Edge and Odds

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)

Edge and Odds

Invest with smart knowledge and objective odds

NEW$ & VIEW$ (5 DECEMBER 2014)

  • November Nonfarm Payrolls: +321K vs. consensus +225K, +243K previous (revised from 214K).
  • Unemployment rate: 5.8% vs. 5.8% consensus, 5.8% previous.
ECB Holds Fire on New Action The European Central Bank opened the door to a dramatic escalation in its campaign to stimulate the eurozone’s stagnant economy, but deferred any moves until early 2015.

[image]ECB President Mario Draghi said Thursday that officials discussed purchases of government bonds, otherwise known as quantitative easing, a move that would mark a new chapter in the bank’s fight against excessively weak inflation. But he added they needed more time to gauge the effects of policies that they had already implemented while assessing how falling oil prices might affect the region’s already weak consumer prices.

“We discussed the possibility of doing QE” with buying government bonds “as one option,” Mr. Draghi said after the ECB left its key interest rates unchanged at record lows at the bank’s monthly meeting. The ECB will reassess its policies early next year and decide whether it needs to do more, Mr. Draghi said, raising expectations that the ECB could act as soon as its next policy meeting on Jan. 22, although he didn’t commit to a time frame. Confused smile

“Early means early. It doesn’t mean at the next meeting,” Mr. Draghi said.

Financial markets reacted negatively despite Mr. Draghi’s suggestion that bolder action could come soon, as investors had hoped for a more ironclad commitment to begin large-scale bond purchases, a policy that has been used extensively by central banks in the U.S., the U.K. and Japan. European and U.S. stocks fell Thursday, and the euro rose on Mr. Draghi’s comments.

Draghi did not say “soon”, he said early, like “early as a teenager on Saturdays”…But on Nov.20, he did say “without delay” and “as fast as possible”. It now appears that may not be possible soon. Anyway, we now know that “early means early”. 

But markets don’t seem to care what early or without delay or as fast as possible mean:

“They’re almost there but not quite over the line,” said Ken Wattret, economist at BNP Paribas. “The pieces of the jigsaw are falling into place.”

Blind trust in the saviour who says a lot more than he does.

The ECB opted against immediate action despite an annual inflation rate of 0.3% in the eurozone in November, far below the central bank’s target of just under 2%. The ECB lowered its 2015 forecast for consumer-price growth to 0.7% from 1.1% and in 2016 from 1.4% to 1.3%. The inflation forecasts didn’t fully incorporate the most recent drop in oil prices, which could push inflation even lower. (…)

BTW, there are new pieces to the jigsaw:

Mr. Draghi’s remarks contained a number of hints that more central-bank stimulus may be coming to Europe soon. He said the ECB would be “particularly vigilant” about the effect the sharp reduction in oil prices could have on consumer prices and expectations for future inflation, using a phrase that his predecessor, Jean-Claude Trichet, often deployed to signal imminent ECB action. (…)

Surprised smile Mr. Draghi suggested that the ECB would move even in the face of German opposition if the ECB’s inflation target was at risk. “We don’t need unanimity” to launch quantitative easing, he said, adding that he was confident a program could be designed to achieve a consensus within the ECB, if needed. The ECB could also purchase other private-sector assets, he said, saying officials have discussed all types of assets except gold. (…)

It’s one thing not having unanimity, it’s quite another thing to go against Germany. Ambrose Evans Pritchard seems to agree:

ECB paralyzed by split as irreversible deflation trap draws closer ‘It is now patently clear that Draghi lacks the crucial German support for launching full-blown QE’

(…) Crucially, he revealed that the EBC’s six-strong Executive Board is divided on the bank’s vague pledge to boost the balance sheet back “towards” the levels of early 2012, an implicit €1 trillion commitment. (…)

Mr Draghi’s failure to secure the full assent of his own board is a major headache. The mood is entirely different from events in 2012, when he launched his “do-what-it-takes” plan (OMT) to act as a lender of last resort for Italy and Spain. That plan had the full backing of the (then) German board member and the support of Chancellor Angela Merkel, who preferred ECB action to another traumatic bail-out vote for Club Med debtors in the Bundestag. This time Mr Draghi faces stiff resistance from across the German establishment.

While the ECB Council operates on a basis of one-man, one-vote, there would be a political storm if full-scale QE was forced through by an Italian ECB president at the head of a “Latin bloc” of debtor states against explicit German objections. Such action would be a recruiting trumpet for Germany’s AFD anti-euro party and would endanger German popular consent for monetary union. The scale of such action might also infringe on the Bundestag’s budgetary sovereignty, and violate Germany’s Basic Law.

Mr Draghi is understandably loathe to take such a hazardous step, forced to bide his time in the hope that Berlin will gradually yield as deflationary forces threaten Germany itself.

Pointing up This may happen. Data collected by Marchel Alexandrovich, at Jefferies Fixed Income, show that the number of goods in Germany’s price basket in outright deflation jumped from 22.9pc in September to 31.2pc in October.

The ratio is 36.7pc in Italy, 40.9pc in Spain, 41.7pc in Holland, 43.6pc in Portugal, 54.1pc in Slovenia and 85pc in Greece. Japan’s experience in the 1990s showed that the process is very difficult to reverse once the deflationary effects reach 60pc. (…)

The implication is that Euroland risks falling into an almost irreversible trap if the ECB fails to take pre-emptive action immediately.

Euro-Area Growth Held Back by Investment Drop in Third Quarter Euro-area investment fell for a second quarter, holding back growth and underlining the weakness in the economy that prompted the European Central Bank to cut its forecasts.

Investment declined 0.3 percent in the three months through September after a revised 1.2 percent decline in the previous quarter, Eurostat, the European Union’s statistics office in Luxembourg, said today. Gross domestic product increased 0.2 percent, matching an initial estimate published last month.

Bundesbank cuts German growth forecast Central bank predicts economy will expand 1% next year

(…) Germany’s central bank now says the country’s economy will expand 1.4 per cent this year, 1 per cent in 2015 and 1.6 per cent in 2016. In June, it had expected growth of 1.9 per cent this year, 2 per cent next year and 1.8 per cent in 2016. (…)

The Bundesbank cut its price projections to 0.9 per cent this year, 1.1 per cent in 2015 and to 1.8 per cent in 2016. It said, however, the rate of inflation excluding energy was likely to increase to 2 per cent in the year after next as wages rose. In June, inflation forecasts stood at 1.1 per cent for this year, rising to 1.5 per cent in 2015 and 1.9 per cent in 2016.

Corporate Credit Disputes the Equity Market on Risk

Lately, corporate credit has become more risk averse, while the common equity market has become more tolerant of risk. Compared to its 376 bp average of 2014’s third quarter, the high yield bond spread widened to a recent 380 bp. It was in June 2013 that the month-long average of the high yield bond spread was greater than 480 bp. Coincidentally, at the start of the previous two extended series of Fed rate hikes, the high yield bond spread was less than 400 bp.

Similar to the broadening of the high yield spread, the long-term Baa industrial company bond yield spread has widened from a Q3-2014 average of 152 bp to a recent 186 bp. Also, the month-long average of the Baa industrial spread last surpassed 186 bp in June 2013.

At exactly the same time that corporate bondholders are demanding higher yields as compensation for a perceived increase in risk, equity investors are accepting less in terms of core profits when purchasing common stock. For example, the year-long ratio of profits from current production to the market value of US common stock dipped from a Q3-2014 average of 10.1% to a recent 9.8%. It was in 1997’s third quarter that this measure of equity-market risk aversion last fell in a similar manner.

For a sample commencing with 1987’s final quarter, the yearly changes of the high yield bond spread and core profits as a percent of the market value of common stock generally conformed to expectations — that is the credit and equity markets both turn more, or less, risk averse — 61% of the time.

Often when they disagree or move in different directions, the high yield bond market ultimately proves more prescient than the equity market. The late 1990s offers a prime example of when the credit and equity markets disagree on risk, the credit market often ends up winning the dispute. Notwithstanding a widening by the high yield bond spread from Q4-1997’s 337 bp to Q1-2000’s 522 bp, core profits still sank from 9.5% to 6.0% of the market value of US common stock. What is especially noteworthy about this unmatched overvaluation of common equity is how the span’s 49% cumulative increase by the market value of common stock not only defied the accompanying -5% drop by core profits, it also seemed oblivious to a rise by the US high yield default rate from 2.4% to 5.9%.

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In addition, an incredibly excessive overvaluation of equities can be inferred from how the market value of US common stock soared higher by a cumulative 99% from December 1996 to March 2000 despite an accompanying ascent by the US average high yield expected default frequency metric (EDF) from 3.6% to 8.6%. The aggregate high yield EDF metric functions as a helpful indicator of where the default rate is likely to be one year out. The latest high yield EDF metric of 2.7% is consistent with an outlook for defaults that should not be disruptive to financial markets.

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The EDF/NAI model — employing the US average high yield EDF metric, the three-month change in the average high yield EDF, and the latest moving 12-month average of the Chicago Federal Reserve Bank’s national activity index (NAI) — does a remarkably good job of explaining the high yield bond spread. This approach shows that the recent high yield bond spread of 480 bp is close to its predicted value of 460 bp.

Thus, the EDF/NAI model suggests that the market has not been unduly harsh in its pricing of high yield bonds. If anything, the market may be too generous in its pricing of common equity.

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NEW$ & VIEW$ (4 DECEMBER 2014)

The best account of what really happened:

Saudi Arabia Sees Oil Stabilizing

OPEC’s biggest oil producer, Saudi Arabia, now believes oil prices could stabilize at around $60 a barrel, a level both it and other Gulf producers believe they could withstand, according to people familiar with the situation.

The shift in Saudi thinking suggests the de facto leader of the Organization of the Petroleum Exporting Countries won’t push for supply cuts in the near-term, even if oil prices fall further. Brent crude dropped 62 cents a barrel to $69.92 on Wednesday. (…)

Before last week’s OPEC meeting in Vienna, the Saudis had been considering a Venezuelan proposal to cut the producer group’s oil output sharply. The possible deal finally fell apart when Russia, a major oil producer that isn’t a member of OPEC, refused to participate in a general supply cut, according to people familiar with the situation.

That gave Saudi Arabia and its Gulf allies cover to push an unpopular strategy at OPEC’s main meeting last Thursday of not changing the cartel’s production target, in an attempt to defend market share rather than prices. That view prevailed, leading Brent crude to fall 10% in the past week. (…)

During an early November meeting on the Venezuelan resort island of Margarita, Saudi Arabia’s oil minister, Ali al-Naimi, had told Venezuela’s foreign minister and OPEC representative, Rafael Ramirez, he would support a cut only if the Venezuelan minister could convince others both inside and outside of the cartel to participate, according to people familiar with the situation.

It was a “mission impossible,” said one OPEC delegate. Struggling OPEC members like Iran, Libya and Iraq argue they should be exempted from any move to cut output. Historically, persuading non-OPEC members to join the group in reducing supply has met with limited success.

However, just 48 hours before OPEC’s semiannual meeting last Thursday, Mr. Ramirez gathered senior energy officials from Saudi Arabia, Russia and Mexico—another non-OPEC member—in Vienna’s Hyatt hotel.

On the table was a proposal to take two million barrels a day of oil supply out of the global market of more than 90 million barrels a day, according to people familiar with the situation. The bulk of the cut was to be shouldered by OPEC, but Russia and Mexico combined were expected to contribute a reduction of 500,000 barrels a day, the people said.

The meeting ended without any deal to cut supply, Mr. Ramirez told reporters immediately afterward. Within hours, Russian state oil company OAO Rosneft said it wouldn’t cut its oil output.

Mr. al-Naimi finally decided it would be better to endure short-term pain from low oil prices than risk losing market share in the long run, according to people familiar with the situation. (…)

Mr. al-Naimi told the ministers that enduring lower prices would force high-cost oil producers outside of OPEC, like U.S. shale-oil companies, to cut back production themselves, tightening the market by the second half of 2015, the people added.

The rest of OPEC gave in to Saudi pressure and the cartel reluctantly agreed to maintain its oil production at 30 million barrels a day. On Tuesday this week, the kingdom’s cabinet said OPEC’s decision reflected the group’s “cohesion and unity.”

There Are 300,000 Iraqi Barrels Signaling Oil Glut Will Deepen

Not only is OPEC refraining from cutting oil output to stem the five-month plunge in prices, it’s adding to the supply glut.

Just five days after the Organization of Petroleum Exporting Countries decided to maintain production levels, Iraq, the group’s second-biggest member, inked an export deal with the Kurds that may add about 300,000 barrels a day to world supplies. (…)

The deal allows for as much as 550,000 barrels a day of crude to be shipped by pipeline from northern Iraq to the Mediterranean port of Ceyhan in Turkey, according to the regional government. The Kurds were already exporting about 220,000 barrels daily, according to data compiled by Bloomberg. (…)

Flow of Opec petrodollars set to dry up Collapse in oil price could suck $316bn from global investment

Big oil producers have pumped the windfall they enjoyed from soaring oil prices over the last decade into a huge range of global assets, from US Treasuries and high-grade corporate bonds to equities and real estate. (…)

The flow of petrodollars into the global financial system boosted liquidity, spurred asset prices and helped to keep borrowing costs down. (…)

George Abed, director for Africa and the Middle East at the Institute of International Finance, said at their peak in 2012, Opec petrodollar flows into liquid investments such as US Treasuries, high-grade corporate bonds and equities stood at $500bn. Next year, they could drop below $100bn if prices average $78 a barrel, he said. (…)

Less global liquidity just when the Fed is retrenching…

Dollar’s Rise Causes Pain Abroad A surging dollar and falling commodities prices are confounding central bankers by widening the gap between the U.S. economy and struggling nations in Europe and Asia.

(…) The dollar’s gains are intensifying declines in commodities including food, metals and especially oil, which is down nearly 40% since mid-June. Sluggish growth in Europe and Asia is undermining demand for these goods, leaving markets flooded with extra supply. Most commodities are priced in dollars, so consumers and companies outside the U.S. see their buying power shrink when their currencies weaken.

These trends present new challenges for policy makers in Europe and Japan as they struggle to preserve meager recoveries and fight low inflation. Central banks are considering—or have already introduced—drastic measures, such as negative interest rates and buying billions of dollars in bonds. But the precipitous fall in the price of oil—the most-expensive import for many countries—is reducing the effectiveness of measures aimed at raising consumer prices. (…)

The Bloomberg Commodity Index, which tracks 22 markets, has fallen 11% this year in dollar terms to a five-year low. The same index is down 0.3% in 2014 when converted into euros and has gained 1.5% this year in yen.

That means prices at the pump have dropped 16% in the U.S. from a year ago, according to AAA. But gasoline is down only 6.8% in euro terms for German drivers, according to European Commission data. Travel firms fear a stronger dollar will force customers outside the U.S. to dial back vacation plans. (…)

Fed Beige Book Shows ‘Widespread’ Job Gains Across U.S.
More Cost of Health Care Shifts to Consumers

Americans increasingly have to dig into their own pockets to pay for medical care, a shift that is helping to curb the growth in health spending by employers and the government.

The trend is being accelerated by the Affordable Care Act because many private plans sold by the law’s health exchanges come with hefty out-of-pocket costs, which prompt some people to delay or put off seeking care.

For the exchanges’ 2015 policies, which went on sale last month, “bronze-level” plans have an average deductible of $5,181 for individuals, up from $5,081 in 2014, according to a November report from HealthPocket, which publishes health insurance market analyses. Bronze plans generally cover 60% of consumers’ medical expenses.

While surveys show steeper out-of-pocket costs lead some people to defer even routine medical care, economists say the trend brings an important upside: It is helping fuel a period of historically low growth in health-care spending, which eases the federal deficit.

The federal government said Wednesday that 2013 was the fifth consecutive year in which health spending grew at less than 4%. The 3.6% rate is the lowest since the government began tracking such spending in the 1960s. While economists initially credited the recession for the soft spending growth, the trend continued even as the economy improved.

A study published last year in the journal Health Affairs examined data covering more than 10 million workers at large employers where out-of-pocket costs increased. The study found that the employers’ health spending growth fell over the four years studied, and it attributed about one-fifth of that slowdown to steeper out-of-pocket costs. (…)

Doctors such as David Holte, an orthopedic spine surgeon in Waconia, Minn., say they are seeing a change in peoples’ behavior as out-of-pocket costs rise.

“Patients are shopping around more,” said Dr. Holte of Twin Cities Orthopedics. “Back when everything was covered, they would get tests done and also get stuff done they didn’t need. Now they’re having cost discussions and putting off knee and hip replacements.”

One in three Americans said they or a family member delayed medical care because of costs in 2014, according to a report last month by survey company Gallup. That is the highest percentage since Gallup began asking the question in 2001.

The 2010 health law is likely to continue the shift. To keep premiums low, insurers designed the plans to include steep out-of-pocket charges. Silver plans, which are the most popular plans purchased on exchanges and cover 70% of medical expenses, have an average deductible of $2,927 for individuals and $6,010 for families for 2015, according to HealthPocket.

Since 2009, the average deductible for workers who get employer health coverage has shot up 47% to $1,217 from $826, according to a September survey by the Kaiser Family Foundation and the Health Research & Educational Trust, a nonprofit affiliated with the American Hospital Association. (…)

Another reason why profit margins rose, and middle America got squeezed.

Baby Bust Threatens Growth The U.S. economy, already struggling with stagnant wages and lackluster spending, faces another obstacle to growth: fewer births.