WEEKY ECONOMIC AND MONETARY REPORT
26 July 2013
The US economy doesn’t look too bad (though there are concerns about retail sales,
and about the knock-on effect of Detroit’s bankruptcy), Japan seems to be picking up,
and, finally, there is better economic news from the UK. Even the eurozone appears in
(slightly) better shape… On the other hand, today’s edition of The Economist focuses on
the slowdown in the BRICS – which, in its view, removes one of the major positive
factors for global growth. It is, therefore, a mixed picture ahead of what is (for most of
Europe, at least) a Summer break.
I
G20
The main focus of last week’s meeting of G20 Finance Ministers and central bankers
was, as expected, the OECD’s 15-point plan to attack corporate tax avoidance. This
includes proposals for automatic data-sharing about where companies choose to pay
tax (and how much they pay), as well as a commitment:
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to end firms’ ability to decide for themselves where they book sales; and
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to prohibit ‘double-dipping’ – whereby firms can claim tax deductions in more
than one country for the same transaction.
There will be a Multilateral Convention on Mutual Administrative Assistance on Tax
Matters, and the OECD has been tasked with producing a detailed time line for progress
by next year.
Other than taxes, the big issue in Moscow was the endless debate on growth vs
austerity. According to press reports, the US argued for jobs and growth to have
priority; in contrast, Germany emphasised the need for fiscal tightening. In the end, the
US seems to have won – though the battle will remerge at the St Petersburg Summit in
a couple of months.
Beyond that, the meeting also spent time on what will happen when the US cuts back on
its bond-buying programme. It was agreed that this must be “carefully calibrated and
clearly communicated” – though there appears to have been no discussion of the actual
timing.
II
DETROIT BANKRUPTCY
It is worth flagging last week’s decision (by the city’s Emergency Manager) to put Detroit
into formal bankruptcy under Chapter 9 of the US Tax Code.
First, although it is not by any means the first US municipality to declare bankruptcy
(others include Harrisburg, PA, and Central Falls, RI) Detroit is far and away the biggest.
It could also set a precedent for other troubled cities – notably Oakland, CA – since its
problems are far from unique. If it did set a precedent, the impact on the US $3.7 trillion
municipal bond market could be enormous – and it is worth emphasising that investors
world-wide have bought into the US muni market.
In simple terms, Detroit’s tax base has fallen steadily as its population has shrunk, and
as the remaining population has become disproportionately old, black, poor and
unemployed. At the same time, successive city governments have awarded public
sector unions extraordinarily generous pay, pensions and healthcare deals – and have
financed them with a toxic mix of bonds and derivatives.
The result is that Detroit now has a total debt of more than US $18 billion – and its
pension fund is still at least US $3.5 billion underfunded. At present, 65% of total
revenues goes to debt service and payments to retirees – leaving education, health,
police etc grossly underfunded, with nothing for investment.
The city’s (state-appointed) Emergency Manager is an experienced bankruptcy lawyer,
and he has put forward a comprehensive restructuring plan that would see “general
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obligation” bondholders get just 20 cents on the dollar, and existing retirees have their
pensions and health benefits cut sharply.
This is radical. Until now, GO bonds have been widely considered senior to all other
securities – and it has proven virtually impossible to cut pension/healthcare benefits
retroactively. However, things are changing. In particular, the Central Falls bankruptcy
set a precedent on pensions that Detroit is now hoping to follow. At the least, it seems
likely that benefits will be trimmed to reflect the US $3.5 billion underfunding of the
pensions pot.
However, the stakes are very high, and the issue of municipal bankruptcy seems certain
to go all the way to the Supreme Court. The reason is clear. Looking at the US as a
whole (and using plausible discount rates), state and municipal pensions programmes
are no more than 50% funded – leaving a gap that may be as much as US $2.7 trillion.
Either benefits are going to have to be cut very sharply, or the Federal government will
have to take over the obligation (most unlikely), or the muni market is going to collapse much as Wall St. analyst Meredith Whitney predicted (to much scorn) several years
ago. If the last occurs, many foreign banks and pension funds will themselves be hit.
III
RECENT ECONOMIC AND MARKET DEVELOPMENTS
As noted, today’s issue of The Economist focuses on the recent slowdown in the
emerging markets – which it sees as “a turning point for the global economy”. Over the
last few years, we have come to see the BRICS, in particular, as the key global
“locomotive”. But the latest projections show all of them are slowing down. This year,
for instance, the Chinese economy will grow no more than 7.5% - still impressive, but
the weakest in a decade. India’s growth rate will be around 5%, and both Brazil and
Russia will grow no more than 2.5%. As for South Africa, the Reserve Bank has just cut
its forecast for this year to 2.4% - far les than the country needs to provide jobs for a
very young (and rapidly urbanising) black population.
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For the older, richer economies, the picture is – as discussed below – a bit more
encouraging. However, it is worth noting that, even here, most countries have still not
made up all the ground they lost as a result of the financial crisis:
Current GDP relative to GDP in the first quarter of 2008
Canada
US
Germany
+5.1%
+3.0%
+1.3%
France
Japan
UK
-0.8%
-1.2%
-3.3%
Italy
-8.7%
For the smaller countries of Southern Europe in particular, the out turn is, of course, a lot
worse.
A
THE US: There are a few dissenting voices who cite disappointing quarterly
earnings and weaker than expected retail sales. But the general view is that the US
economy is, more-or-less, back on track.
For the most part, optimists were in the ascendant this week, as it was reported:
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that Markit’s ‘flash’ PMI rose from 51.9 to 53.2 last month;
-
that new home sales surged 8.3% to a four-year high in June (despite a sharp
rise in average mortgage rates, which are up a full point since May), and are
now up 385 year-on-year;
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that durable goods orders were up 4.2% last month; and
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that the (final) reading for the July Michigan confidence index was 85.1, up
from 83.9 in June.
On the other hand, it was also reported:
-
that the Richmond Fed’s business index fell unexpectedly this month, from +7
to -11;
-
that existing home sales fell 1.2% last month, much worse than the 1.9% gain
that had been expected; and
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-
that initial jobless claims were up 7,000 in the latest week.
Much will depend on a busy schedule of economic releases next week – including nonfarm payrolls for July (expected to be up 179,000) and the advance estimate of the
second quarter growth rate. The FOMC will also meet – and markets will (inevitably)
over-interpret any comments by Bernanke on ‘tapering’.
Meanwhile, US equities seem to have stalled this week. Strong results from Apple
were, for instance, offset by disappointing quarterly earnings from McDonald’s – and the
result is that what had been a month-long winning streak has come to a halt. Through
Thursday, both the DJIA and the S&P500 were essentially unchanged, though the (techheavy) Nasdaq was up 0.4%. As for the US bond market, that has sold off sharply. The
yield on the benchmark 10-year Treasury, for instance, has risen from 2.49% to 2.57%,
while the 30-year yield has risen from 3.57% to 3.64%. However, it is worth noting that
bond prices are actually up over the last two weeks – which suggests that commentators
may be wrong to write off the 20-year bull market in bonds just yet.
Finally, there has been intense speculation over Bernanke’s successor at the Fed – with
widespread expectation that the White House will make an announcement over the
Summer.
Earlier in the week, the WSJ confidently asserted that the former Treasury Secretary,
Larry Summers, was Obama’s preferred choice. Given Summers’s capacity for
alienating even his friends, that did not go down well – and it was quickly reported that
Summers had been privately dismissive of QE (with the implication that he would stop
the programme if he were at the Fed). As a result, one-third of Senate Democrats have
now written to Obama, urging him to nominate Janet Yellen – who, though older than
Summers (she is 66, he is 58), is both a competent economist and much more
supportive of QE. That may well carry the day. However, it is also worth noting that
there is a third dog in the fight – Tim Geithner, who is said to be closer to the President
than either of the other candidates.
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B
EUROPE: Our position on the eurozone crisis is unchanged – it isn’t over, but it
does seem to be in medium-term remission. This is indicated by sovereign spreads
over German bunds – which have narrowed significantly in the latest week for all
peripheral eurozone members:
Eurozone: Sovereign 10-year spreads over German bunds (basis points)
July 19
July 25
Belgium
100
88
France
67
61
Greece
878
850
Ireland
233
211
Italy
288
272
Portugal
534
479
Spain
314
296
That said, there are two countries that are still causing concern:
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Greece: Yesterday, the Greek Parliament finally passed the last of 22
measures that the Samaras government had promised as the price for the
next €4 billion tranche of its €173 billion bailout package. This should mean
that at least 2,000 teachers will be removed to the so-called ‘labour pool’.
However, the troika is keeping Greece on a very tight leash: the next €2 billion
(which should have been released with the €4 billion) has been delayed until
October.
-
Portugal: Although the government has failed to push through the austerity
programme that it had promised, and although President Cavaco Silva failed
in his efforts to push through a Government of National Salvation, the heat
seems to be off. It is assumed that the Passos Coehlo government can limp
on through the Summer. That may be an assumption too far.
Plus, there is Cyprus waiting in the wings with another bail-out demand. And Spanish
PM Rajoy faces a crucial Parliamentary hearing in the next week or so, which will
determine whether the PP can survive a major funding scandal. Even Italy is wobbling;
although Interior Minister Alfano (Berlusconi’s top lieutenant) survived a confidence vote
this week, his People of Liberty party could drop out of the coalition at any time.
Turning to the eurozone economy, the news this week has been mixed.
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On the positive side, it was reported on Wednesday that Markit’s ‘flash’ composite PMI
for July rose from 48.9 to 50.4 – the biggest jump since 2011 (and much better than the
expected 49.1). Unfortunately, much of the improvement seems to have come from a
couple of countries – notably Germany, where the composite PMI rose from 50.4 to 52.8
(with the manufacturing PMI rising from 48.6 to 50.3). France’s PMI also rose – from
47.4 to 48.8, though this is still below 50.
Nevertheless, the PMIs were considered fairly good. In addition, it was reported:
-
that the Commission’s EZ-17 economic sentiment index improved in July from
-18.8 to -17.4, its best (or least bad) reading since August 2011 - though it is
still well below its long-term average; and
-
that eurozone retail sales were up 1% month-on-month in May, the first
increase since 2011.
There was also some positive news at the national level. In Germany, for instance, it
was reported that IFO’s business confidence index rose this month from 105.9 to 106.2
– the third straight increase. In France, too, Insée’s manufacturing sentiment index rose
from 93 to 95, and the government predicted positive growth of around 0.2% for the
second half of the year. Even in Italy, consumer confidence came in at a high for the
year in July, and in The Netherlands, the producer confidence index hit a 15-month high.
Perhaps more surprising was Spain, where there was an unexpected drop in the
unemployment rate from 27.2% to 26.3%, as the jobless total fell 225,000 in the second
quarter. The government acknowledged that GDP probably fell another 0.1% in the
second quarter – but that, too, was better than expected.
On the other hand, it was also reported this week:
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that average eurozone property prices are now at a seven-year low – even
though German prices are at a 10-year high and Austrian prices are at a
record; and
-
that bank loans to eurozone businesses fell another €13 billion in June (with
lending to households also down).
Plus, the IMF has weighed in – predicting that there will be no eurozone recovery this
year. Its latest forecast is for GDP growth of -0.6% this year, and just +0.9% in 2014.
The Fund is also worried about ‘fragmentation’ of the eurozone – and one of the obvious
economic themes for the last year or so has been the contrast between the fortunes of
Germany (and its satellites, like Austria and Finland) and of the Southern states. This
was highlighted this week in Eurobarometer’s semi-annual poll, in which 77% of German
consumers rated their economic situation as ‘good’ or better, compared with under 5%
in Greece, Spain, Slovenia, Portugal and Cyprus, and just 5-10% in Ireland, Italy and
France.
The UK economy is also giving out mixed signals – though, in its case, the signals seem
to be accompanied by rising confidence.
The key release this week was the first estimate of second quarter GDP growth – up
0.6% (or 1.4% year-on-year), compared with 0.3% in the first quarter. Even though UK
manufacturing is still lagging (it was up just 0.4%, and is still 10% below its peak), this
was considered good news. In addition, it was reported:
-
that bank lending to business rose a net GBP 172 million in June – the first
increase since January; and
-
that homebuilding is now running at a five-year high.
There are problems – in particular, the unexpected jump in government borrowing to
GBP 8.5 billion in June. But there is some confidence that the worst is over. However,
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that is not reflected in equity markets. Throughout Europe, markets have been hit by
fears about China – with the FTSE-100 and the Xetra Dax both down 0.9% for the week.
C
JAPAN: Once again, ‘Abenomics’ escaped serous criticism from the G20 – even
though many emerging economies (particularly in Asia) see it as outright mercantilism.
Indeed, it has been a good week for the PM and his team – not least because, as
expected, the LDP and Komeito did very well in elections for the Upper House, winning
135 seats out of 240.
On top of that, it was reported earlier today that Japanese consumer prices (ex-fresh
vegetables) were up 0.4% year-on-year in June – which was a bigger jump than
expected. And, earlier in the week, the government upgraded its economic forecast for
this year – for the third straight month.
Now, the issue is what Abe will do with his mandate. Almost every policy initiative he
has hinted at will upset some interest group. In particular:
-
joining the US/Asian talks on a Trans-Pacific Partnership will alienate farmers;
-
imposing a consumption tax will upset almost everyone; and
-
boosting the military will antagonise the left.
Still, he will have to do something to show he is serious. The problem is that the market
may not like what he does. Last week, the Nikkei-DJ was up 0.6% - despite falling
sharply ahead of the elections. This week, it has sold off steadily – and slumped over
400 points today. For the week as a whole, it is down 3.2% - which is a surprise, given
Abe’s apparent success.
D
CHINA: The Chinese economy continues to be a puzzle. On Tuesday, PM Li
Keqiang appeared to set a floor for GDP – insisting that the government would not let
the growth rate fall below 7%. That was what the markets wanted to hear. However,
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there has to be some question as to whether the government can ‘fine tune’ growth in
that way.
On Monday, for instance, it was reported that China had a net foreign capital outflow of
RMB 41.2 billion in June – the first outflow since November. On Wednesday, it was
reported that the HSBC/Markit manufacturing PMI hit an 11-month low of 47.7 in July –
down from 48.2 in June (and hard to reconcile with any growth rate close to 7%).
The government’s response has been:
-
to liberalise interest rates further – in particular to narrow the spread between
deposit and lending rates that state banks have to offer; and
-
to announce a new mini-stimulus package, which includes the temporary
suspension of taxes on firms with a monthly turnover of less than US $3,250,
reduction of red tape for exporters, and new bond sales for infrastructure.
Despite all that, the Shanghai stock market has continued weak.
E
OTHER EMERGING MARKETS: Three other countries are worth noting this
week:
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Brazil: Faced with slumping growth and political unrest, President Dilma
Rousseff has seen her personal popularity fall this year from 58% to just 30%.
That has prompted calls for her predecessor, Lula, to make a comeback as
the PT’s Presidential candidate in 2014.
-
Argentine: The legal row over Elliott Associates’ attempt to extract 100 cents
on the dollar for the rescheduled sovereign debt it bought in the markets
continues. Now, it has been reported that the IMF may file an amicus curiae
brief in support of the Argentine government’s position – despite the fact that
Argentina actually faces the (admittedly remote) possibility of being the first
country to be expelled from the Fund for faking economic data.
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-
Russia: It was announced yesterday that the Duma had approved a US $14
billion infrastructure programme that had initially been floated by Putin in
June. This will be financed out of Russia’s reserve fund, and will also include
tax breaks for SMEs. It was prompted by the revelation that GDP growth in
the first half of the year was only at an annual rate of 1.7%.
III
FOREIGN EXCHANGE MARKET DEVELOPMENTS
Last week, the dollar was down 0.6% against the euro (closing on Friday in New York at
US $1.314/€), down 0.9% against sterling (closing at US $1.526/GBP), and up 0.9%
against the yen (closing at Y100.4/US $). The weakness of the yen came about despite
a rally on Friday, ahead of Abe’s strong showing in Upper House elections. The
strength of sterling was put down to the more hawkish tone that had come out of the
BofE’s MPC after its first meeting under the new Governor, Mark Carney.
This week, through late trade on Friday:
-
the dollar is down another 0.9% against the euro, and is currently trading at
US $1.327/€;
-
the dollar is down 0.7% against sterling, at US $1.537/GBP; and
-
the dollar is down 2.2% against a newly-resurgent yen, at Y98.2/US $.
It is also down 1.2% against the Swiss franc, at SF0.9294/US $.
The strength of the yen clearly reflects the Upper House elections – and the stronger
than expected Japanese inflation data. Sterling’s strength – the third straight week it is
up against the dollar – reflects the stronger UK GDP data and the feeling that the MPC
(without former Governor King) is less likely to vote for expanded monetary
accommodation, As for the euro, its strength reflects the robustness of the German
economy – and the hope that the ECB will not be forced to bail out the Southern tier
states any time soon.
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Plus, there is little doubt that the Detroit problem has focussed foreign investors’ minds
on the possibility that the US muni market is not as safe as had been assumed. As a
result, the dollar is currently at a five-week low.
As for gold, one might have assumed that the combination of Detroit’s problems and
Abe’s aggressive approach in Japan would give the price a boost. Indeed, gold has
strengthened significantly. Last week, the price was broadly flat; this week, it is up 3.2%
(or 8.2% month-on-month) – and is currently trading around US $1,327/oz.
IV
OIL
One surprise this week is that the Brent premium has not disappeared; indeed, it has
widened – albeit slightly.
At the close last Friday, Brent for September delivery was trading at US $108.07/barrel,
while September WTI was at US $108.05. As a result, week-on-week, the Brent
premium had narrowed from US $2.84 to just two cents. In late trading today, Brent is at
US $106.64 (down 1.3% for the week), while WTI is at US $104.18 (down 3.7%) –
pushing the premium back to US $2.46.
The explanation for the re-emergence of a positive Brent premium is primarily because,
at these prices, it is beginning to pay US refiners on the East Coast to import Brent.
The situation with regard to WTI is more complicated – particularly given that US crude
stocks are continuing to fall. According to the EIA, for instance, total US crude stocks
fell 2.83 million barrels in the latest week – or 9.7 million barrels in just two weeks.
Moreover, stocks at Cushing, OK were off two million barrels last week. That should
have forced WTI prices up. However, US crude production also hit 7.56 million b/d in
the latest week – the most since December 1990. Moreover, the price of WTI had risen
20% year-to-date, primarily because of improvements in the distribution network which
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had permitted higher utilisation rates at US refineries – now running at an average rate
of 92.3%. Some correction was, therefore, probably inevitable – even though it was also
reported this week that total oil product demand in the US this month was up 4% yearon-year.
Another EIA report this week provided its ‘best guess’ of OPEC revenues in 2012.
According to the EIA, net OPEC revenues (ex-Iran) were a record US $982 billion last
year – of which Saudi Arabia accounted for US $312 billion (in real terms, just short of
the 2008 record). While most members benefitted, revenues in Angola and Nigeria fell –
both because of increased security fears and falling US demand.
According to Bloomberg, most traders expect crude oil prices to fall again next week –
though that also depends upon the continued weakening of Tropical Storm Dorian. If
Dorian strengthens, prices could firm sharply.
V
BANKING
There are several stories this week that are worth following:
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G-SIFIs: Over the weekend, the FSB released its list of what it considers to
be globally-significant financial institutions – which will incur a supplemental
capital charge to reflect the fact that they are “too big to fail”. While the 28
banks on the list are, more-or-less, resigned to their fate, the nine insurers are
outraged – and will fight hard to convince regulators that they should not be
lumped in with banks.
-
Basel 3/CRD 4: It was reported this week that Deutsche Bank intends to
shrink its assets to achieve the minimum 3% leverage ratio which is now
included in CRD 4 (the European Directive which incorporates Basel 3).
Other banks seem likely to follow. It has been suggested by RBS that
European banks as a whole may shed as much as a €2.7 trillion in assets
over the next three years to meet the new leverage ratio test – which would
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potentially be devastating for European businesses (which tend to depend
heavily on bank finance).
In contrast, there have been reports in the UK that Governor Carney intends
to take a softer line on bank capital than his predecessor. The Nationwide (a
mutual bank) and Barclays have apparently been given an extra year to meet
the 3% leverage ratio – and further concessions are possible.
-
US litigation: The cost of dong business in the US by European banks just
grows and grows… Yesterday, for instance, the SEC reported that UBS had
agreed to pay Fannie and Freddie a total of US $885 million to compensate
them for misrepresentation of mortgage-based securities during the housing
bubble. There are 18 other banks being pursued on this issue - including
most of the major Europeans. (Cit and GE Capital are reported to have
settled, though for how much is not known.)
-
SAC: Just to show that they also go after local offenders (at least,
sometimes), US Federal prosecutors announced yesterday that they had
issued a criminal indictment against SAC Capital Advisers – which is whollyowned by the legendary Wharton alumnus, Steven Cohen. This follows a civil
suit filed by the SEC last week. The criminal indictment alleges insider trading
that is “substantial, pervasive and on a scale without known precedent”. It
will, no doubt, be a sensational case, far more significant than the similar case
involving Galleon.
VI
NEXT WEEK
In the US, non-farm payrolls for July will be released. Although the market is less
focussed on this than in the past, it will still be important. Current thinking is an increase
of 179,000 – down from 195,000 in June.
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Other US economic releases include:
-
the advance estimate of second quarter GDP growth;
-
the Case-Shiller house price index for May;
-
consumer confidence for July; and
-
factory orders for June.
In Europe, both the ECB and the BofE’s MPC meet on interest rates. No change is
expected – though the markets will watch the MPC for so-called ‘forward guidance’.
In China, the official PMI will be released. It is likely to be stronger than the (unofficial)
HSBC reading, released this week.
Finally, Spanish PM Rajoy has to testify to Parliament on the funding scandal in his
party. This could lead to the collapse of his government – with implications for the euro
crisis. However, betting is that he will get away with it.
Regards,
Economic Evaluation (London) Ltd
PS
The next report will be submitted on August 9, ie there will be no report next
week.
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