Economic and market themes: 2014-03-28

• The West has accepted Crimea’s annexation and will likely only increase sanctions if Russia goes further
• The Ukraine – IMF deal will put the Ukrainian economy through the wringer
• Russia’s economy is going to tank due to capital flight
• Brazil’s economy is in jeopardy of recession
• The US is doing ok but not great as data have improved
• The Fed’s ad hoc approach is bad policy

Ukraine. Let’s start with Ukraine. The Ukrainian story continues to take a lot of twists and turns. Here’s the latest I have. The European/NATO/US side has accepted the annexation of Crimea as a fait accompli. This marks the first annexation of one European country’s territory by another since World War 2. So it is a very big deal.

But the West seems to be accepting it begrudgingly because there is no military solution in Ukraine. Instead, the US is leading the charge to impose sanctions on Russia as a signal of worse economic damage to come if Russia continues on these lines. Though it isn’t clear yet, I believe no further sanctions will be placed on Russia unless it goes further into Ukraine or does something else to provoke a response.

There are a number of articles coming out that say the Germans have no alternative to Russian gas, that the Germany business community doesn’t want more sanctions and that Europe’s situation is so delicate that the crisis could tip it back into recession if it takes sanctions too far. I agree with this assessment.

The IMF deal will be difficult for Ukraine. We are looking at an inflationary downturn due to the huge increase in fuel costs. Because the energy subsidy hit is a one-off, we could argue that it does not embed inflation in the Ukrainian economy. It’s just a one-time increase in the price level that will be worked back by the deflationary forces of austerity and constrained consumer demand. Remember that German Finance Minister Schaueble is saying point blank that the EU will draw on experience with Greece to deal with Ukraine. So you can see where this is headed. Ukraine is the new Greece. And that likely means an economic depression which will also trigger social unrest and political instability. It might bring the nationalism issue to the fore in an ugly way which provokes a Russian response. Let’s wait and see.

I like Ambrose Evans-Pritchard’s article about the deal because it highlights the moral hazard of vulture funds getting a free pass along with Russian banks. No haircuts are coming. Taxpayers are going to take the haircuts and bondholders get off scot-free. Noteworthy is that Ukraine’s government debt to GDP is rather low at 50%. Yet, austerity is coming. What Ukraine has now is a balance of payments and corruption problem. It remains to be seen whether the IMF solution is a good one or one that damages the economy so much that default is more likely down the line – after the hedgies have made their score.

Russia. The sanctions imposed on Russia are not damaging to the economy. What has damaged Russia is sentiment because of capital flight and the declining ruble. Euromoney also notes that contagion to elsewhere in the CIS will come via the damage to the Russian economy. And the World Bank thinks Russian GDP will shrink if the Crimean crisis worsens. Russia’s military build-up on the Ukrainian border means that this could happen.

Brazil. If Russia has a recession, it could be joined by Brazil. I know PIMCO is talking Brazilian bonds up. Nevertheless, the downgrades by S&P point to serious macro-economic problems there. And I think recession has a 50-50 chance of happening. Real interest rates in Brazil are crushingly high and that will slow credit growth, slow fixed investment and put a damper on the property market. Petrobras was downgraded along with Eletrobras and Petrobras is already cutting capital spending. House prices in Brazil have increased by as much as 250% in the last six years. The talk of a housing bubble is rampant. If the housing sector goes into a tailspin a recession is inevitable.

China. I wrote yesterday on China. So I refer you back to that article. No one is talking about recession but Goldman is forecasting annualized growth numbers of 5% for Q1. That’s half of the growth rates we used to see in China. SO the slowdown is sharp. I believe we will almost certainly see stimulus as a result. But I also believe that the Minsky moment has arrived and that means China has to be concerned about how controlled the credit unwind actually is. Interestingly, the credit unwind could have a mixed impact on Australia’s housing market. The real economy effect is negative. See this story on Glencore’s coal mine shutdown for example. But I am hearing stories about potential capital flight out of China into Australia. There is some concern domestically in Australia that Chinese demand is pricing Australians out of their own houses. Though I think this smacks of nationalism and is overblown, if Chinese capital flight does materialize, Australia’s housing market (and Canada’s too) would benefit.

United States. If you look at the data coming out of the US, it isn’t bad. Q4 2013 GDP was revised up to 2.6% from 2.4% annualized. Jobless claims have indeed dropped to the point where the comparisons to year ago levels are still favorable. And some of the manufacturing indices are showing further growth like the KC Fed one released yesterday. Yes, the housing market is softening. But on the whole, nothing is pointing to recession yet. We seem to have 2%-ish growth ex. inventories on our hands. This will continue to be my thinking on the US until the data turn materially worse or materially better.

On the Fed side of things, I do want to point out the speech by Philadelphia Fed President Plosser about systematic policy and forward guidance because he is saying what I am thinking. Despite Plosser’s diplomacy in defending present Fed policy, it is clear he is uncomfortable with the ad hoc approach to policy that Bernanke and now Yellen have taken. David Beckworth voiced the same sentiments in a recent post saying that ad hoc monetary policy was the wrong approach. I had thought Yellen would use the increasingly robust forward guidance framework to fill in more details, using a rules-based approach. After all, isn’t that what her optimal control policy was supposed to be about? But that is not what we are seeing at all.

The Fed is back to ad hoc as it moves to normalize policy and that can only mean communication error at this delicate point in the shifts of monetary policy. The ad hoc approach is exactly why the markets are confused about the timetable between the end of tapering and the beginning of rate hikes. Is it six months lag, 9 months? What data determine when the hike occurs? Nobody knows because the Fed makes it up as it goes along. Since the fed is now moving to tightening from easing, that leaves markets with less information just as a regime shift is occurring. I see this as a big mistake.

I could go on but I am going to leave it there for now. Have a great weekend.

Edward