talking to my students I was always surprised at how easily they assumed as unquestionable the expected consumption figures from China. And there is a lot to question.

When we talk about the slowdown in China some assume a total collapse. And it is not. But it’s the end of a model of aggressive debt and building “anything” to “grow”. Excessive and unproductive debt. According to Morgan Stanley the country today needs four times more debt to create an additional unit of gross domestic product compared to only five years ago.

Changing the model to a more sustainable and consumer-oriented one is not bad.

– 41% of Chinese investments flow to the consumer sector and services, compared to less than 30% a few years ago.

– The economy is being modernized: Imports of high-tech products have been reduced from 85% of the total to 71%.

– Exports of high added value goods grew 50% from five years ago to 85.4%. Incidentally, this is something that terrifies the Japanese and their “monetary imperialism” as some Asian commentators call it (https://www.dlacalle.com/abenomics-failure-in-six-charts/).

The Chinese economy is increasingly less industry and more services. Because the model was not sustainable. Gone are the steel mills that manufactured and then re-melted end product, the ghost towns and 28 million unsold homes … and the rows of windmills and solar panels without connection to the grid. Anyone who’s ever seen them never forgets them.

No one can consider the change as negative. South Korea and Taiwan held that transition without a problem, they just had to adapt to GDP growths of +2 – +4%. However, since Chinese excess debt is huge, especially in SOEs, the process is not so simple. Because the economy saves less (falling three percentage points since 2010) and borrows more.

The fact that much of this debt is financed internally by local banks does not mitigate the risk. A pyramid scheme doesn’t stop being one just because participants lend to each other.

A 200% debt to GDP when 48% of companies in the Hang Seng, especially semi-state owned do not generate returns above cost of capital is a huge problem. It has a large impact on the financing capacity of the productive sectors, as mentioned in the CICC report “A Tale of Two Economies”.

However, the slowdown of the “old Chinese economy” is not cyclical. It is structural. And it has a huge impact on the commodities market. We are seeing a very significant impact on the demand for coal, copper, iron ore and oil, creating an overcapacity that depresses prices in the medium and long term. Something that benefits other importing countries.

Producers of commodities had become accustomed to an ever increasing demand driven by China and now face the excess supply. Those producers, especially in iron ore, coal and copper, always try to replace lost revenues by producing more, thinking that in a not-too-distant future the demand slowdown will reverse. A serious mistake.

The impact of the “Chinese slowdown” in oil, copper, coal and iron ore is a much more reliable indicator of growth in industrial activity than GDP.

Let’s start with something crucial. We should not ignore the “inventory” effect. A huge amount of Chinese purchases  are not consumed, just stored. Unadjusted estimates of demand have been lethal for many producers. Inventories of iron ore for example, have risen by 57% between 2013 and 2014. And for coal and petroleum products inventories are at peak levels of 2010.

– In oil, OPEC members are already considering to reducing exports by one million barrels a day. China consumes nearly 10% of the world’s oil and means almost one third of oil exports. However, Chinese demand in January and February fell 1.9%. In the early months of 2014, adjusted for inventories (ie, removing what you buy to store) demand fell by 4.6% over the same period in 2013. Chinese demand expectations are wrongly based on the country reaching a per capita consumption similar to the U.S. or the OECD and, as always, they forget efficiency and substitution. Believe what you believe, but distrust those optimistic estimates that are reduced by 30-35% each year.

– In iron ore, China represents 63% of global exports. Analysts from UBS to Standard Chartered, warn of the difficulty for the country to meet its demand growth estimates of 3% annually, leading to an oversupply in 2014 reaching 136 million tons, 170 million in 2015. As an example of the “Chinese slowdown”, in 2012 there was a shortfall of iron ore of 70 million tonnes. In a few months it turnmed to a similar level of surplus. Chinese steel consumption has stagnated below 60 million tonnes per month since December 2012 ( https://www.dlacalle.com/iron-ore-more-oversupply-more-china-worries/ ).

– In coal, China accounts for almost 50% of world coal consumption. With a government program seeking to reduce pollution, growth expectations of Chinese demand do not exceed 1.6% per annum. That is, it is very likely that imports will not exceed 220 million tons. With growth of global production and exports from Australia, South Africa and Colombia, the world faces another year of excess supply of more than 20% ( http://www.reuters.com/article/2013/05/09/ energy-coal-idUSL6N0DQ0UU20130509 ).

– In copper, the problem is the same. Increasing supply, decreasing demand from the main consumer, China, which accounts for 39% of the global market. The estimated surplus of refined copper was revised up from 327,000 in 2014 to 369,000 metric tons, and in 2015 is expected to exceed 400,000 .

We should be very careful to ignore the effects of overcapacity when exporting countries are looking to offset lost revenues with more production, and let us not forget the depressing effect of excess storage. Because it’s a lethal combination in the world of commodities.

Ignoring the elephant in the room is one of the biggest mistakes we make when making estimates for the future. We take exceptional periods, access to credit, liquidity, consumption or growth, as new paradigms that will perpetuate forever. We do not question whether it is sustainable or not. Or worse, when it is perceived as excessive, we tend to justify it.

In the analysis of commodities the mistake is even greater because it is applied to the largest consumer in the world: China. And when economists make a mistake up to 40% in their estimates for three consecutive years but 2020 expectations remain unchanged, the problem is magnified.

Bulls already know the arguments … “Chinese demand will be multiplied by two in the next twenty years” etc.. In 2012 a friend at Exxon said to me about the Chinese growth. “I do not believe it. And those who plan using the official estimates of growth in China as a reference can only be disappointed. ”

For the commodities market, and for all, the change in the Chinese model is a positive because it was unsustainable. But let’s not ignore the wave effects it can have on a world hooked to China’s perennial growth.

Of course, many will say that everything I say is irrelevant, because China, as any good communist dictatorship, grows and consumes whatever the Communist Party decides. Yep, but the argument works both ways. If the Party decides to change the model, it will change it.

In any case, an economic model is no less unsustainable because the ruling party dictates it. It falls under its own weight sooner or later. And with a little luck, it takes the ruling party down with it.

– See more at: https://www.dlacalle.com/el-frenazo-chino-ataca-a-las-materias-primas/#sthash.yEd2qI6B.dpuf

CO2 collapses 41% MTD

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CO2 2014

CO2 continues to collapse (-41.8% MTD, -16% YTD) after the EU intervention has failed to address the massive oversupply of free credits  and demand continues to fall.  CO2 trades at €4.5/mt (31st March 2014). It traded as high as €35/mt in 2008. -87.7% from the peak, or a massive -30.7% per annum for a “politically designed” commodity created to desincentivize CO2 emissions.

Same story over and over: Oversupply meets falling demand:

–  Oversupply: The market reserve mechanism was introduced by the EU because even once CO2 backloading is applied, the oversupply of CO2 in the EU ETS will trough at around 1.5bn credits. The reserve mechanism will be used when the total number of allowances in circulation, defined for a single year as all the allowances and international credits issued from 2008 to that year, less the total emissions produced and any already in the reserve (basically the oversupply of the system) is above a certain level. This means that oversupply of emission rights in any given year will continue to be around 2bn tons of CO2 to 2020 in the most optimistic scenario. The supply of CO2 (EUAs) has exceeded demand by at least 20m Mtons almost every month since 2010. 

– Demand down: In the EU, 2013 verified emissions for the EU-ETS will be 3.8% lower yoy, and will reach 1.79bn tCO2, while ETS demand for 2014 is expected to fall another 3%. 

According to SocGen, CO2 emissions for the largest four sectors in the EU-ETS comprise nearly 95% of all emissions, historically. Combustion installations are by far the largest contributor, emitting over 70% of all CO2 in Europe. Verified emissions for combustion installations in 2012 were 11% lower than their 2007 peak, mirroring similar decreases in electricity consumption across Europe. Emissions from energy-intensive industries, like mineral oil refineries, pig iron/steel, and cement clinker/lime production have essentially stagnated since 2009, after a material drop coinciding with the beginning of the recession.

The European Union is 30% of the emissions of the world, but (hold on) 100% of the cost as no other country has adhered to emission trading schemes. Therefore, a slowdown in industrial production and a debt crisis that could delay the extremely aggressive and optimistic plans for a low carbon economy announced for 2030, added to the slow but sure slowdown in power demand is proving that a system that was artificially created is causing the demise of a government-forced scheme that ultimately was only a tax.

CO2 (as I mentioned in 2009) is a “fake commodity” artificially invented, where demand and supply are imposed by political entities… and it still does not work. Neither the Copenhagen, or Cancun summits, or the efforts of several investment banks and environmentalists have helped to raise the price. Interventionists were rubbing their hands at the prospect of increasing the price of CO2 through more than questionable environmental policies, and now they need to find inflation through imposition.

Unless we see a much more drastic approach from the EU to address the oversupply of EUAs the picture is not positive. But at the same time, a drastic approach attacks the economic recovery and adds a burden to industries all over Europe, so I would not count on it. According to Citi it would require a 14% increase in power and industrial demand to start to address the oversupply of EUAs.

In summary, lower industrial demand is driving emissions lower, and a miscalculated free rights scheme continues to show a massive oversupply.

See more at: https://www.dlacalle.com/why-co2-collapsed-20-in-two-days/

Further read: https://www.dlacalle.com/co2-collapses-to-all-time-low/

 

Iron Ore… More Oversupply… More China worries

Energy, Global Economy, On the cover, Sin categoría, , , ,

Iron Ore correction

 

Same as with copper. China slowdown means trouble for iron ore. More supply and less demand.

China is the world’s biggest buyer of iron ore, accounting for 63% of global imports last year. China will import a total of 872 million tons in 2014, and 916 million tons in 2015 according to official Chinese estimates. However, this figure is likely to be revised down. The country’s crude-steel production may total 802 million tons this year, from 803 million tons estimated in December, and increase to 819 million tons in 2015. This improvement doesn’t reduce the oversupply. Macquarie’s China steel survey also highlights disappointing demand indicators after Chinese New Year.

UBS points out a downside risk to 3% China’s steel growth outlook. Added to this the China credit concerns and the fact that Chinese port inventories are up 57% year-on-year adds to a concerning outlook for demand. As I wrote here months ago… Careful with China.

Moving to the supply side, the fact that producers are happy to increase output even if prices fall to $70 (breakeven) means that large iron ore producers like Rio Tinto Group and BHP Billiton Ltd will not take action to reduce oversupply. According to Macquarie BHP & Rio continue to invest pro-cyclically “whereas we believe it should be the dividend that flexes to reflect business conditions while keeping capex steady through the cycle”. What’s more, recent acquisitions are a reminder that both have been poor at picking the cycle historically.

New iron ore supply from Australia may total 92 million tons this year, pressuring prices in the second half, according to Standard Chartered in a Bloomberg news report.

Standard Chartered bank predicts a global surplus of 136 million tons in 2014, increasing to 170 million tons in 2015, from a 77 million ton deficit last year.

I see the same pattern as with crude, coal and copper. Excess supply brought to the system to “accommodate” the “high growth” in Chinese demand is meeting the reality of overly optimistic expectations of Chinese industrial output growth.

When producers overestimate demand from the largest customer by far… Things get nasty.

Remember what I said on copper… domino effect. Good for importers, though :).