Economic and market themes: 2014-02-21

Themes for today

• Real economy deterioration in Argentina, Brazil and Turkey is evident.
• Ukraine may be isolated without contagion.
• US data continues to surprise to the downside.
• Eurozone data may surprise to the upside.
• Sweden may be a flashpoint for debt deflation dynamics in Europe.

Argentina. You may have noticed a pickup in the number of Argentine links recently. That is because I am keeping a close watch on the situation there due to the real economy deterioration I am seeing. While I don’t think Argentina is any more important than Ukraine in the grand scheme of emerging markets, the contagion possibility to Brazil is where we should watch Argentina. Official statistics show 5% growth in 2013 with unemployment declining to 6.4%. But the situation is probably not anything like that on the ground. Of particular concern is the abrupt deterioration in consumer confidence in January, down 23.4% and the worst number month-to-month since 1998. This is a very negative sign. To me this also signals that we should expect the economic situation in Argentina to deteriorate further. And we should expect the Argentine situation to spill over into Brazil via trade linkages. One tidbit that I found interesting is that Argentina is repaying Repsol for expropriating its 51% of YPF in Argentine government bonds. That is very ingenious of Argentina because it preserves foreign exchange. Note that Repsol has had to write down $1 billion on that investment.

Brazil. The Brazilian government is cutting spending to undertake “fiscal consolidation” aka austerity in order to reduce inflation. Finance Minister Guido Mantega of currency war-fame says this will permit “sustainable growth of the country.” Of course, this means reducing  growth estimates. Government growth estimates used to be 3.8%. They have now been brought down to 2.5%. And this is a multi-year problem. Growth has stalled in Brazil, with 2.7% GDP growth in 2011, 1% in 2012 and 2% in 2013. Analysts expect 1.79% in 2014 which is less than half what government is saying. I believe the downturn will have a negative impact on corporate balance sheets and make Brazil more vulnerable to crisis via corporate problems. Moreover, the Argentine situation adds a decelerator. French automaker Peugeot has suspended production in Brazil, blaming the economic situation in Argentina. And then there are the fears of a housing bubble. Robert Shiller and others have warned that price trends are unsustainable. House prices have tripled since just 2008, rising much faster than rent. This is a clear outgrowth of Brazil’s loose monetary policy during the currency war days as it tried to stem the tide of hot money flowing out of developed markets and creating asset bubbles in Brazil. Here is a case of damned if you do, damned if you don’t becuase we got a housing bubble in any event. Bad debt from this sector will strain bank balance sheets during the coming downturn. Also see the banking legal issues stemming from interest rates during the previous period of high inflation. The potential liability is as high as $140 billion for the banks. 

Turkey. I thought this was an interesting analysis at the FT. “At the moment Turkey’s banks have a large stock of external debt, around 21 per cent of the value of their deposits. On their own the banks may be able to deal with a slightly higher rate of NPLs, but the risk is of a double whammy of rising external costs and a deteriorating loan book. If any rise in the cost of servicing this foreign currency denominated debt and in securing funding from abroad is passed on to borrowers the this could create a vicious cycle, as higher borrowing costs push the economy down even further, and turning a credit boom into a deep bust.” And note that in aggregate, Turkey’s gross external financing needs are now 25% of GDP with $90 billion of short-term foreign debt to be rolled over. The nexus of a slowing economy, increased credit losses, a high current account deficit and banks and corporates with high external debts makes Turkey uniquely vulnerable.

Ukraine. While it looks like Ukraine will default on its debt, where is the contagion? Will it infect Russia? How will it infect Russia? With Argentina, Brazil and Turkey I see the connections to other vulnerable markets as greater. I am not convinced that Ukraine will produce contagion.

United States. The latest data point showing the US disappointing is existing home sales, which were at an 18-month low in January. As with the GDP data, a lot of this is weather related. And we know this because in Canada too the figures were weak due to weather. But weakness is everywhere: rail traffic, Walmart earnings, homebuilder sentiment, business inventories, jobs, etc. There have not been a lot of good data points coming out of the US. One thing I am keeping an eye on is jobless claims, which suggest US GDP growth peaked at end of Q3 2013. If you look at claims levels from last year, they were in the sub-350,000 range by May 2013. As a result, I expect year-over-year jobless claims comparisons to turn positive sometime in 2014. This means more people will be filing for jobless claims than were a year ago. The last time jobless claims flipped to positive on a year-on-year basis on a sustained level was October 2007, two months before the recession began. Jobless claims are a very good coincident indicator.

The Fed simply misread the data in 2007 and 2008. https://t.co/hbdQDTJkWS pic.twitter.com/jmYhX9irUk

— Edward Harrison (@edwardnh) February 21, 2014

European data look better though. But data out of Spain, Greece, Italy, Portugal and the Netherlands are improving. These were the big trouble spots. Data out of Germany are improving too. France is still the outlier. So where I thought the risk was to the downside for Europe and to the upside for the US, it looks like the reality is just the opposite, with the US underperforming and European beating expectations. This is why I find the Vox column here on deflation misguided. Mickey Levy tells us that deflation is not a problem in the US but it is in Europe. The reality is that the economy is not accelerating in the US as he claims. Rather, it is improving in Europe. I am not going to make hay out of this since the path is still unclear but I think deflation is a threat.

Sweden. We see the deflation threat most acutely in Sweden where authorities are dealing with a housing boom in a decelerating economy. Sweden is in deflation now. The month-to-month change of 1.2% in January was so large it brought the year-on-year change to negative territory at -0.2%. The central bank is worried about deflation. And if overvalued house prices fall, they will have a big problem. Moreover, consumer confidence in Sweden is dropping. Look to Sweden for deflation and debt deflation before the eurozone outside of France.

These are starting to look like turbulent times now, with emerging markets causing the most turmoil for now. But other areas in the global economy are showing strain: the US, China, Sweden, Australia, Canada, France. It’s not just emerging markets we should be watching for signs of where contagion could bring on crisis.