Tag Archives: global economy

The Largest Financial Trade In History And Its Risk

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


For a Competitive Energy Policy

20/9/2014 El confidencial

“Industry will gradually lose its competitiveness if this course of increasing subsidies is not reversed soon”, Kurt Bock, CEO BASF

Europe needs to exit the crisis through competitiveness and security of supply.

Europe must change an energy policy that has forgotten companies and households with the objective of  being “the greenest of the class” without paying attention to costs and competitiveness.

European companies and families cannot continue to bear the costs of planning mistakes and subsidy generosity, because the situation is dramatic.

Europe’s energy policy has forgotten companies and households with the goal of being the greenest of the class.

In Europe, electricity costs are on average 50% higher than in the USA and in industrial gas, almost 75%. Between 2005 and 2012, thanks to the shale gas revolution, gas prices in the US fell by 66%, while in Europe they were up 35%. In turn, power prices in the United States fell by 4% while soaring 38% in Europe. It’s the difference between an energy policy that promotes efficiency and replacement through low costs, and Europe’s policy of promoting forced substitution through subsidies.

European companies are among the ones paying the highest prices for electricity and gas in the OECD. A German medium-sized industrial company pays twice the electricity tariff than a counterpart in Texas, according to Ecofys. The average of the Spanish industrial sector pays more than twice what the comparable US one.

The “green” policies and the development of renewables have allowed wholesale electricity prices to fall; while at the same time, adding fixed costs and subsidies, consumer prices have skyrocketed . For example, in Germany wholesale generation prices have fallen nearly 38% since 2005 and the average electric bill has gone up 60%. A mistake that destroys jobs and businesses that needs to be tackled. In countries like Spain  we must differentiate wind power, which represents 20% of the energy generated in 2013 and 19% of the cost, from solar, which represents only 5% of energy produced and 20% the total cost of generation.

Green policies and the development of renewables have allowed the price of wholesale electricity down; but adding CO2 costs, fixed costs and subsidies, consumer prices have soared

The European Union is less than 14% of CO2 emissions in the world, but 100% of the cost. Interestingly, despite the green policies of  the EU, the United States has reduced CO2 emissions since 2005 by 12% to 1994 levels, a more significant reduction than Europe’s.

All these problems result in lower industrial production, increased offshoring of companies, difficulties to compete and, of course, less employment.

For these reasons, the energy policy of the European Union must comply with the principles of safety, diversification and competitiveness.

Keep betting on renewables without passing the bill to businesses and families. Subsidies must be changed to tax incentives, as in the US. This prevents planning mistakes when estimating demand, subsidies and costs as the tax incentives are only provided when demand is real through agreements with consumers (PPAs, power purchase agreements). Every year I hear that solar will be competitive next year. And every time I hear it, the electricity bill goes up.  After nearly a decade of subsidies, solar and wind technologies promoted by many leading European companies are competitive and at grid parity in some countries, without subsidies. To continue to demand subsidies in mainland Europe is at least suspect.

Addressing the problem of overcapacity . Europe cannot be “green” yet subsidize inefficient coal technologies, pay unnecessary capacity payments, or maintain excess capacity, with reserve margins above 17%. And all paid by consumers.

Replacement, not accumulation. Europe cannot allow new generating capacity when consumers pay the accumulated excesses. The new generation capacity has to come from replacement, and the change should be done at lower costs.

Addressing the problem of overcapacity. Europe may not want to be the greenest yet subsidize inefficient coal technologies hold unnecessary capacity payments, payments for unjustified subsidies interruptibility or maintain excess capacity … And all paid by consumers

Solving the problem of security of supply,developing local energy sources  -shale gas, oil, renewables-, as well as improving interconnection between European countries to use “hubs” to reduce dependence from Russia and other countries, using the various -almost idle- storage facilities and regasification terminals.

Do not demonize technology in a regional and ideological way . Citizens should know that replacing nuclear and gas power with renewables would increase electric bills by three or four times. Remember that the average best price of renewable generation is today 68 euro/ MWh, “only” twice the wholesale price in Germany, and 30% higher than in Italy.

Electricity prices in Europe in 2003 were among the lowest in the OECD and today they are some of the highest. Why? Because the final consumer bill was loaded with all kinds of fixed concepts. In Spain more than 62% of the bill are regulated costs, taxes and subsidies. The European average is 54%.

Europe’s energy policy can not be about “not in my garden”. Pretending to eliminate nuclear power plants when most countries have a few miles, in France, dozens of nuclear reactors, is ridiculous. France has the lowest power prices in Europe and a safe, reliable and competitive nuclear fleet is one of the reasons why tariff prices have not soared. The other is that France did not jump to subsidize tens of thousands of Gigawatts of expensive renewables in early stages of technological development. As long as nuclear power is competitive, efficient and safe, Europe must continue taking advantage of it.

The challenges faced by Europe in its energy policy are enormous. But the opportunity is exciting, and the foundation to make Europe a competitive, self-sufficient world power is already in place.

Technology replacement should be achieved through lower cost,  the same way as crude oil ended with whale oil . Not because it was decided by a committee, but because the cost was lower.

The mistakes of 2007 began with optimistic estimates of demand growth, with errors of up to 35%, and so it came to be the first time in history since the industrial revolution in which governments incentivised the most expensive technologies. Europe’s decision to substitute cheap energies for expensive ones have cost many lost jobs and industries.

Security of supply must be achieved, also, from a flexible and diversified energy mix which must be cheap and efficient. Not via subsidies, but through the tax incentives that prevent “fake demand signals” and prevent overcapacity.

Energy is the cornerstone of the future of Europe. Sinking competitiveness would likely worsen the crisis. Europe has the tools, using all technologies, to ensure an abundant and cheap energy supply. Anything else would bring it to repeat the mistakes of 2007.



Important Disclaimer: All of Daniel Lacalle’s views expressed in this blog are strictly personal and should not be taken as buy or sell recommendations.

Inversion Deals. Running away from the taxman

“You gave me nothing at all, now let me give it to you. You Taught me how to be cruel, now let me try it on you “ Jim Steinman.

Every time I read estimates of future revenues if countries raised taxes to “the rich” and large companies, I am amazed at the naivety of thinking that everyone affected is going to stay put and not react . I’ve never seen a single estimate reflect the potential loss of economic activity.

All these “expected rervenues” are based on the assumption that nothing would change. And I am dismayed at how little we look abroad. Public spending estimates always start from the premise that you earn a lot and they spend little . And when fiscal revenues decline, we always hear that “here is not going to happen.”

Well,  inversion deals in the United States, is something we should think of, and with concern in the EU, which is already suffering the trickle of companies moving outside its territory-what I call the “silent Depardieu” -. Please keep it in mind because it is in danger of accelerating.


Imagine that you have a company and you get charged very high taxes. You may decide to acquire or merge with another in a tax friendly country and move the corporate headquarters to that nation. Thus, the new group, added to all the strategic reasons to merge, benefits from a preferential tax treatment.

It’s not easy to do. The merged company must have less than 80% of its shareholder base in the United States, and at least 25% of the activity of the new group should be generated in the new headquarter centre.


This is a media error. The problem, in most of the cases, is not only are the taxes paid, but the bureaucracy and obstacles to generate economic activity . Many of the companies that have left the United States for Canada or Ireland do it also because the conditions for their activity are more attractive.

Given the complexity of making the change to a different country, these transactions generally have a very clear strategic logic. Mergers ‘criticized’ by the United States government since 2004 have created more than 6 million jobs worldwide and globally generate higher tax revenues in the countries where they operate, according to UBS (” A New Wave of Tax Inversions“).

Therefore, much of the complaint of the Obama administration is not justifiable from the social point of view, only from the perspective of their revenue-raising estimates. According to Congress between 2015 and 2024 18.5 billion dollars of tax revenue could be lost to inversion. There is, however, no talk about how much more the US could earn by lowering five points the corporate tax rate. An equivalent amount if we assume the same margins and profits of 2014 and an annual 1.6% growth in Gross Domestic Product (GDP).

That concern for “lost revenue” would not exist if taxes went down . Is it a race to zero where the other countries would lower even more their tax rate? Of course not, as companies work with many scales of risk and opportunity. If taxation is competitive, it will not move because of small differences. There are many relevant factors.


In the United States Corporate tax rate is one of the highest in the OECD . Rather than reducing it, laws were implemented to avoid inversion deals, one in 1983 and another in 2004. Congress imposed its “American Jobs Creation Act” of 2004. Of course, before long, inversion deals accelerated . Between 2007 and 2014 more companies have left the United States to more business friendly countries than in the entire period from 1981 to 2003, according to the Congressional Research Service .

Legislative repression and calls to patriotism, even inflammatory proclamations to “boycott” companies, have failed. Instead of facilitating a transition to a more competitive tax and regulatory environment, and only an improvement of 5 points would have sufficed, the solution proposed now is to legislate again. And I believe it will not work.

Why should we fear it in Europe?

When we count on the money of others to maintain the bloated spending, we should at least take care of our laying hen . And in Europe the risk of a wave of migration is high.

In the Eurostoxx 50 a large proportion of big companies have behaved as “covert social security.” European companies, relative to revenues, hold between 17-20% more employees on average than their US peers. In fact, in some sectors, such as telecommunications, infrastructure and energy, European companies have an average of up to 30% more employees than their American or British competitors. Companies in the S & P 500 ( United States) at the same time have a much healthier cash situation and and debt ratios are much more robust than their European counterparts .

Additionally, if we consider all taxes -green, regional, local, social tariffs, etc- the largest European companies pay in taxes up to 40% of their domestic operating profit .

This explosive combination of lower productivity and increased taxation has not yet generated a large number of ‘migration’ deals as in the United States for three reasons:

  • In Europe, large companies tend to maintain a strategic symbiosis governments. And that is partly why they have more employees and have less stringent profitability targets and shareholder return policies.
  • Many large European companies often hold ‘captive assets’. That is, it is difficult to move to another country when you have huge regulated assets or concessions.
  • A “cultural” issue. Managers who have spent many years, even decades, developing a career between local business. See how rare it is to find CEOs and business managers which are foreigners.

Considering all these barriers, company migration has not been avoided in the EU, so think what might happen if the proposed tax increases are imposed . We will see, as in the United States in 2004, an unprecedented exodus of business.

We can not stem the tide. To think we’re going to avoid the internationalization and tax optimization of companies through repression is a huge mistake. Tax receipts grow with economic activity, not because of a committee decision.

Taxes are the payment for a service, not the ransom of a kidnapping. Someday we will remember it.

Important Disclaimer: All of Daniel Lacalle’s views expressed in this blog are strictly personal and should not be taken as buy or sell recommendations.

Eurozone Banks Face the Toughest Stress Test

El Confidencial 26/7/14

“Stress tests are like Cuban universities, everyone passes, but the title is worth nothing.” 

If anything has been shown in the recent episodes of negative surprises from some European banks – from Portugal to France or Germany – is that European banks have not yet solved their problems. We confuse the important exercise of transparency and improvement carried out since 2012 with a magic solution to a problem created by a decade of excess. Is impossible to assume that banks have cleaned up their balance sheets when non-performing loans reach EUR 932 billion across Europe, 7.6% of total loans in the eurozone, according to Price Waterhouse Coopers .

When we talk about the bank stress tests (“stress tests”), many analysts regard them as the definitive marks, not as what they really are: a dynamic analysis of constantly changing circumstances . And, of course, these tests are not infallible, as we have seen so many times (Dexia, Savings banks, Cypriot banks, etc..).


It is an analysis that uses a common methodology for all countries, in which the impact on the capital ratio of a bank of various risk events is analyzed .

The general public tends to think of banks as “entities that collect deposits and make a lot of money,” and this is wrong. Because we tend to look at the P&L (accounted profit and losses), and not the cash flow and balance sheet.

A bank, for every Euro received from deposits usually borrows up to 25 times. That deposit is actually a loan, it is not sleeping in a safe.

For every Euro that the entity gives as a loan, banking rules allow the use of more or less capital depending on the risk that is assumed for the operation. If the bank lends to a very safe company with a low probability of default, the percentage of capital required for the loan is very low. The rest is debt.

These loans, if they work, generate a profit, and during the life of such loan the bank generates a margin between the cost of money and the interest rate charged… if the bank gets the principal back. If not, the balance sheet will deteriorate rapidly.

Whhen things go wrong, such “capital” shrinks very quickly. This is why people do not understand how in 2007 a ​​bank could have reasonable solvency and liquidity ratios and in 2008 be on the verge of bankruptcy. A citizen does not see how fast the core capital can disappear when a large percentage of loans become risky (non-performing), which means that there is a high degree of probability that the borrower will not be able to pay the interests and principal. This rapid decline in the middle of a recession can leave the bank without resources.

As such, stress tests aim to analyze whether in a drastic change in the economic environment, banks would retain the 10-11% of capital that they have on average today.


The stress tests aim for two objectives. Firstly, analyze the impact on banks’ fragile financial structures of events like a recession, losses on sovereign bond portfolios, aggressive currency depreciation, etc.. Furthermore, the test stress tries to be righteous enough to not make an unnecessarily negative exercise that endangers the public trust in the institutions.


Many large banks are currently generating returns of around 4% (return on equity), far below the typical target levels of around 15%.

Research by EY suggests that banks will find it extremely challenging to achieve this kind of RoE uplift. Cost reductions of around 35% or revenue growth of more than 20% might be required just to achieve their average cost of equity (10%). Should banks wish to reach 15% RoE they would be required to reduce costs by 66% or grow revenues by 44% — a goal beyond the scope of most banks in the current climate.

A problem of low Return on Equity (peripherals around 2%, average eurozone banks below 6%)  and high exposure to government loans is not solved in two years, but deposits have stabilized and banks have sold large packages of toxic real estate assets. That does not make the sector “totally healthy”.

The stress tests of 2014 will be very demanding and assume , among other risks:

  • An adverse scenario of falling GDP in Europe of 0.7% in 2014, -1.5% in 2015, plus a 21% drop in house prices, added to increased inflation.
  • Losses in the portfolio of sovereign bonds from increases in their risk premiums. Increases of 150 basis points in European premium or 200bps in the US sovereign bonds. Assumes a drop of 6.5% off in Spain, for example, 6% in France and 7.6% in Italy and 4.4% in Germany in the 5-year bonds.
  • Possible 25% depreciation of the Hungarian and Polish currencies , and 15% of the Czech, Romanian or Croatian.

Although these may seem aggressive estimates, the expected impact on banks is relatively small .

However, do not forget that these exercises are theoretical and, like everything else, reality often shows unexpected effects. But the exercise is important.

Do not expect the credit will grow dramatically because banks pass the theoretical examination of the stress tests.

Although the level of private credit has begun to recover slowly, with an expected growth of 0.5% to the private-sector, 4.4 billion euros in 2014 -, the European Union remains, by far, the most bloated financial system in the OECD.

  • European banks are the most intervened, regulated ans State-controlled of the OECD. Not only due to the weight of public sector banks, but because of the disastrous intervention in the M&A and divestment processes , with governments pushing to lend at all costs. let’s not forget the “crowding out” effect of government debt versus households and businesses, encouraging the purchase of sovereign debt through regulation, as explained here  and in English here.
  • In Europe the banks finance 80% of the real economy , while in the U.S. is about 30%.
  • Total assets of the banking system of the euro area accounted for 349% of GDP in 2013 . A reduction of 12% since 2008. Much higher than the U.S. or Japan (Chart courtesy of Merrill Lynch) figure. While it is true that part of it is because European banks have more deposits, it shows a bloated banking system.

  • Additional credit expansion is not the solution , as we forget where we came from … A brutal credit growth since 2001, as the graph below shows (mdbriefing.com). Morgan Stanley estimates that European banks have sold or refinanced only between 20 and 25% of the 700 billion of non-performing loans that the regulation required them to urgently address in 2014.

Banks cannot drink and sing at the same time. It is impossible to strengthen balance sheets, avoid taking excessive risks while lending like 2008 just because we think that credit is the solution. First because they can’t and second because they shouldn’t.

The stress tests of 2014 are not the same as those of 2011. European banks have improved.  Non-performing loans are expected to be reduced in 2014 while operating profit is estimated to be up 4.2% after three years of decline . The risks still exist, but it is not as severe as it was in 2011. Forcing to lend at any cost is a great danger.

Liquidity injections by the ECB do not solve a key problem. Where do we put all that money?  Europe has an average of 25% industrial overcapacity. When I asked on CNBC a senior manager of the ECB where they thought they were going to invest 400 billion euros of TLTRO, he failed to give me a single key sector where those funds would be deployed.

Credit is growing again, but it should not reach the levels of 2004 to 2010 again. As Von Mises said, “no one should expect that any logical argument or any experience could ever shake the almost religious fervor of those who believe in salvation through spending and credit expansion.” 

I’m afraid that with negative deposit rates, liquidity injections and stimuli, we aim to re-ignite the credit bubble before the European banking system recovers its strength. Then, when it bursts, we will surely blame the ‘free market’… and de-regulation. 

Important Disclaimer: All of Daniel Lacalle’s views expressed in his books and this blog are strictly personal and should not be taken as buy or sell recommendations.