FLOWS - Liqudity, Credit & Debt

Soft Patch 04-01-15 Richard Duncan

The US economy will expand by only 0.2% during the first quarter of 2015 according to GDPNow, an economic model published by the Federal Reserve Bank of Atlanta. The GDPNow model is revised after the release of every significant economic data point. At the end of January, it indicated that the economy would grow by 2.4% during the first quarter. Since then, however, the incoming economic data has been so consistently weak that the model now suggests the economy will barely grow at all. In other words, the United States has entered a new economic “soft patch”.

Job creation has been strong. In January 237,000 new jobs were created and, in February, 288,000 more. Almost all other incoming data has been disappointing. Average Hourly Earnings were only 1.5% higher in February 2015 vs. February 2014. Personal Spending fell by 0.2% in January and only managed to expand by 0.1% during February. Retail sales contracted by 0.8% in January and by a further 0.6% in February. Industrial production contracted by 0.3% in January and increased by only 0.1% in February. That sent Capacity Utilization down to 78.9% in February from 79.4% as it was initially reported for January. Durable Goods Orders rose 2% in January, but fell 1.4% in February; and fell during both months when excluding volatile transportation equipment.

Housing starts plunged 17% in February vs. January, leaving starts 3% lower than one year earlier. Exports were down 3.9% and imports were down 1.4% in January (the most recent data available) compared with one year earlier. Moreover, all of this weak first quarter data came on top of data for the fourth quarter that was not much better. US GDP expanded by just 2.2% during the fourth quarter of 2014. The Q4 GDP Deflator was only 0.1%. Had this been at the Fed’s inflation target of 2%, there would have been next to no real growth whatsoever.

There is no shortage of valid reasons that explain why the US economy is weakening again. The strong US dollar makes US produced goods less competitive in the global market. That accounts for the depressed industrial production. The collapse in oil prices has caused a falloff in new investment in the US energy sector. Globalization – and the relocation of factories to ultra low wage countries - continues to put downward pressure on US wages, deterring consumption.

Credit growth in the United States remains too weak to drive economic growth as it did in the past. The most recent data available shows total credit (adjusted for inflation, which was only 1.2%) increased by just 2.4% during the fourth quarter, whereas 5% to 6% credit growth would be required to return to the economic growth rates experienced during the decades leading up to the crisis of 2008. Economic weakness in the United States has put an end to US import growth, resulting in near recession conditions globally. And, as always, when the United States buys less from the rest of the world, the rest of the world buys less from the US. This and the strong dollar explain the slump in US exports.

And, last, but not least, QE 3 ended in October. Consequently, asset prices are no longer rising as quickly as before. During 2013, the Fed created $1 trillion through QE and the S&P 500 Index rose 30%. Last year, the Fed created $500 billion and the S&P rose 11%. This year, the Fed has not created any money through a QE program and the stock market is flat. The QE-induced Wealth Effect has been the main driver of US economic growth since this crisis began. Now that QE 3 has ended, much less “wealth” is being created and the economy is slowing again.

The sharp economic slowdown, in combination with the strong US dollar, is negatively impacting US corporate earnings, which not only fell during the full year in 2014 (for the first time since 2008), but which are also expected to contract further during both the first and second quarters of 2015. Equity valuations are already considerably stretched. Falling profits significantly increase the risk of a sharp stock market selloff.

Against such a weak economic backdrop, the Fed will find it very difficult to justify an interest rate hike this year. The currency markets have already priced in higher US interest rates. If the Fed fails to deliver, the dollar’s sharp appreciation during recent months may suddenly reverse. If economic conditions continue to deteriorate next quarter, speculation will begin to mount that QE 4 cannot be far away. That kind of reversal in expectations would cause violent upheavals across numerous asset classes.

So, keep an eye on the Atlanta Fed’s GDPNow model. If it continues to weaken, we may be in for a considerable amount of volatility – and excitement – during the weeks ahead.

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GEO-ECONOMICS - Echo Boom

JP Morgan Has A "Problem" With Emerging Markets 03-30-15 Zero Hedge

Over the weekend, we highlighted a new study by the Center for Global Development which identified the emerging markets that are most vulnerable to an “external shock” whether in the form of a Fed “liftoff” or a geopolitical shakeup such as a wholesale Russian invasion of Ukraine. With EM multiples, spreads, and currencies trading at a discount to their DM peers, some investors may be tempted to look for a relative value play in the face of increasingly overbought DM equities and fixed income.

Despite what look to be "cheap" valuations, JPM calls the EM contrarian approach “tactically challenging” thanks to leverage, a difficult environment for economic growth and Janet Yellen:

EM equities are trading at much lower multiples than DM ones, its external bonds still offer high yield spreads over DM equivalents, and most of its currencies are some 20-30% undervalued versus the dollar. We meet few managers who claim to be OW EM. But there is no free lunch in EM as its fundamentals look daunting. We have found contrarian, value based strategies tactically challenging and usually prefer to see the start of some improvement in fundamentals and price momentum before diving in…

What are the current challenges to EM? In a nutshell, increased leverage and foreign borrowing, structural weakening of growth, and the coming end of easy Fed money. Each of these is a problem, in our view. In combination, they could be a serious problem. There will surely be episodic rebounds and outperformance in EM assets, but until at least one, if not two of these threats turn around, we will find it hard to expect medium-term outperformance of the full EM asset class..

EM growth has decelerated markedly… 

To elaborate, EM growth has been slowing steadily and dramatically since the financial crisis, rebounding initially at 8% in 2010, but has likely fallen to below 4% this year. Productivity growth has come down globally, but more in EM than in DM, with EM labor productivity growth down to almost zero this past year, versus an average of 3-4% before the crisis...

...while both the public and private sectors have taken on more debt…

Unlike the delevering that has spread across DM households, government and banks in the aftermath of the financial crisis, emerging economies reacted by ratcheting up debt, with bank credit now some 25% higher relative to GDP than before the crisis…

...and the market fears the first casualty of a rate hike cycle may well be EMs...

The by now over 6 years of zero US interest rates are making investors wonder who will fall out when the Fed starts shaking the money tree and most have EM very high on this list,creating downside on the EM asset class as we approach the first rate hike...

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As a reminder, here's the breakdown of who's most at risk, and who's improved their position since the eve of the crisis:

GEO-ECONOMICS - Echo Boom

Here's Which Emerging Markets Are Most Vulnerable To "External Shock" 03-29-15 Zero Hedge

With a no longer “patient” Fed set for “liftoff” sometime this year, some observers (including IMF chief Christine Lagarde) are bracing for emerging market turbulence. A new paper from the Center for Global Development attempts to discern which EMs are most vulnerable to an “external shock” (be it geopolitical or financial) and also seeks to determine which countries are more prepared to weather a storm now than they were pre-crisis. 

According to the study, the relevant factors are

1) current account balance,

2) ratio of external debt to GDP,

3) ratio of short-term external debt to reserves,

4) fiscal balance to GDP,

5) government debt to GDP,

6) inflation versus targeted inflation, and

7) financial “fragility”. 

From the study:

The values of the indicator for 2007 and 2014 are presented as well as the country rankings in both years. According to this methodology, the greater the value of the indicator the more resilient a country’s macroeconomic performance to external shocks is assessed to be. 

And here’s The Economist, simplifying things a bit further: 

How resilient are emerging-market economies? Many are struggling, thanks to the economic impact of a strong dollar. But what would happen if things suddenly got a lot tougher? A new paper, from Liliana Rojas-Suarez of the Centre for Global Development, a think-tank, offers some interesting data.

Let’s imagine that something really bad happens. The Federal Reserve tightens its monetary policy too soon; some new global debt crisis begins; Russia launches a full-scale invasion of Ukraine. Ms Rojas-Suarez wants to understand which emerging-market economies are most vulnerable.

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