Core Meltdown

It has become common for observers of the European economy to refer to the problem countries of Spain, Portugal, Greece and Ireland as the periphery and the remainder (especially the powerful north - Germany, Holland, Belgium, France, Finland, Austria) as Core. I am not quite sure where Italy belongs, but I think it's commonly thought as core too.

Regarding the sovereign crises (or shall we call it 'common currency crises'?) in Europe, it has been commonly believed that problems, as long as they are limited to the periphery, could be dealt with. It's not all that easy, as all Euro countries share the same currency and banking system. One curious fact is that the Greek state's 2-year bonds yield 30% (as nobody wants them), while the Greek banks can obtain financing from the ECB at the refinancing rate of 1.5%. As you may have heard in the media, the situation is dire, and it feels like there are no real solutions.

The problem has just gotten worse last week as Italian bond prices collapsed, and at some point the 10-year bond yielded more than 6% for the first time. This in itself has a funding cost consequence (ie an additional 150bps on 119% of debt/gdp=1.8% of GDP/year in interest, see table below), but it also brings vivid memories of Portugal back. The Portuguese bonds crossed the 6% yield mark in September 2010, and today, 10 months later, are at 12%, rated sub-investment grade by Moody's and the country has received EU/IMF aid in the meanwhile. Almost seems like there is no turning back.
Given the sizes of the economies and of their debt, problems limited to Greece+Portugal+Ireland, can be manageable, however once they spread further and attack the bigger economies of Spain (1tn+) or Italy (1.5tn with 1.8tn of debt), it's all over. It's too big to bail. And it seems like we're now closer to this nightmare scenario.

However, there is one other potential nail in the EU's coffin - that is problems at the core. Besides an economic slowdown, which I think is slowly unfolding as described here, a strategist from DB has today pointed to some serious tensions building in France.

In the good old days before the crises in 2008, tensions were visible in the periphery, and one important measure was a loss of competitiveness, which manifested itself with higher imports and less exports - ie a trade deficit. Ireland, Spain, Portugal and Greece were all running trade deficits of 5-10% - something extremely rare in other countries, but the monetary union apparently allowed it. Of course it couldn't last forever, and once wholesale funding for banks wasn't available to support this excess consumption, and secondary effects such as house prices lost strength, hard reality bit.

Now, this is the trade deficit/GDP for France:
It looks like France is having the same problem - it's not competitive enough vs the world (but Germany in particular), and is importing more. This is the breakdown:
Seems like on a cyclical basis commodities play a role, but on a structural basis it's a lot about machinery and the like.

In the pre-EUR era (70's+80's) the French Frank (FRF) has devalued massively against the Deutschmark (DEM), and it feels very much like the pressure is there again based on the trade dynamics.
Unfortunately, all this leaves us with a rather sad conclusion - that the EUR is a failed project, and too many differences exist between the EUR countries and their policies to share the same exchange rate over time. I'm starting to think that Milton Friedman was a very visionary man, when he said that the Euro project would not survive the first [significant] recession and end up breaking up.

Hard to take a Bone from a Dog

The ISM Manufacturing came above consensus and my own bearish expectations, causing a short-covering rally. There is however ample reasons to believe that the cyclical momentum is still negative.

For one, the ISM components are pointing to weakness going forward. The New Orders-Inventory spread has some leading power over the headline index and it has collapsed:
The non-farm payrolls report was very weak, and the trend NFP growth model is poitning to weakness (55k/month job growth):
The ISM non-manufacturing is pointing to very weak growth:
This leaves us in either slow-growth/muddle-through territory, or will take us to outright recession. It's not conclusive, but warrants caution. The risk is clearly that growth reaches a stall speed , which in itself is dangerous. As someone has recently pointed out, whenever GDP growth drops below 2% in the US, it actually goes down all the way into negative territory (with very few exceptions). And there is every chance that growth will dip sub 2% in the next quarter or two.

Finally, I would like to make reference to a an excellent piece "Hard to take a Bone from a Dog", in which the author points out how difficult, if not impossible it will be for the US government to reform entitlements (medicair/medicaid etc). Maybe the Republican party will need to change their stance on this subject, or maybe they are planning to do so anyhow, and the current episode around the debt ceiling is just posturing.

Cyclical view

For good two months now, economic data has been coming in weaker than expected. This logically leads to consensus growth downgrades, however so far these growth revisions have been concentrated in the 1st half of 2011, and have not been reflected in the 2nd half growth expectations as well as FY 2012.

As can be seen, after a weaker 1st half (1.8 and 2.45) consensus is expecting 3.2 in H2 and 3% in 2012 (which hasn't moved since late last year).

If this soft spot becomes yet softer, there is every chance that it will start affecting growth expectations further out, and that will lead to weaker risk assets and a stronger USD (at least absent a vigorous QE3 response). There is good reasons to expect further poor data in the near term, and I would expect the markets to start discounting the risk of a more serious growth deceleration (lower stocks, higher volatility and credit spreads).

Most market professionals recognize that the ISM Manufacturing survey (in particular the New Orders component) is one of the best global leading indicators. In the beginning of every month when it is released stocks and bonds swing violently depending on the surprise direction. For two weeks leading up to the ISM release, regional surveys are made available, which give us some insight what to expect. Thus far the Philadelphia Fed and Empire State Surveys turned out very weak, pointing to a June ISM reading of around 46.3 (44.5 if we were to use the "Philly" only). Even adding 3 points to this estimate, which is the divergence we had between the ISM and the Philly+Empire proxy in this cycle, takes us to <50, ie economic contraction.
So, there is every chance we get a sub-50 reading on the ISM, when it's reported on the 1st of July - I think that can spook the markets. Not only would it be the 1st reading since mid-2009 indicating contraction, but the idea that it's just a temporary slowdown, mostly Japanese supply chain driven, would have to be reviewed. The street is is still quite bullish on the economic forecasts (as the table above illustrates), and the downgrades have not yet been made. This is very well illustrated by our friends at Citi.
The graph shows, that based on a model (which I suppose, uses many of the economic indicators discussed here), growth forecasts are currently too high by a sizable margin.

Finally, it's worth noting, that my favorite European leading indicator - real growth of M1 - has peaked in mid 2009, and the decline since, indicates an imminent drop in the IFO (leading index) and the growth pace in the core European countries (no, not the periphery - Germany, France, Sweden etc)
This indicator has done a good job since the early 90's. In the previous cycle it lead by about 2 years, and based on that lag, we should see a lower IFO in the months to come.

Conclusion and implications: sell the EUR, sell stocks or go short cyclicals/defensives, and wait.

Remember what Warren Buffet once said - Money flows from the impatient to the patient - so wait and be patient - the opportunity to go long your favorite long-term plays, will certainly come!

Fiat FX World

So why the title of this blog?

Our modern financial system is based on paper currencies, which have no intrinsic value. The 100 USD note has value because we can exchange it for goods and services, but also and more importantly, because there is is a limited supply of 100 USD notes in the world, and (even more importantly), because we trust that that supply will not go up too fast.

The truth is however, that over time, with the rising supply of money, cash has indeed lost quite a bit of their value in real terms. This charts shows the decline in value of one (nominal) USD using the consumer price index:
With the Fed's target of "low but positive inflation" a dollar has turned into 6 cents. Another aspect of the Fed's policy that contributed to this decline, is its willingness to intervene (ie print or lend money) in times of crisis. This was taken to an extreme during the Greenspan era, when every significant decline in stock prices was met with more expansionary monetary policy. After the initial shock, this liquidity is usually not withdrawn, and the money supply (and debt) ends up increasing faster than economic activity.

So the unit we use for measuring value, and often as a store of wealth, is actually an asset with ever less real value, as its quantity can be easily changed by the authorities, in order to accommodate short-term objectives. This phenomenon was not confined to the US Dollar, most countries have maintained positive inflation, and effectively been devaluing their currencies in real terms.

All this is relevant today, because the developed world is facing the most dismal economic outlook:
1) debt and future liabilities are way too high
and
2) many tail winds from the past years are turning into head winds

...and chances are very high, in my opinion, that the most convenient way for authorities to get through this, will be to print, and make the loss of wealth and income less obvious in nominal terms. As John Maynard Keynes famously said about inflation: There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

Debt and Future Liabilities

During the last 30 years debt levels have exploded in the US. Most of this debt build up occurred at the consumer (or household) level, with many people borrowing against real estate, but the financial system also became more highly leveraged. On my latest numbers this brings the total to 336% of GDP, with household debt at 89% and government debt at 95%.

With the financial crises, and collapse in real estate values, the private sector has stopped borrowing more, and in order to avoid a prolonged recession or depression the government stepped in, increasing government spending and deficits:

We are now at a juncture where the government is running unsustainable fiscal deficits of 10% in order to maintain growth at a reasonable level, while the private sector heals. However, so far it is difficult to speak of any improvement at the private sector level, rather a stabilization at best. It should also be noted, that the fiscal deficit can only be reduced gradually (say 2-3 percentage points/year) without bringing the economy down.

The public debt situation level is high as it is, however it gets worse. Demographics - the retirement of baby boomers - and promises made by the US government imply and significant rise in government spending on social security and health in the coming years.
This graph was taken from the Pimco website, from a recent monthly piece by Bill Gross. It shows the massive unfunded obligations of the US government related to socail security and health (this category is otherwise known as entitlement spending). As a side note, the US government has 14.27 trillion USD of debt (the number I use in the total debt chart), however Bill Gross uses the category called debt held by public for the smallest circle, which excludes ~5tn of debt held in government accounts for funding future social security spending and the like. BTW neither includes Freddie Mac and Fannie Mae debt at a cool 40%+. The big blue circles are future entitlement obligations, and they dwarf existing public debt.

The debate in Washington, about the debt ceiling and budget reform does not make one optimistic, and appears like mostly posturing by the republicans. What is clear from this, is that entitlement reform (ie reduction) is what is needed to avoid disaster, but it is also a very unpopular political decision nobody wants to make. Today "entitlements" represent 55% of the budget outlays, defense is 20% and interest payments are 6%. Most of the haggling between the two parties is concentrated on the remaining 19% (the nondefense discretionary category), which covers such trivialities as education, police, highways - ie all other government spending.

Although the outlook for the US is particularly poor, most developed countries are facing similar challenges. Even if debt growth was not as extravagant in the last two decades in, say, France, the problem of unfunded pension and health spending, with a deteriorating demographic ratio is certainly real and comparable. Indeed, the seven (most) industrialized nations are on a terrible debt trajectory:
Even Germany, the bastion of fiscal responsibility and the European leader in manufacturing and exports, doesn't look good:
It should be noted, that Emerging Markets are not faced with that kind of debt overhang, and thus have much better prospects:

Structural Winds of Change

As noted earlier, debt has been rising very fast for the last quarter century, nicely outpacing GDP growth. This was a strong growth tailwind as can be seen here:
The Credit Impulse is the change in the rate of growth of credit (in this case household+corporate debt). It has provided a boost to GDP for the bigger part of the past three decades. It is safe to say that debt can not keep on growing at this pace, as debt levels are already at unprecedented and dangerous levels. Going forward debt dynamics will be a headwind.

Interest rates have been trending down since early 80's (when Paul Volcker squeezed the pips out of inflation)
This phenomenon had massively positive implications for the value of assets (bonds up, equities up, real estate up - all seem more attractive and profitable as cost of financing goes down) and leverage (can borrow more). This phenomenon was driven by other very important trends such as:
1) global disinflation as Asia becomes the (cheap) supplier of many tradable goods and
2) as Asian (and other EM) currencies are pegged to the USD and run trade surpluses, these countries accumulate USD reserves and "recycle" or reinvest them in US treasuries, thus making financing for US entities cheaper.

There is good reasons to believe that all of these are slowly changing course. Asia no longer provides an unlimited pool of cheap labor, and there has been a lot of anecdotal evidence in the past year of rising wages and even labor shortage in China, as well as stories of rapid rises in salaries for low-skilled workers elsewhere in Asia (ie in Bangladesh from 40 to 80 USD/month for textile workers).

Currency revaluation pressures (generally through the inflationary mechanism) are putting pressure on many EM currencies to appreciate, which will bring the current accounts closer to balance and reserve accumulation will slow if not stop. Global reserves held at Central Banks have reached 9.86 trillion USD, and appetite for further accumulation, and more importantly accumulation of US bonds is not there. China realizes that it already holds way too much US debt.

A trade-off, which is getting worse, is the one between growth and inflation. Apart from wage pressures in low-cost countries, we are also confronted with an increasing competition for finite resources. Emerging Countries, who represent a much larger population than developed countries (very roughly 4bn people vs <1bn in developed) are growing and consuming an ever larger share of energy, metals and food stuffs, which puts pressure on prices.
In the past, only after several quarters of very strong growth, would commodity prices start to rise. This time around we had the slowest recovery from a recession (in the West), and the highest rise in commodity prices (post-recession). This is something we unfortunately have to get used to, as the resources EM is competing for, are finite and ever more costly to extract.
It should be remembered, that the US is the biggest consumer of oil in the world (18.7mbpd out of 82.8mbpd) and two-thirds are imported.

Conclusion and Implications

The above is to illustrate that the favorable growth dynamics of recent years and decades, are becoming much more unfavorable, while the developed countries (with very few exceptions), are confronted with a pile of debt and pension obligations to populations with ever more retirees. In short, I don't believe there is any way these liabilities can be made good in real terms. Thus it is only a question of how the governments will default on them. Inflation will most certainly play a role. Longer-term real return on government bonds should be very poor - not only is the starting nominal yield historically low, inflation over the next 10-20 years is likely to be above average.

The investment implications are:
- high economic volatility as cycles are shorter, as we oscillate between deflation to inflation
- this leads to higher financial market volatility - careful with leverage
- gold, the ultimate currency which can not be printed. Out of the 10 trillion of (EM) central bank reserves very little is held in gold, while over two-thirds are in USDs. Room to grow here as debasement worries rise.
- commodity producers - you want to own the companies who own the stuff in the ground... but it's cyclical and cycles will be vicious
- EM currencies (especially Asia+LatAM) - vs underweight in USD+EUR+JPY in particular
- EM stocks - of course a lot of micro-level factors play a role, but despite the recent hype, developed market investors have low allocations to this superior category
- as things get worse capital controls and various forms of financial repression will be enacted in developed countries, so careful where you hold your assets

Finally, it should be noted that this is not a cyclical call. We may very well have another deflationary scare ahead of us where US Treasuries rally, and hard assets underperform. The growth path of some still export-dependent EM will not be smooth. But ultimately, the authorities will "engage all the hidden forces of economic law" and produce inflation, which is their only chance to tackle the massive debt overhang.

Time to sell the AUD

AUD is the currency with possibly the best fundamentals in the world.

Australia is the provider of raw materials to commodity-hungry Asia - China in particular. Aussie exports grew from 108bn in 2003 to 231bn in 2010 and around two-thirds of the exports are commodity related (iron ore, coal, fuels, metals). Thank you China, Japan and south-east Asia.

The AUD is also one of the highest yielding currencies out there. With 4.75% on the overnight rate, it's the highest in G10 and only a handful of emerging countries offer higher nominal interest rates (Brazil, Indonesia, Turkey). In real terms it's also comfortably positive at around 200 basis points over inflation, beating most of its Asian neighbors and most, if not all, other developed countries.

So why do I think AUD is a short now?

The first reason is a likely slowdown in China. As the western deflationary fears hit Chinese shores in 2008, the authorities embarked on an unprecedented credit creation exercise. As has been pointed out before, the money supply created in the middle kingdom was higher than the monetary stimulus in the US, UK, Eurozone and Japan combined (in USD terms). I'm nore sure if this still hods true post-QE2, but the point is that what the Chinese did was money creation on an extraordinary scale.

The party was great fun. The funds fueled an investment boom, which in many ways worsened imbalances in the country (too much investment and too little consumption) and abroad (on the trade front). However, as all parties, it eventually comes to an end. No country can sustain 40% M2 growth for very long, and now we are entering the most delicate stage of the credit cycle: when the rate of growth of money slows. There goes a graph from our friends at Nomura to illustrate the point:


So the worry is that as China is slowing (as it's visible in PMI and industrial production numbers in recent months), it's appetite for Australian commodities will diminish slightly - or at least will not grow as fast.

The second reason for shorting the AUD is a mix of valuation metrics, and the impression that the currency has diverged.

The first chart shows a simple AUDUSD regression model using interest rates, commodity prices and a Chinese growth indicator. Clearly there is a gap here. Maybe it's a structural break... maybe not.


The second chart is a similar model for AUDCAD (two commodity currencies - we take the US dollar out of the equation), which forecasts the AUDCAD rate 12 month forward. Although in 12 months the forecast AUDCAD level is roughly at where we are today, the current divergence points to around 10% AUDCAD overvaluation in the next couple of months.


Finally, this is a trading call. The longer-term fundamentals for the AUD are quite good, but it is a very cyclical currency, and looks too frothy now, given the downside risks to Chinese growth.