Economic and market themes: 2014-02-28

Themes for today

• Emerging market political risk is now front and center.
• US data suggest consumption growth is vulnerable to poor wage trends.
• The European periphery banks are benefitting from lower sovereign yields.
• The potential for China’s currency regime to change is a developing story.

Emerging markets. As this week comes to a close, the emerging markets crisis has moved fully into the political realm. Where a lot of the focus early on was on fund flows and the fear of a sudden stop of currency flows to countries with current account deficits, much of the risk is political in nature. For example, in Ukraine, it is not at all clear who will replace Yanukovych in power. And this comes at a time when Ukraine is asking for $35 billion in aid from Europe. There is huge uncertainty there. Some are talking about an eventual split in Ukraine into two parts. The currency is now in freefall as a result. And that makes default all the more likely. In Venezuela, there has been a media blackout as protests increase. And inflation is the highest in the world. In Thailand, terrorism is now a part of the situation with a bomb attack over the weekend. Some believe that eventually the army will intervene. The list goes on. But the bottom line here is foreigners don’t invest in politically unstable countries and that’s where capital flows can come to a sudden stop. When this happens, contagion can bring on problems elsewhere. We are just getting started with this crisis.

United States. In the US, the revisions to GDP for Q4 2013 just came out and they show growth of only 2.3% versus the initial estimate of 3.2%. Things to note are the downshift in personal consumption from an initial 2.9% estimate to a 2.6% reading. And then there is the fact that Q4 business inventories rose $117.4 billion, the largest increase since Q1 1998. The previous estimate was even higher at $127.2 billion. I think what we see in the US is a +2% baseline for consumption, aided in the past by declining savings and releveraging. With GDP bolstered by inventory building. What we would like to see is less inventory building and more business capital expenditure plus a good dose of wage expansion.

Below are two charts that highlight the wage versus consumption picture. Click on the links for charts. I believe what we are seeing there is a constant level of consumption growth in accordance with households’ desire to smooth out consumption patterns. And this level of consumption growth, which is higher than wage growth, can only continue via releveraging or improved wage growth. Eventually, consumption growth will drop from these levels. And notice the step fall of wage changes into negative territory.

US: Real disposable personal income (y-oy % change) 2007-2014 pic.twitter.com/lPLlrXYJfX

— Edward Harrison (@edwardnh) February 25, 2014

US: Real personal consumption expenditures 2007-2014 (y-o-y % change) pic.twitter.com/6QnLaueOEC

— Edward Harrison (@edwardnh) February 25, 2014

Also, note that jobless claims are ticking up slightly. The 4-week is now 338,250. If claims rise 10-20,000 per week further over the next few months, we will be in a situation where comparisons to year-ago data are unfavourable. This is always a harbinger of slowing economic growth.

Europe. The numbers coming out of Europe are still uneven as one should expect when recovery is just beginning. A lot of people are talking about QE as a measure to stop deflation. I think the concept that QE would prevent deflation is a monetarist view which is misguided because the root problem in Europe is a poor labor market both in terms of job gains and wage rate trends. Edward Hugh’s piece on QE in Europe was more insightful because it demonstrated that deflation may be a way out for the ECB from its OMT bind. The German constitutional court made the OMT threat less credible but with deflation looming, the ECB can still go and buy up periphery and core country bonds with the premise of stopping deflation. The bank – sovereign nexus is critical in thinking about credit conditions in Europe because lower sovereign yields are important to the balance sheets of European banks. In the periphery, the decline in yields of sovereign debt has cleaned up their balance sheets to the point where I expect the French and German baks to be in a worse capital position than the periphery banks. And note that a country like Greece, where bad debt is still rising, can benefit from the balance sheet effects of the banks’ holding of the appreciating Greek sovereign assets. Greek bonds were the world’s best performers last year and they continue to appreciate. At some point, the feedback between banks and sovereign will be enough to stop the bad debt increase and to allow Greece to hit the markets with deals in the 2-to5 year range. I am looking at both Spain and Greece to show upside surprises this year.

China. It is interesting that the Chinese currency is now depreciating with active support from Chinese authorities. If this goes on much longer it could be a political issue. My understanding here is that this gives Chinese exporters a reprieve while the rebalancing shift occurs and may boost GDP somewhat as a result. For the Japanese and other Asian exporters though, this is a big problem because it has negative implications for their trade balance. I expect to hear more political tension because of this shift.

The stories in the links will be very useful in following these themes. Those stories represent a large part of what I am seeing that helps me synthesize what’s going on in the markets and in the economy. I try to group them by subject so they flow together. The four macro stories I am following most are the emerging market political crisis potentially leading to contagion story, the potential US consumption growth slowdown story, the periphery sovereign-bank capital upside surprise story and the potential profit margin/multiple contraction story developing in the US.