The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Invest with smart knowledge and objective odds

EMERGING SUBMERGING

I do not invest in emerging markets. Too many moving parts (earnings, accounting, disclosure, forex, politics,…) with unlimited potential grey and black swans from so many corners. It is almost impossible to correctly value emerging markets and adequately measure risk vs reward. Last 15 years: much volatility (risk) with zero overall growth (reward). Only for traders who can be repeatedly smart (lucky?). Key word is repeatedly. Poor odds for me! North American equity markets provide a large enough playground that I can better understand and value. Despite what they say, diversification is not necessarily risk/return positive.

VWO

spy

tsx

From time to time, an emerging markets crisis rocks all other markets for a while. The root causes are generally the same: rapid increases in U.S. interest rates and the U.S. dollar.

Jerome Powell explained the links between U.S. monetary policy, the USD and emerging economies and markets in a speech to the Institute of International Finance in October 2017. That was before he became Fed Chairman.

But in a May 7, 2018 speech to an IMF conference, the new Fed Chairman felt the need to tell the world that U.S. monetary policy isn’t the major cause for EM crisis.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

But Powell added these warnings given that Fed policy was for scheduled rate hikes well into 2019:

I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.

Risk sentiment will bear close watching as normalization proceeds around the world.

Global policy normalization is central banker current wording for scheduled multi-year rate increases. You have been warned.

What Powell is referring to with “risk sentiment” is the highly sensitive risk-on/risk-off trigger on emerging debt and equity markets that effectively dictates capital flows so important for dollar-indebted EM countries and companies.

In previous EM crisis, developed world banks were the lenders to EM countries. This time around, the lenders are mainly bond investors and the borrowers a mix of EM corporates, small to very large, and, to a lesser extent, sovereigns.

In previous crisis, the epicenter was relatively limited to one or a few countries like Mexico in 1982, Thailand and Malaysia in 1997. Redirected capital flows made the crisis global but the economic damages were limited in time and scope. This time around, the visible problems are in Turkey, Argentina and Venezuela but heavily dollar-indebted corporations, spread across the world, are silently suffering the pain of being slowly strangled but rising rates and the strong USD. Eventually, the strangled groundhogs will suddenly emerge from their increasingly uncomfortable undergrounds in need of financial air or simply declare bankruptcy.

In previous crisis, the risk-off trades were in equities and the debt instruments of specific countries and banks. This time around, the risk-off trades will combine both equities and EM bond funds, creating a lot more additional pressures on the weak currencies and further boosting the USD, amplifying the problem in the process. ETF investors will want to rush to the exits, only to find very narrow exit doors with few buyers on the other side? This time around, the next EM crisis will also be a liquidity crisis that will likely impact all asset classes in both emerging and developed markets.

Data from the Institute of International Finance show that EM ex-China debt has almost doubled to $27T since 2007 while China’s has been multiplied 6 times to $36T.

image

Corporate borrowings have ballooned across the world while central banks drove interest rates through the floor.

image

U.S. interest rates are now going in the wrong way for these unprepared borrowers. The Fed has set the path straight up for short term rates, from nearly zero in 2015 to their current 1.75% on their way to 2.9% at the end of 2019 per the most recent Fed dot plot. Longer term rates are feeling the upward pressure while also lifted by rising inflation and inflation expectations. Ten-year Treasury yields bottomed in 2016 at 1.4% and have since gone up 170 bps even though still offering a historically low 0.6% real yield.

With more than $3T in EM debt maturing between now and the end of 2019, refinancing will necessarily cost between 300 and 500 bps more on fixed rate debt alone, a whopping $120 billion jump in annual interest costs on fixed rate debt. Some 50% will be absorbed by the non-financial corporate sector.

This, without taking into account the damage inflicted by the rising USD.

Foreign investors have increasingly bought domestic-currency bonds, seeking both credit and currency gains. If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves. (Fitch)

Add rising oil prices and you get something close to a perfect storm. It will likely start in the EM world but interest rates and oil prices are rising across the developed world as well where non-financial corporates are also highly indebted.

Groundhog days ahead! Watch your step.

NEW$ & VIEW$ (5 MAY 2016): Of Demographics and Productivity

Freight Rail Traffic Plunges: Haunting Pictures of Transportation Recession

Total US rail traffic in April plunged 11.8% from a year ago, the Association of American Railroads reported today. Carloads of bulk commodities such as coal, oil, grains, and chemicals plummeted 16.1% to 944,339 units. (…)

Only five of the 20 commodity categories saw gains. Of the decliners, coal was the biggest. But petroleum products also plunged 25%, and grain mill products dropped 7%. Even without coal, carloads were down 3% year-over-year.

But it’s not just coal. In April, loads of containers and trailers fell 7.5% year-over-year to 1,028,460 intermodal units. They transport goods for retailers and wholesalers. They haul parts, components, and assemblies for manufacturers. They haul imported goods from ports and borders to different destinations across the country, and they haul goods to be exported to the ports and borders. They’re a measure of the real economy.

For the first 17 weeks of the year, total rail freight fell 7.8% from the same period a year ago, with carload traffic down 14.3% and intermodal down 0.8%. (…)

It didn’t get any better at the end of April: for the week ending April 30, carloads plunged 14.1% and intermodal traffic dropped 8.6% from the same week a year ago. (…)

Insurers Seek Rate Hikes to Cover Obamacare Costs Insurers have begun to propose big premium increases for coverage next year under the 2010 health law, as some struggle to make money in a market where their costs have soared.

(…) Still, the analysts said, a number of insurers are likely to seek significant hikes as they aim to cover costs that have continued to outstrip their estimates—in some cases coming after earlier premium increases.

The increases, along with the continued lagging results for insurers, are a sign that the exchange business hasn’t stabilized for insurers in the first few years of the health law’s full implementation, prompting health plans to continue to push for more changes to the law. (…)

In Oregon and Virginia, the first two states to make insurers’ premium proposals for 2017 public, several big insurers are showing how those projections bear out.

Providence Health Plan, currently the largest insurer for people buying coverage through the Oregon health exchange, is seeking an average increase of 29.6%.

In Virginia, where premium increases had been relatively modest to date, Anthem Inc. is asking for an average increase of 15.8%. (…)

Increases can be blunted for many lower-income consumers by federal subsidies that flow directly to the insurer, offsetting the consumer’s premium bill. (…)

U.S. Trade Deficit Narrows as Exports & Imports Both Fall

The U.S. foreign trade deficit decreased to $40.4 billion in March from $47.0 billion in February, marginally revised from $47.1 billion. Exports of goods & services fell 0.9% (-5.4% y/y) as imports dropped 3.6% (-9.1% y/y).

The trade deficit in goods was $58.5 billion in March, following February’s $64.5 billion. Goods exports decreased 1.6% (-8.1% y/y). Four of the five major categories fell, with nonauto consumer goods exports down 9.3% (-4.1% y/y). Autos & parts were down 5.6% (-3.3% y/y), foods, feeds & beverages 3.7% (-15.0% y/y) and industrial materials & supplies 2.5% (-15.7% y/y). Capital goods exports rose 2.4% (-3.7% y/y) and “other” goods were up 15.0% (8.4% y/y).

Imports of goods were also down in March, by 4.3% (-11.2% y/y). Every major end-use category declined, with non-auto consumer goods down 9.9% (-13.8% y/y), food, feed & beverages down 5.9% (3.7% y/y) and capital goods down 3.2% (-9.1% y/y). Imports of industrial materials & supplies were off 2.9% in March (-22.8% y/y) and autos & parts 2.6% (-3.3% y/y). “Other” goods imports did increase, by 16.4% in the month (13.8% y/y).

The dollar value of energy-related imports rose in March by 11.2% (-38.1% y/y) after a sizable decrease in February. Quantity, measured in thousands of barrels, increased 9.4% (+4.9% y/y). The dollar value of crude petroleum imports rebounded 13.7%% (-36.2% y/y) as the per barrel cost of crude edged up to $27.68 (-40.4% y/y).

 large image large image

Pointing up New U.S. Rules Make Foreign Goods Better Deal for E-Shoppers A change in trade rules is making it cheaper and easier for American consumers to buy overseas goods online, heartening merchants abroad but threatening stiffer competition for U.S. retailers.

A change in trade rules is making it cheaper and easier for American consumers to buy overseas goods online, heartening merchants abroad but threatening stiffer competition for U.S. retailers.

Since about a month ago, the government has allowed Americans to import up to $800 at a time of most foreign goods without having to pay import duties or tax. That’s quadruple the previous exemption of $200. (…)

Until the new rules took effect March 10, duties averaged 33% on the top 50 products brought into the U.S. when purchases exceeded $200, according to United Parcel ServiceInc. On a $201 purchase of costume jewelry, U.S. customs would collect a duty of 110%, more than doubling the price.

Now, those duties are zero, providing the price totals less than $800. (…)

By 2020, however, about 943 million people world-wide are expected to buy online from abroad, spending an estimated $994 billion—nearly quadruple the sum 309 million such people spent in 2013, according to a study by Accenture and AliResearch, an arm of e-commerce company Alibaba. Already, 5 4% of U.S. online shoppers have made a purchase overseas, according to a survey by comScore and UPS, as consumers increasingly shop on their phones and look for unique products. (…)

SOMETHING HAS TO GIVE

Friday’s employment number could change things but as of this morning US and global growth look tepid and slowing.

This is from ISI’s Ed Hyman yesterday. He was dismayed by their important airlines and trucking surveys which have been falling abruptly in recent weeks. Also, the ADP report for April made him revise his April employment forecast to 175k from 200k. Later in the day, Markit’s Composite PMI was suggesting 160k jobs in April.

Corporate executives must be busy trying to maintain profits this year given the very weak revenue growth rates:

image

Subpar business sales have already triggered a pullback by planned capital spending. A more reserved approach to business outlays on staff may be forthcoming. (Moody’s)

image

Three weeks ago, NBF Economics and Strategy warned:

While hiring has yet to respond to slower economic growth and lower labour productivity, corporate profits already have. Profits are falling at the fastest pace in years and it’s a matter of time before corporations adjust headcount accordingly. As today’s Hot Charts show, human resources departments tend to react to corporate profits with a one to two quarter lag, which suggests a soft Q2 for employment creation.

image

Maybe, we are there now.

The ROW is not in better shape as the JP Morgan Global Manufacturing survey revealed yesterday:

The growth rate of the global manufacturing sector ground to a near-standstill at the start of the second quarter. At 50.1 in April, the J.P.Morgan Global Manufacturing PMI™ posted a reading barely above its no-change level of 50.0 and the second weakest during the past forty months.

Rates of expansion in output and new orders also decelerated back towards the broadly stagnant outcomes registered in February. Conditions remained muted in
many domestic markets, while international trade flows continued to deteriorate. The level of new export business fell for the third straight month and to the greatest extent since September of last year.

The performances of the main industry groups covered by the survey all remained lacklustre during April. Output growth slowed to marginal rates at both consumer and intermediate goods producers, while the investment goods sector stagnated.

Developed and emerging markets both exhibited a degree of weakness during the latest survey month. Developed nations (on average) saw their combined pace of output expansion slow to a three-year low. Production growth slipped to a 16-month low in the European Union, to a (Markit) survey low in the US and declined at the fastest pace in two years in Japan.

April saw output fall back into contraction territory in the emerging markets, the tenth time in the past 12 months that a decrease has been registered. China stagnated, growth slowed in India and Indonesia, while Brazil, Russia and Malaysia recorded substantial downturns in production.

In effect, we are in a synchronized lull in manufacturing:

In spite of all the QEs and other currency manipulations, world exports (i.e. demand) have stalled as this Gavekal slide illustrates.

image

(…) More than a dozen factory executives interviewed at the twice-yearly Canton Fair in Guangzhou all warned of difficult trading conditions, particularly in Europe. A few said they had seen a modest improvement in US demand this year but not enough to offset the weakness elsewhere.

With buyers coming from all over the world and thousands of manufacturers offering everything from buttons and zips to food products and electronics, the Canton Fair is a barometer of the state of global demand and of China’s important manufacturing industry. (…)

Exporters say they remain under pressure to cut prices and minimum order sizes to secure contracts. (…)

  • SLOW AND SLOWER

The top chart is USA, the lower chart is G7 ex-USA (RBC):

image

John Mauldin reminds us that ΔGDP = ΔWorking Age Population + ΔProductivity and that the trends are not our friends:

Of course, nowadays the working age does not stop at 65, but the trends are generally not much different, especially since older workers tend to work in services where pay and productivity is lower. In any event, when the labor force is not growing, it must become more productive to provide economic growth, which is no longer happening as RBC illustrates:

image

image

In all, the basic economic fundamentals are a strong and stronger headwind for global economies, explaining why central banks seem to be pushing on strings with all their QEs and negative rates experiments while fiscal policies remain neutral at best. Mix politics and social tensions with this and no wonder there is no traction anywhere.

(…) Since the economic recovery began in mid-2009, output per hour worked has expanded at an average annual rate of 1.3%. That was the worst performance over a seven-year stretch since the late-1970s to mid-1980s, which were marked by back-to-back recessions.

In the first quarter, the picture worsened: Productivity in the nonfarm business sector declined at a 1% seasonally adjusted annual rate, the Labor Department said Wednesday. From a year earlier, productivity was up just 0.6%. The quarterly drop marked the fourth decline in the past six quarters. (…)

firms struggling to produce goods and services efficiently are boosting headcount to compensate, though the added workers are having a limited impact on output. In the first three months of this year, workers toiled for longer hours—and for higher wages—but their output barely nudged up.

Unit labor costs, a key gauge of compensation costs, increased at a 4.1% annual rate in the first three months of the year from the prior quarter. That was the sharpest jump in more than a year. Labor costs climbed 2.3% from a year earlier, well above recent inflation reading.

Indeed, wage growth showed some progress. Hourly compensation increased at a 3.0% annual rate compared with the prior quarter. That comes after hourly compensation grew at a 0.9% annual rate in the fourth quarter, and could be a signal that a tightening job market may be putting pressure on employers to better pay packages. (…)

Nerd smile All this to say that we should all modify our mindset away from expectations for a return of rapid growth rates and understand that the economy is set to grow very slowly for many years. Investors will be walking on a tight rope, always worried to tilt towards recession and deflation. We should abandon the hope that our central bankers will bail us out, rather hoping that they will merely keep us straight. More than ever, investing will need to focus on risk management as the downfall would be much more painful than the upside reward.

Oil Rallies as Investors Shrug Off Rise in U.S. Stockpiles Crude and WTI prices bounced back, with investors focusing on tightening supply in Canada and Libya.

(…) Analysts at JBC Energy estimate that some 500,000 barrels a day of capacity is currently offline due to the wildfires. (…)

The authorities that control the eastern half of Libya moved this week to block oil exports, including from the Marsa El-Hariga terminal, which represents the bulk of Libya’s exports—more than 150,000 barrels a day. (…)

A U.S. government report on Wednesday showed another hefty increase in domestic crude-oil inventories. Last week, U.S. oil stockpiles rose by 2.8 million barrels, more than double the rise forecast by analysts in a survey by The Wall Street Journal. Gasoline stockpiles also rose unexpectedly, sending combined oil and fuel stockpiles to a record high of 1.37 billion barrels, according to the U.S. Energy Information Administration. (…)

Stanley Druckenmiller Cites Similarities to 2008 Crisis

(…) The Federal Reserve, he said, is to blame. By keeping interest rates so low, the Fed is “raising the odds of the economic tail risk they are trying to avoid.” It is an “ephemeral sugar high.”

Is The Emerging Markets Rally Built on Flimsy Foundations?

(…) From its January low, MSCI’s Emerging Markets stock index has risen 18.2%. So far this year, the Brazilian real is up 11.6%, the Russian ruble 10.7% and the South African rand 4.2% against the dollar. Local-currency bond returns have been turbocharged by those moves. (…)

Investors put around $63 billion to work in emerging markets in March and April, the Institute of International Finance estimates.

There are three big factors behind this shift. The first is the apparent stabilization of China, an outsize contributor to emerging-market growth and a clear influence on commodities prices that matter for many countries. The second is looser financial conditions sparked by the gradual approach by the U.S. Federal Reserve to raising rates and the resulting softer dollar.

And the third is that emerging-market pessimism had become so widespread that it only took a small turn in sentiment to push prices sharply higher. (…)

There is even hope that emerging-market growth may be turning up. Citigroup’s economic surprise index has moved into positive territory, although the bank’s economists note China has had a big influence on this swing. After five years of a narrowing gap between emerging-market and advanced-economy growth, the International Monetary Fund forecasts that growth in emerging nations will accelerate again in the coming years.

But it is too early to be really confident that the turn is sustainable: May’s market wobbles, which have dented returns, are testament to that. (…)

(…) Demographic analysis by Standard & Poor’s has found that ageing populations across emerging markets are forcing governments to increase access to healthcare while relying on a shrinking workforce to pay for social programmes, leading to a deterioration in public finances and a rise in government borrowing.

By 2050, S&P expects average debt in emerging markets to rise from 42 per cent of GDP to 136 per cent, compared with 134 per cent in advanced economies, unless policy changes are made.

The shift would result in a drop in the number of countries with “investment-grade” sovereign ratings, according to S&P, putting pressure on investors searching for the highest quality assets.

(…) emerging markets such as Brazil, India and Turkey are expected to sharply increase spending on healthcare in the next few years.

Increases in the ratio of old individuals to young workers are predicted to be felt more keenly in emerging markets than developed economies in the next few decades, with Brazil’s old-age dependency ratio forecast to triple by 2050, while those in the US and UK grow at a steadier pace.

In March, the International Monetary Fund announced that the consequences of shrinking and ageing populations would be large and growing fiscal burdens with age-related spending as a percentage of GDP would reach unmanageable levels unless steps were taken to deal with the issue. (…)

Chart: Old-age dependency

China fertiliser maker defaults on bond Cash-strapped local governments lose appetite for bailouts