Economic and market themes: 2014-03-14

Themes for the week

• US data have been better
• European periphery market access continues to improve
• Dollar weakness may be China-related
• Gold continues to get safe haven bid
• China’s slowing more likely to be abrupt
• Ukraine has become a military issue; contagion will increase
• A full-blown emerging markets crisis is now likely

My overall thesis here as I write the weekly theme post is that we are going to have a full-blown emerging markets crisis, that will take on global dimensions. There are two reasons for this, contagion from a military and economic confrontation between the EU, US and Russia over Ukraine and the likely uncontrolled slowing of growth in China.

Before I move into these issues I want to run down the themes in the order of the bullet points above.

United States. First. in the US, the data have been good enough that analysts like Marc Chandler are talking about green shoots. Many analysts have been saying the poor figures in recent months were due to weather. And I have always said we could get a credit accelerator, particularly if capital spending picks up. But I am sceptical about the pace of this expansion going anywhere materially above 2% at this point.

The data have been good in recent days, but the underlying trend is not as good. Retail sales were up 0.3% in February, ahead of expectations. However, this was for the first time in three months that retail sales have improved with sales falling 0.6% in weather-scarred January. Last week’s jobs report showed the same improvement. After two months of poor jobs figures, we got a decent but still sub 200k non-farm payrolls number. Only 388,000 jobs have been created in the last three months, however. And that’s worst in 19 months. Another bright spot was weekly jobless claims. They came in at 315,000, pulling the 4-week average way down to 330,500. Note, however that year-over-year comparisons are not going to be any more favorable going forward because jobless claims had already started to come down last year. They averaged 347,000 a year ago, only 16,500 more than now.

Bottom line: It is good to see these numbers beat expectations. But we need to keep in mind that wage growth has not broken out despite claims to the contrary. And that means the underlying pace of recovery cannot break out yet unless households dissave and leverage up. I believe, the peak growth is in the rear-view mirror.

Europe. In Europe, the improvement in sovereign credit continues. Fitch affirmed the EU’s rating as AAA and stable. In Spain, bond spreads to German Bunds are now at the lowest level since 2010 and yields are the lowest since 2006. Last week, Spain sold 5.004 billion euros of bonds in the three to five year maturity with record low yields. Yields have since dropped further. Portuguese bonds are also at a four-year low. Ireland went to market with a 10-year issue that was 2.9 times oversubscribed. Yet the yield came with a 2-handle at 2.967%, a record low for Ireland. Even Greece is seeing a pickup everywhere across the curve, though the 6-month rate is still 3.6%, down from 4%. The Ten-year is at a four-year low. According to Merrill Lynch, the average yield across the periphery has fallen to 2.438%, the lowest in the currency bloc’s history.

Because eurozone banks have huge exposure to their sovereigns, this is working. 5.7% of all eurozone bank assets are debts by eurozone sovereign governments,the highest ratio since 2006. That’s 1.75 trillion euros in government debt on bank balance sheets. This concerns people who see the bank-sovereign nexus as problematic. As soon as yields diverge again, it will be a drag on balance sheets, bank capital and, therefore, credit. For now, the cycle is virtuous and gives banks time to raise more funding as the ECB’s stress tests come into play. I see the periphery doing well until the emerging markets crisis impacts Europe and the global economy.

Currency. Now the euro is getting a bid and is at the highest levels since late 2011. That doesn’t make any sense since the Fed is tightening and the ECB is loosening, the US dollar should be moving higher, but it’s not. One possibile explanation is that China’s move to depreciate the Yuan is causing the euro to rise as the Chinese impact the currency markets everywhere. I am not a currency expert. So I have to punt here. I do know, however, that the move higher in the euro is causing howls of disapproval in Europe and may precipitate an easing move by the ECB. Other safe haven assets like the Yen, the Swiss France and gold are moving higher as the EM crisis grows worse.

Gold. At last check, gold had vaulted up to 1383.90. The metal is putting a huge move, and all of the technical readings are bullish, in view of the large pullback and gold’s ability to break through multiple points of resistance. I am keeping my out of consensus $1600 price target for gold and am now fully bullish on gold as a safe haven asset given the deterioration in the situation in emerging markets.

China. And that brings me to EM. China has to be the first concern. The data out of China show a marked deterioration in the growth path. Industrial output rose 8.6% year-over-year, the weakest numbers since 2009. The pace of investment growth eased to 17.9% year-over-year, the weakest numbers since 2002. And retail sales rose 11.8% year-over-year, the weakest numbers since Feb. 2011. That’s three broad indications of weakness, not just in manufacturing but in consumption as well.

Chairman Li recently demurred when asked how far Beijing would let economic growth slip before it steps in. His answer showed tolerance for lower growth as long as enough new jobs get created. Translation: The Chinese are serious about rebalancing this time and they will let growth decelerate more than anticipated as long as the job situation is not negatively impacted.

I don’t think they can pull it off though. Caijing talks of Li Xinchuang, executive vice-secretary general of the China Iron & Steel Association, saying China’s steel overcapacity is “beyond imagination”. Reuters sources say that Chinese banks are cutting loans to bloated sectors by 20% as a result. Reuters writes that the “squeeze has already caused a cash crunch for smaller steel mills and some commodity traders, especially in steel and iron ore. Some 16 steel mills in the top producing province of Hebei, around Beijing, have stopped production due to financial troubles, provincial governor Zhang Qingwei said last week. Some mills in northern Jiangsu province have also closed down.”

This rebalancing is having a terrible impact on commodity markets. And this affects not just the commodities sector globally but the shadow banking system in China due to the use of commodities as collateral for loans by the shadow banks. Deutsche Bank hones in on iron ore for use for steel mills as a point of weakness because “iron ore positions are typically un-hedged thus subject to high volatility. Furthermore, as a low value product with greater difficulty for storage, iron ore financing is not sustainable, in our view.”

And the knock-on effects this will have on the household sector is large, especially in view of the headwinds now facing the housing sector. Bottom line: China is going to slow more dramatically than Chinese authorities anticipate before they have a chance to reflate. The contagion into commodity producers from Perth to Peru will be large. A recent analysis shows Chile, Colombia, Russia, South Africa and Peru as most vulnerable here.

Ukraine. And speaking of vulnerability, Russia is also getting hit hard by the Ukraine crisis now. The potential annexation of Crimea by Russia is an important escalation of this crisis and all of the Rhetoric that has come out subsequently shows this. Until the Crimean escalation, I was not worried about contagion from Ukraine except to Russia I had said on March 4th that “only if we see military action or if Putin pushes beyond Crimea into the rest of Ukraine will economic penalties be on the table.” But the Crimea standoff is now a military confrontation as Russia warned today it was prepared to intervene in eastern Ukraine due to civil unrest there between pro- and anti-Russian factions.

Just look at the arrest of the Ukrainian oligarch in Austria and the targeting of Russian business close to Putin. The rhetoric out of the Obama Administration leaves no room for maneuver if Crimea votes to join Russia or if Russia intervenes in Crimea militarily. Meaningful economic sanctions would have to occur, with the EU probably joining suit. Sanctions against Russia would lead to tit-for-tat sanctions against the EU and the US. This would be disastrous for Europe because of Europe’s dependence on Russia for natural gas. The recovery would end and another debt crisis would be likely.

Emerging Markets. Moreover, as the effect on Russia has increased, the contagion to emerging markets has to as well. A full-blown emerging markets crisis is now likely. The combination of an accelerated slowdown in China, military confrontation in Ukraine, economic sanctions in Russia, and another slowdown in Europe will be too much to bear for the emerging markets. Once meaningful sanctions on Russia go into play, we are in a new world. A tit-for-tat response will be crippling for Europe and a full blown emerging markets crisis would commence. We are dangerously close to this now.