Economic and market themes: 2014-02-07

Themes for today:

• EM crisis in its infancy. Question goes to contagion
• US economic growth is decent but weaknesses now supporting bonds
• Europe is recovering with Spain brightest in periphery; France in trouble

I am now going to make a habit of writing posts that give a roundhouse view of the economic and investment themes to compliment my single theme posts. I think connecting the dots between various issues is a good way to look at the markets and the economy. So I feel I often miss out on the ability to say something on important topics in my mono-themed daily commentaries. Here goes for a second time.

Emerging markets. Let’s look at emerging markets here first. My contention is that the emerging markets crisis is in its infancy and could stay that way if contagion doesn’t take hold. If you think back to the taper tantrum that started in May 2013, India was hit pretty hard and its currency was falling to record lows. Since that time, with the help of Raghuram Rajan’s credibility as the new central bank head, India has stayed out of the headlines. So, as the new wave of EM volatility hit when the Fed started tapering, India was less affected. Attention turned to Turkey and Argentina and South Africa. I see this as an indication that appropriate policy responses can stem the tide of contagion and insulate an economy somewhat from the effects of the emerging markets crisis.

The question is whether this crisis will return in one form or another because of the underlying weaknesses in the Emerging Markets in terms of domestic and foreign debt, balance of payments and political institutions. Jim Rogers says yes. He says that we are having an emerging markets crisis and that it will get worse and that no country will be insulated from the real economy effects. Take a look. The Rogers interview stars about three minutes in. (Also see my bit at the end on fiat currency).

My own view is that, yes, the crisis will continue, and contagion will rise. The level of global policy co-ordination will be a critical factor regarding whether the crisis becomes a global economic crisis or remains a crisis of just the most overburdened and unbalanced countries. I spoke briefly with Steve Hanke about this and he thinks currency coordination is a critical issue, but not necessarily between EM and DM mcurrencies but more importantly across DM currencies, especially USDEUR. I look forward to hearing more about this in the coming weeks, perhaps on Boom Bust.

Also, what I have been saying is that corporate debt in EM has been a relative safe haven because international EM corporates’ revenue streams are diversified away from the domestic market and we should expect contagion to hit the international corporates last. If contagion does hit them, we will know the crisis has worsened.

On that note, it was interesting to see an FT piece on external debt in EM that compared external debt levels in 1997 to today.

As the chart’s title title suggests, many of these countries are in decent shape. But not that decent. On average, in fact, the two groups have more foreign currency debt today than they did on the eve of the 1997 Asian crisis – although those averages are skewed by the two outliers in red, Turkey and Hungary.Here is a chart from Jens Nordvig and colleagues at Nomura. It shows foreign currency debt – banks loans and bonds – as a percentage of GDP for what are identified as troubled currencies and more robust ones, comparing levels in 1996, 2007 and September 2013.

Next, let’s look at the composition of that debt. Our first set of charts below shows the amount of cross-border bank lending to Nomura’s troubled countries, plus China.

All of these counties have enjoyed rapid economic growth during the past two decades so a run-up in external liabilities by their banks may not come as a surprise. Nevertheless, we can see that in many countries, original sin is alive and kicking.

The bottom line here is the exposure is reduced but it is still there, particularly in Turkey and Hungary. On the corporate side, I still believe the liabilities are better matched by revenue but we should remember that currency rate declines will bite tot he degree debt is not well matched by revenue.

United States. As I write this, I am waiting for the jobs number for January to come out. The December number was a huge disappointment but ADP private payrolls growth has been humming along and jobless claims are still in the 330,000 range. That says the labour market in the US is OK. It is not falling out of bed yet. I will be amending this post with the data when it comes out in three minutes.

OK. The numbers are out. Expectations were: Payrolls +175k Private +161k Unemployment 6.7% Hourly earnings +0.2% Work week 34.4. We got +Payrolls: 113k Private +142k Unemployment 6.6% Nothing spectacular but nothing terrible. It was a big miss though as it comes well below a nice 200K threshold. This will be supportive of bonds and has me thinking the bond bearish case is probably fatally flawed.

My concerns in the US are wage growth and inventories. I don’t see real final sales growth going much above 2% without significant wage growth, irrespective of the increase in house prices and shares. here has been no wage growth to speak of in the US and that is a limiting factor on growth. In fact, all of the inventory builds in the second half of 2013 that added growth are negative. All of the US automakers have more than 3 months of cars on their lots.

“The slowdown in the pace of sales for January contributed to a swelling inventory of vehicles on dealer lots. GM said its inventory ballooned to 114 days’ supply. Fiat Chrysler said its inventory amounted to 105 days worth of vehicles at January’s sales pace, up from 79 days in December. Ford’s inventory rose to 111 days. Inventory expressed as days of supply is calculated by dividing the number of unsold vehicles at month’s end by the daily average selling rate. “

So, we have a middling jobs recovery with weak earnings growth and inventory builds as the Fed tapers. That’s not robust by any means but it doesn’t spell recession either. I think the taper stays on track even with these jobs numbers. The decline in interest rates (2.64% 10-year after the jobs number) is enough to give the Fed room to continue tapering. Moreover, If the doves tried to hold up a taper, you would see dissent from George, Fisher, Plosser. Yellen doesn’t want that so the Fed will continue to taper. And that makes EM a continued place to watch for reaction.

Europe. The big news coming out of Europe today was that the German Constitutional Court referred the ECB’s bond buying to the European Court. The German court also said it will rule on the legality of the eurozone’s bailout scheme, the European Stability Mechanism (ESM), on March 18. The second ruling is less important than the first because the OMT bond buying program is the only thing keeping the periphery from default. If OMT had been ruled illegal, we would be in a world of trouble. I expect the European Court to rule in favour.

Right now the talk is of the ECB expanding its balance sheet by not sterilizing its SMP program i.e QE for Europe. The ECB had bought up periphery bonds from 2010 to 2012 and given euro banks cheap loans against those bonds as collateral. But the banks are keeping the loans and that means the ECB has to drain the market of about 170 billion euros worth of bonds to keep its balance sheet in check.

The concern is that Europe is in such a disinflationary trend that deflation is right around the corner and the Europeans are afraid of becoming the next Japan. I think we will see QE in Europe but I do not think it will have any measurable impact on inflation.

As long as OMT is in place and periphery yields stay low, the recovery in the periphery will continue. Spain is the brightest contender here. Structural problems in Italy, Portugal and Greece make them different than Ireland and Spain, though given the severity of the depression, I do expect Greece to be in a full recovery soon if they aren’t already. The question is longer term.

On the bank front, watch for signs that it is the German and French banks which need capital. That puts France in an awkward position as its domestic economy is still in a recession, unemployment is still increasing and the government debt levels are increasing as well. France is in violation of the Maastricht 3% hurdle to boot. Getting the capital into these banks makes France sseem a lot more like Spain than Germany, especially when you think France’s housing market is still well overvalued and house prices are falling.

That’s all I have time for. See you with some general thoughts next week.