At 17-years-old, Donald Trump was named a captain for his senior year at a military boarding school. Spending five years at New York Military Academy, the school taught Trump to channel his aggression into achievement.
Under the Trump budget, almost every budget increase goes to military departments, 10% increase Y/Y in the budget for military spending. It’s not a rocket science to figure out Trump madly loves force.
Even Trump’s Secretary of Defense loves force. Mad Dog James Mattis once said, “It’s fun to shoot some people. I’ll be right up there with you. I like brawling.”
At his confirmation hearing in January, Mattis said, “My belief is that we have to stay focused on the military that is so lethal that on the battlefield, it is the enemy’s longest day and worst day when they run into that force.”
Then there came 59 Tomahawk missiles to military bases in Syria and “Mother of All Bombs” on Daesh tunnels in Afghanistan. All of those came during the heightened tensions with North Korea.
War is Good for the Cold-Hearted Stock Market
North Korea acting out is a good thing for America. War throughout the history has made us united. Not to mention that the stock market goes up.
As you can see in figure 2, the stock market barely reacted to the recent U.S. military actions that Trump gave a green light to.
As a trader and investor, I wouldn’t be concerned about the potential war with North Korea. (Although I would be concerned about the loss of human lives and loss of limbs.)
In early 2013, there were increased tensions with North Korea, similar to today. At the time, the stock market did not give a damn about the threats from DPRK.
Not only does the stock market not care about North Korea, but also for any other war in the past century. War is good for the cold-hearted stock market.
Over the past 4 decades, Dow Industrials on average was turned on by U.S.-led military operations, returning 4% in a month after the beginning of military operations and more afterward.
Recent Three Wars
When the U.S., with support from allies, started bombing against Taliban forces in Afghanistan on October 7, 2001, the stock market went up, not down. Even after 12 days later when the first wave of conventional ground forces arrived, the stock market kept going up. By the year-end when Taliban collapsed, S&P 500 was up about 14.5%.
When the U.S. began the major combat operations in Iraq on March 20, 2003, the stock market skyrocketed as shown in the candlestick bar on the highlighted portion of S&P 500 Weekly chart in figure 6 below. By the time the operations ended on May 1, the stock market was up about 11.5%.
The only difference this time is we got leaders who very much loves forces and are violent themselves. Another difference is that North Korea is little powerful today than they were in 2013. But they are very weak compared to China, Russia, Europe, and U.S. It’s better to act now before North Korea gets even stronger. Although lives and limbs will be lost, I think there’s a greater cost if we allow North Korea to get even stronger.
China and North Korea
With China possibly increasingly going against North Korea, Kim Jong-un might act even more violent. I don’t think China really wants to break off its relationship DPKR due to the geographic proximity and China’s willingness to make more friends in the region. Besides being a military and diplomatic ally, China is also an economic ally. In 2015, the second largest economy accounted for 83%, or $2.34 billion, of the North Korea’s exports.
In late February, China sanctioned coal shipments from North Korea, who is a significant supplier of coal. Instead, China has been ordering the coal from the U.S. In the past, Trump said he wants to help the country’s struggling coal sector.
As Reuters reported, Thomson Reuters Eikon data shows “no U.S. coking coal was exported to China between late 2014 and 2016, but shipments soared to over 400,000 tonnes by late February.”
Is China having a change of heart on its relationship with North Korea? I don’t think as China’s trade with North Korea still increased by almost 40% in the first quarter of this year. China also buys other stuff, such as minerals and seafood. Looks like China wants to be on the good side of North Korea and Trump. The Art of the Deal.
Is this time is also different when it comes to the stock market? I don’t believe so. I’m not worried about the negative impact on the stock market due to North Korea, even though they were to be invaded.
However, I’m watching very cautiously China and Russia getting into an armed conflict with the U.S because of the North Korea situation. Armed conflict between the superpowers is a game changer. Although that’s very unlikely as superpowers argue all the time.
Suggestion For Your Portfolio
The situations might affect the markets for a very short period of time, especially if there’s uncertainty. But investors shouldn’t worry about it. The market could care less about a war, specifically when it’s aboard.
During the times of war, don’t reduce your holdings because of misconception war is bad. If you do, you will miss the gains.
On June 23rd, Britain people will vote to stay in or leave (Brexit) the European Union. The verdict matters a lot since it is a life-changing decision. I will briefly address some of the pros and cons of Brexit, but will further address it after the vote, especially if UK leaves EU.
The European Union costs United Kingdom 350 million pounds ($503 million) a week. That’s $26.2 billion a year, 4.6 times less the UK education budget of $121.1 billion in 2015. That $26.2 billion is 1% of 2015 GDP of $2.63 trillion. That $26.2 billion is 2.45% of 2015 total spending of $1.07 trillion.
Note: That 350 million pounds a week cost is before “the rebate.” In 2015, Britain actually paid under 250 million ($359 million) pounds a week. But hey, UK does not control the rebates. The cost of membership has been increasing over the years, especially after the financial crisis.
What happened with Greece and is still happening, is a warning sign of more economic troubles to come in Europe. That possibly will continue to increase the cost of EU membership.
Under EU fundamental right of free movement, Britain cannot prevent anyone from another member state coming in to the country. This has resulted in a huge increase in immigration into Britain from Europe.
In 2015, 270,000 EU citizens immigrated to the UK and 85,000 EU citizens emigrated aboard. Net-migration was 185,000.
2.94 million people living in the UK in 2014 were citizens of another EU member country. Those people account for 4.7% of the UK population.
2.2 million citizens of another EU member country are in work, 7.02% of working population. Majority of EU member citizens are coming to the UK for work reasons. 61% of the migration who came for work reasons were EU citizens.
See how EU citizens coming to the UK for work reason started to accelerate in 2013. This can be related to economic difficulties such as Greece, Spain, Portugal and Italy. As I mentioned above, “What happened with Greece and is still happening, is a warning sign of more economic troubles to come in Europe.” That should lead to even more upsurge in migration for work reason, making it more competitive for UK citizens to find jobs and possibly lowering wages.
If UK decides to leave EU, the country would be able to reform immigration laws without input from the EU and increase jobs and wages for UK citizens (hopefully they have the skills).
EU membership makes UK attractive for international investment and provides access to trade deals with more than 50 countries around the world (expensivemakeup, isn’t it?). Because EU institutions have the ability to prevent the UK from negotiating its own trade deals outside Europe, it would have to re-negotiate some trade deals, with EU and non-EU countries including the US, China, Japan and India. It is extremely possible the Brexit will impair confidence and investment for few years.
In 2015, the EU accounted for (pdf download) 43.7% of exports and 53.1% of imports
In 2014, the EU accounted for 496 billion pounds ($712 billion) of the stock of inward Foreign Direct Investment (FDI), 48% of the total. Globally, the UK is the third largest country in terms of its absolute value of inward FDI stock ($1.7 trillion), followed by China ($2.7 trillion) and U.S. ($5.4 trillion).
Why is FDI so important? It has the potential for job creation and productivity, increasing both output and wages.
If UK were to leave EU, it would dampen FDI due to uncertainty of the future. Firms would reduce investment in UK, leading to lay offs and so on (domino effect).
3.3 million UK jobs are linked to UK exports to other EU countries. Auto industry would be particularly at risk. In 2015, 77.3% of cars built in the UK were exported, a record high. EU demand grew 11.3%, with 57.5% of exports destined for the continent. In 2014, the motor vehicle manufacturing accounted for 7.9% (pdf download) of total manufacturing, up from 5.4% in 2007. The end of free trade agreements would definitely hurt UK automotive industry.
If UK were to leave the Single Market (EU), locating production in the UK would be less attractive because it would become more costly to ship to EU members. 77% of members of SMMT (Society of Motor Manufacturers and Traders) – the voice of the UK motor industry – believes remaining in EU would be the best for their business. 9% believes Brexit is the best path. 14% doesn’t know, like economists don’t know the real impact of Brexit due to a large base of issues and views.
66% believes EU important to them because of its access to EU automotive markets.
Brexit would send a ripple effect. For the government (less tax revenue), for businesses (rising costs) and for consumers (lower income).
There’s also the issue of UK citizens in the other EU member countries. They have the right to live, work, vote, run a business, buy a property, and use public services such as health. Some, if not all, of these rights could vanish if UK leaves the EU.
Sure, UK will try to protect them. Since one of the main goals of Brexit is stop the inflows of immigrants into UK from EU, EU might retaliate against it.
UK (the wife) has been married to EU (the husband) for 43 years (UK joined EU in 1973). Part of her wants to get out of the cage. Other part of her wants to keep some of the benefits. If Brexit, it will be very expensive and messy divorce, but may be for the good.
There are so many views on this “monumental” and “out-of-focus” complicated issue. Not every issue is covered in this article. If UK is the first country to leave EU, I will do much more research and analyze it.
If you have any views, I would love to know in the comments below. If you have any questions about any issues related to Brexit, I would be happy to answer them ASAP. Don’t be surprised if the answer is 5 paragraphs long. Thank you.
One huge risk that I will not address here, but will address in a future article is “lack of liquidity”. While I was doing research, I came across more information that I expected. I’m still getting more information and I believe it will be a great article. I will give a sneak peek of the article in the bottom of this article.
Earlier last month (December 10, 2015), Third Avenue’s Focused Credit Fund (FCF), a large mutual fund specializing in risky, high-yielding bonds, announced it would block investor redemptions, “no further subscriptions or redemptions will be accepted.” In mid-2014, they had $3.5 billion assets under management (AUM). As of December 31, 2015, they only had AUM of $660.67 million, as investors rushed to get their money back because of weakness in the junk bond market.
Now, investors’ money are being held hostage. “The remaining assets have been placed in a liquidating trust”, said David Barse, CEO of the firm, as the investor requests for redemptions and the “general reduction of liquidity in the fixed income markets” made it impossible for the fund to “create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”
The process is a pain in the ass, “Third Avenue anticipates that the full liquidation process may take up to a year or more.” Again, investors’ money are being held hostage.
This events highlights the danger of “over-investments” into risky areas, high levels of corporate debt, AND the lack of liquidity (will be addressed in a future article). With interest rates hovering around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt.
Investors who poses a higher risk appétit can find junk bonds, yielding higher interest rates, to be “useful” for their style and capacity of investment. More rewards for more risks, right?
As the global economy continues to struggle, namely China and emerging markets, yield on junk bonds have been increasing since they are a higher chance of defaulting.
Rising interest rates adversely impact bond prices, pushing their yield of the bond higher (inverse relationship). While increase in rates does not largely affect junk bonds since they have a higher coupon (yield) and shorter maturities (shorter maturity means less price sensitivity to rates), current junk bond market combined the impacts of a stronger dollar and low commodity prices can be extremely adverse and dangerous.
High-yield debt yields, as represented by Bank of America Merrill Lynch U.S. High Yield Master II Effective Yield, have been increasing since mid of last year. It rose from 5.16% (June 23, 2014) to current 9.23%. That’s whopping 78.88% increase, representing the growing risks of junk bond market.
According to Lipper, investors pulled out a total $13.88 billion from high-yield funds in 2015, with $6.29 billion in December alone. As redemptions increase, funds may suffer as high-yields are harder to trade due to its lack of liquidity (will talk more about the major risk of illiquidity in a future article) and funds may have to take an action like the Third Avenue did.
Credit spreads (difference in yield between two bonds of similar maturity but different credit quality) are widening, which possibly signals a wider economic trouble ahead. Widening credit spreads mark growing concerns about the ability of borrowers to service their debt. Not only borrowers will suffer, but also lenders since they lost money.
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread, representing the credit spread of the high yield bond market as a whole, have been increasing the middle of 2014. It’s currently at 775 (7.75%) basis points (bps).
BofA Merrill Lynch US High Yield CCC or Below Option-Adjusted Spread is currently 1,804bps wide (18.04), a level of highly distressed territory. Credits are defined as distressed when they are trading more than 1,000bps (10%) wide.
I believe it will continue to increase this year, reflecting the worsening of the credit conditions that would cause greater concern among investors and policymakers (Hi, Ms. Yellen. Time to reverse the policy?)
iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG), an index composed of U.S. dollar-denominated, high yield corporate bonds, is already down 1.39% year-to-date (YTD) and was down 10.58% in 2015, expressing the increasing uncertainty by the investors, as they pull back their money from high-yielding bonds/ETFs. The exposure of the index to CCC rated bonds, B rated bonds, and BB rated bonds, are 8.88%, 38.73%, and 50.25%, respectively. Stronger U.S. dollar and lower commodity prices are expected (and it will) to hurt the earnings of U.S. companies, increasing the chances of defaults, especially in energy.
The index’s energy exposure is 9.38%. Recently oil prices plunged to levels under $30. Energy companies borrowed a lot of debt during oil price boom, to increase production (so that they can gain more market share), are now being haunted by their own actions. A lot of energy companies are currently under an extreme pressure to make a dime, as oil prices plunge. According to law firm Haynes and Boone, 42 North American oil and gas producers filed for bankruptcy last year. Those 42 defaults account for approximately $17 billion in cumulative secured (over $9 billion) and unsecured debt (almost $8 billion).
Out of those 42 bankruptcy filings, 18 of them come from Texas, a leading state in energy production. According to U.S. Energy Information Administration (EIA), Texas had a capacity of over 5.1 million barrels of crude oil per day and accounted for 29% of total U.S. refining capacity, as of January 2015, and accounted for about 29% of U.S. gas production in 2014.
In 2014, Texas gross domestic product (GDP) increased 5.2% year-over-year (Y/Y), the second greatest change in state GDP after North Dakota. Mining industry accounted for 1.25% increase to GDP, its largest contributor. Texas’s GDP accounted for 9.5% of U.S. total GDP in 2014.
The collapse of energy prices over the past several years are “fracking” down the Texas economy. The Dallas Federal Reserve’s general business activity index “collapsed” to -34.6 in January, the lowest reading since April 2009, when Texas was in recession. Same with company outlook index, it fell to -19.5 in January from -10.5 in December.
The production index – a key measure of state manufacturing conditions – fell all the way from 12.7 in December to -10.2 in January. New orders index fell -9.2 in January from -7 in December.
Employment Index, on the other hand, sharply dropped to -4.2 in January from 10.9 in December. Texas is a home to many energy giants, such as Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI), Exxon Mobil (NYSE:XOM), and ConocoPhillips (NYSE:COP). The companies slashed off tens of thousands of jobs over the past year and cut capex significantly, as the current stressed energy market heavily weighted on them.
In January 21, Schlumberger reported 38.7% decrease in fourth quarter revenue Y/Y, and net income declined substantially to a loss of $989 million, compared with profit of $317 million in the same period of 2014. Texas-based energy giant’s North American region 4th quarter revenue fell 54.79% to $1.9 billion from $4.3 billion in the same quarter of 2014. The company’s earnings announcement warned of a “deepening financial crisis in the E&P industry, and prompted customers to make further cuts to already significantly lower E&P investment levels. Customer budgets were also exhausted early in the quarter, leading to unscheduled and abrupt activity cancellations.” As a result of a weaker quarter and worsening conditions, they plan to lay off 10,000 workers, adding to already laid-off 34,000 workers, or 26% of its original workforce, since November 2014.
On Monday (January 25, 2016), Halliburton reported its fourth quarter earnings. Halliburton’s 4th quarter revenue fell 42% in Y/Y to $5.08 billion, including a 54.4% plunge to $2.1 billion in its North American region, which accounted for 42.4% of total revenue in 4Q. On a GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $28 million ($0.03 per share) compared with net income of $9.01 million ($1.06 per share) in the fourth quarter of 2014.
On Thursday (January 28, 2016), Baker Hughes reported a 48.85% decrease in fourth quarter revenue to $3.4 billion from $6.6 billion in the same period of 2014. On GAAP basis, the Texas-based energy giant (and another one) reported a quarterly net loss of $1 billion ($2.35 per share) compared with net income of $663 million ($1.52 per share) in the fourth quarter of 2014. Its North American region revenue fell 65.59% to $1.14 billion in the fourth quarter, compared with $3.30 billion in the fourth quarter of 2014.
Chevron Corp., (NYSE: CVX), California-based energy giant, posted its first loss since the third quarter of 2002 on Friday (January 29, 2016). It reported a fourth quarter loss of $588 million ($0.31 per share), compared with $3.5 billion ($1.85 per share) in the same period of 2014. During the same period, its revenue fell 36.5% to $29.25 billion from $46.09 billion.
Below is a graph by EIA, showing how the cost of debt service for U.S. oil producers has grown since 2012. In the second quarter of 2015, more than 80% of these producers’ cash flow went to service their outstanding debt, leaving very little cash to fund operations, to pay dividends, and to invest for the future. To adjust to those pains, the producers have significantly reduced capital expenditures.
During the end of Q2 2015, oil prices were around $58. It’s currently at $38. Clearly, the situation has only gotten worse.
Both Exxon Mobil and ConocoPhillips will report its fourth quarter earnings next week.
I believe oil prices have hit bottom and it won’t break $27 this year.
I BELIEVE THE OIL HAS HIT BOTTOM. I'M GOING LONG!!!$CL_F
I believe the market already priced in Iran’s entry into oil war. Recently, hedge fund bearish bets on oil were at all-time high (crowded trade). Crowed trade includes: a large numbers of participants who share similar beliefs and heavy short-term bag holders (speculators). I tend to take advantage of this types of situations.
Not only bearish bets on oil are at all-time high and not only I believe Iran is already priced in, but some OPEC countries, including Nigeria and Venezuela, already started calling for emergency meetings to try to cut production. I’m starting to believe that they can no longer handle the pain. While this is a political game – to gain and preserve more market share – it won’t last long enough to get oil breaking below $27. They can no longer bluff.
For many OPEC members, operating costs are around $30. With slowing global growth, they can’t afford to have even lower oil prices.
Conclusion: Oil has hit bottom and it won’t break below $27 this year. If you disagree with me, feel free to comment below.
Speaking of junk bonds, the energy sector makes up about a fifth of the high-yield bond index. Fitch Ratings forecast the US high yield energy sector default rate to hit 11% this year, “eclipsing the 9.7% rate seen in 1999.”
According to Fitch Ratings, at the beginning of December of last year, “$98 billion of the high yield universe was bid below 50 cents, while $257 billion was bid below 80 cents. The battered energy and metals/mining sectors comprise 78% of the total bid below 50 cents. In addition, 53% percent of energy, metals/mining companies rated ‘B-‘ or lower were bid below 50 at the start of December, compared to 16% at the end of 2014, reflecting the decline in crude oil prices.”
The collapse in oil prices, strong U.S. dollar, and weakening global economy “crippled” manufacturers across the country. The Empire State manufacturing index fell to -19.4 in January from -6.2 in December, the lowest level since March 2009. The reading suggests manufacturing sector is slowing down and it raises questions about the outlook for the economy.
Manufacturing is very important to the U.S. economy. According to National Association of Manufacturers (NAM), there are 12.33 million manufacturing workers in the U.S., accounting for 9% of the nation’s workforce. Manufacturers recently contributed $2.18 trillion to the U.S. economy. “Taken alone, manufacturing in the United States would be the ninth-largest economy in the world.” according to NAM. For more facts and details, click here.
The manufacturing index have been below zero since July. Not only did the headline fell, but so did new orders index and shipments index. New orders fell 23.5 in January from -6.2 in December. Shipments fell -14.4 in January from 4.6 in December.
Slump in new orders can shift the production into lower gear and possibly jeopardize jobs. The employment (number of employees) index continued to deteriorate for a fifth consecutive month. The weaknesses in the Empire State indexes suggests that the earnings of manufacturers are under pressure.
According to FactSet, the S&P 500 is expected to report a Y/Y decline in earnings of 5.7% for the fourth quarter. For Q4 2015, the blended earnings decline is -5.8%. A Y/Y decline in earnings for the fourth quarter will mark the first time S&P 500 has reported three consecutive quarters of Y/Y declines in earnings since Q1 2009 through Q3 2009.
For Q1 2016, 33 companies out of S&P 500, so far, have issued negative EPS guidance and 6 companies have issued positive EPS guidance.
Another drag on earnings can be the current inventories to sales ratio. Since early 2012, the ratio has been increasing.
An increasing ratio is a negative sign because it shows companies may be having trouble keeping inventories down and/or sales have slowed. If they have too much of inventories, they may have to discount the products to clear their shelves, dragging on the earnings.
If you have any questions, feel free to contact me and/or leave comments below. Thank you.
Sneak peek of a future article that addresses one huge risk (lack of liquidity):
“With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.”
On October 22 (Thursday), European Central Bank (ECB) left rates unchanged, with interests on the main refinancing operations, marginal lending, and deposit rate at 0.05%, 0.30% and -0.20, respectively. But the press conference gave an interesting hint. Mario Draghi, the President of ECB, was most dovish as he could be, “work and assess” (unlike “wait and see” before).
The central bank is preparing to adjust “size, composition and duration” of its Quantitative Easing (QE) program at its December meeting, “the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting”, Draghi said during the press conference. They are already delivering a massive stimulus to the euro area, following decisions taken between June 2014 and March 2015, to cut rates and introduce QE program. In September 2014, ECB cut its interest rate, or deposit rate to -0.20%, a record low. Its 1.1 trillion euros QE program got under way in March with purchases of 60 billion euros a month until at least September 2016.
When ECB cut deposit rate to record low in September 2014, Mr. Draghi blocked the entry to additional cuts, “we are at the lower bound, where technical adjustment are not going to be possible any longer.” (September 2014 press conference). Since then, growth hasn’t improved much and other central banks, such as Sweden and Switzerland, cut their interest rates into much lower territory. Now, another deposit rate-cut is back, “Further lowering of the deposit facility rate was indeed discussed.” Mr. Draghi said during the press conference.
The outlook for growth and inflation remains weak. Mr. Draghi – famous for his “whatever it takes” line – expressed “downside risks” to both economic growth and inflation, mainly from China and emerging markets.
Given the extent to which the central bank provided substantial amount of stimulus, the growth in the euro area has been disappointing. The euro area fell into deflation territory in September after a few months of low inflation. In September, annual inflation fell to 0.1% from 0.1% and 0.2% in August and July, respectively. Its biggest threat to the inflation is energy, which fell 8.9% in September, down from 7.2% and 5.6% in August and July, respectively.
As the ECB left the door open for more QE, Euro took a dive. Euro took a deeper dive when Mr. Draghi mentioned that deposit rate-cut was discussed. Deposit rate cut will also weaken the euro if implemented. After the press conference, the exchange rate is already pricing in a rate-cut. Mentions of deposit rate-cut and extra QE sent European markets higher and government bond yields fell across the board. The Euro Stoxx 50 index climbed 2.6%, as probability of more easy money increased. Swiss 10-year yield fell to fresh record low of -0.3% after the ECB press conference. 2-year Italian and Spanish yields went negative for the first time. 2-year German yield hit a record low of -0.32.
Regarding the exchange rate (EUR/USD), I expect it to hit a parity level by mid-February 2016.
As I stated in the previous posts, I expect more quantitative easing by ECB (and Bank of Japan also). I’m expecting ECB to increase its QE program to 85 billion euros a month and extend it until March 2017. When ECB decides to increase and extend the scope of its QE, I also expect deposit rate-cut of 10 basis points.
ECB will be meeting on December 3 when its quarterly forecasts for inflation and economic growth will be released. The only conflict with this meeting is that U.S. Federal Reserve policy makers meets two weeks later. ECB might hold off until the decision of the Fed, but the possibility of that is low.
U.S. Federal Reserve:
On October 28 (Wednesday), the Federal Reserve left rates unchanged. The bank was hawkish overall. It signaled that rate-hike is still on the table at its December meeting and dropped previous warnings about the events abroad that poses risks to the U.S. economy.
It does not make sense to drop “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” (September statement) I’m sure the events abroad has its risks (spillover effect) to the U.S. economy and the Fed will keep an eye on them.
In its statement, it said the U.S. economy was expanding at a “moderate pace” as business capital investments and consumer spending rose at “solid rates”, but removed the following “…labor market continued to improve…” (September statement). The pace of job growth slowed, following weak jobs report in the past several months.
Let’s take a look at the comparison of the Fed statement from September to October, shall we?
The Fed badly wants to raise rates this year, but conditions here and abroad does not support its mission. Next Federal Open Market Committee (FOMC) meeting takes place on December 15-16. By then, we will get important economic indicators including jobs report, Gross Domestic Product (GDP), retail spending and Consumer Price Index (CPI). If we don’t see any strong rebound, rate-hike is definitely off the table, including my prediction of 0.10% rate-hike for next month.
The report caused investors to increase the possibility of a rate increase in December. December rate-hike odds rose to almost 50% after the FOMC statement.
Housing market continues to pose financial stability risk. House price inflation is way higher. Median house prices are about nine times the average income. Short supply caused the house prices to increase significantly. “While residential building is accelerating, it will take some time to correct the supply shortfall.” RBNZ said in a statement. Auckland median home prices rose about 25.4% from September 2014 to September 2015, “House price inflation in Auckland remains strong, posing a financial stability risk.”
Further reduction in the Official Cash Rate (OCR) “seems likely” to ensure future CPI inflation settles near the middle of the target range (1 to 3%).
Although RBNZ left rates unchanged, Kiwi (NZD) fell because the central bank sent a dovish tone, “However, the exchange rate has been moving higher since September, which could, if sustained, dampen tradables sector activity and medium-term inflation. This would require a lower interest rate path than would otherwise be the case.” It’s a strong signal that RBNZ will cut rates to 2.5% if Kiwi continues to strengthening. I will be shorting Kiwi every time it strengthens.
“The sharp fall in dairy prices since early 2014 continues to weigh on domestic farm incomes…However, it is too early to say whether these recent improvements will be sustained.” RBNZ said in the statement. Low dairy prices caused RBNZ to cut rates. New Zealand exports of whole milk powder fell 58% in the first nine months of this year, compared with the same period in 2014. But, there’s a good news.
Recent Chinese announcement that it would abolish its one-child policy might just help increase dairy prices, as demand will increase. How? New Zealand is a major dairy exporter to China. Its milk powder and formula industry is likely to benefit from a baby boomlet in China.
BoJ expects to hit its 2% inflation target in late 2016 or early 2017 vs. previous projection of mid-2016. Again and Again. This is the second time BoJ changed its target data. The last revision before this week was in April. It also lowered its growth projections for the current year by 0.5% to 1.2%.
They also lowered projections for Core-CPI, which excludes fresh food but includes energy. They lowered their forecasts for this fiscal year to 0.1%, down from a previous estimate of 0.7%. For the next fiscal year, they expect 1.4%, down from a previous estimate of 1.9%. Just like other central banks, BoJ acknowledged that falling energy prices were hitting them hard.
Low inflation, no economic growth, revisions, revisions, and revisions. Nothing is recovering in Japan.
Haruhiko Kuroda, the governor of BoJ, embarked on aggressive monetary easing in early 2013. So far he hasn’t had much success.
In the second quarter (April-June), Japan’s economy shrank at an annualized 1.2%. Housing spending declined 0.4% in September from 2.8% in August. Core-CPI declined for two straight months, falling 0.1% year-over-year both in September and August. Annual exports only rose 0.6% in September, slowest growth since August 2014, following 3.1% gain in August.
Exports are part of the calculation for Gross Domestic Product (GDP). Another decline in GDP would put Japan into recession, which could force BoJ to ease its monetary policy again. Another recession would be its fourth since the 2008 financial crisis and the second since Shinzo Abe (Abenomics), the Prime Minister of Japan, came to power in December 2012.
Its exports to China, Japan’s second-biggest market after the U.S., fell 3.5% in September. The third-quarter (July-September) GDP report will be released on November 16.
April 2014 sales tax (sales tax increased from 5% to 8%) increase only made things worse in Japan. It failed to boost inflation and weakened consumer sentiment.
In April 2013, BoJ expanded its QQE (or QE), buying financial assets worth 60-70 trillion yen a year, including Exchange Traded Funds (ETF).
QQE stands for Quantitative and Qualitative Easing. Qualitative easing targets certain assets to drive up their prices and drive down their yield, such as ETF. Quantitative Easing targets to drive down interest rates. Possibility of negative interest rates has been shot down by BoJ. But, why trust BoJ for their word? Actions speak louder than words.
In October 2014, BoJ increased the QQE to an annual purchases of 80 trillion yen. When is the next expansion? December?
Did you know that the BoJ owns 52% of Japan’s ETF market?
For over a decade, BoJ’s aggressive monetary easing through asset purchases did not help Japan’s economy. Since 2001, the central bank operated 9 QEs and is currently operating its current 10th QE (or QQE). The extensions of its QE are beginning to become routine or the “new normal.”
Growth and prices are slowing in China, with no inflation in United Kingdom, Euro-zone, and the U.S. The chances that Japan will crawl out of deflation are very slim.
US Market Reactions (ECB and FOMC):
Next week, both Reserve Bank of Australia (RBA) and Bank of England (BoE) will meet. Will be very interesting to watch.
Markets were pricing less than 30% chance of rate-hike and most people in the financial markets were not expecting rate-hike. Well, not me. I was actually expecting 0.25%, 10 basis points rate increase, as I stated in my previous post.
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Federal Open Market Committee (FOMC) said in statement. They are referring to events that took place in August, that can be described in one word; uncertainty.
Before we go any further, let’s compare the last two Fed statements.
According to the Fed’s famous “Dot Plot” – that is where committee members think interest rates are going – one committee member, for the first time ever, thinks the U.S needs to move to negative interest rates until the end of 2016.
During the press conference, Janet Yellen – the chairwoman of the Fed – indicated that negative rates were not “seriously considered at all today” and that the policymaker in question was “concerned by the inflation outlook”. The Fed looks at a model “Phillips Curve” which states that inflation and unemployment have a stable and inverse relationship. It hasn’t been working lately.
She said something that I found very interesting, “That’s something we’ve seen in several European countries. It’s not something we talked about today. Look. If not– I don’t expect that we’re going to be in the path of providing additional accommodation but if the outlook were to change in a way that most of my colleagues and I do not expect and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools and that would be something that we would evaluate in that kind of context.” This shows that even the Fed is uncertain about the future and another quantitative easing is a possibility.
If you want to see the body language from Yellen as she said it, go watch the press conference video. It can be very interesting. Any body language experts here?
The Fed also raised growth forecast for the year and cut unemployment projection.
Yellen expressed that some countries other than China are also danger to the U.S, “…we saw a very substantial downward pressure on oil prices and commodity markets…significant impact on many emerging market economies that are important producers of commodities, as well as more advanced countries including Canada, which is an important trading partner of ours that has been negatively affected by declining commodity prices, declining energy prices….important emerging markets have been negatively affected by those developments. And we’ve seen significant outflows of capital from those countries, pressures on their exchange rates and concerns about their performance going forward. So, a lot of our focus has been on risks around China but not just China, emerging markets, more generally in how they may spill over to the United States.”
Back to “wait and see” mode again. Weak start in the year hammered the chances of rate-hike in June. Now, outsiders hammered the chances of rate-hike in September. Next stop?
If the current situation stays unchanged, I expect rate increase of 0.10% (again) in October (FOMC press conference will be called if the Fed decides to change rates). But, the current situation might get much worse. The bad news might come from China again.
Xi Jinping, China’s president and Communist Party chief, will arrive in the U.S next week to meet President Obama and business leaders. After the meeting when Mr. Xi is back in China, unpredictability arrives.
China would not want to create tension with the U.S before they meet face-to-face. Thus, unpredictability comes in two or three weeks. China might devalue their currency again, by 5% or more. They might even dump much more U.S Treasuries again.
It’s reported that China dumped U.S Treasurys of $83 billion and $94 billion in the month of July and August, respectively. Why would China sell U.S Treasurys? China is in dire need of cash. Capital outflows are increasing substantially and their stock market are declining substantially. China would want to cut its holdings of treasurys to support the yuan.
According to latest data from the U.S Treasury Department, China’s holdings of U.S Treasuries was $1.240 trillion in the end of July (is probably much less now), the smallest since February 2015. In end-June, China held $1.271 trillion. China remains the world’s largest holder of U.S debt. What does that mean for the U.S?
If U.S’s #1 lender stops supporting or stops buying U.S debt, the cost of everything that depends on Treasury rates could rise, putting pressure on the Federal Reserve and prevent the Fed from raising rates. Treasury yields (inverse relationship with prices) are the benchmark that sets the cost of borrowing.
China’s abandonment of U.S Treasury debt is a warning.
Imagine if China’s major trading partner, Japan, joins China in selling U.S Treasuries. Japan is the second-largest holder of U.S. Treasuries, with $1.197 trillion in July. The devaluation of Yuan will make Japanese exports less competitive. Japan’s economy is still suffering despite Abenomics. As I stated in my post “Global Markets Crash + Asian Crisis Part 2“, Abenomics has failed. Soon enough, Japan might also be in dire need of cash and they might start cutting their holdings of U.S Treasuries.
Recently, Standard & Poor’s slashed its ratings on Japanese debt from AA- to A+ because of weak economic growth, blaming Abenomics “…we believe that the government’s economic revival strategy–dubbed “Abenomics”–will not be able to reverse this deterioration in the next two to three years.” According to Standard & Poor, Japan’s Debt/GDP ratio currently stands at 242.4%, a dangerous level for developed country.
I believe Bank of Japan (BoJ) will increase its purchases of government debt to cover the danger of Japan’s Debt/GDP ratio and will sell portion of U.S Treasurys.
We can conclude everything will probably get much worse. The Fed will have no other choice, but to start another round of quantitative easing. In other words, debt monetization, a process of buying Treasury and corporate debt on the open market, increasing money supply. When increasing money supply, interest rates should fall.
The Fed is being held hostage by outsiders, such as China and Brazil. It probably won’t end well for the U.S, promoting another round of Quantitative Easing.
Last Friday (September 4, 2015), non-farm payrolls AKA jobs report for August came out little bit stronger. 173,000 jobs were added in August and the unemployment rate decreased by 0.2% (5.3% in July) to 5.1% (The Fed considers unemployment rate of 5.0% to 5.2% as “full employment”), lowest since April 2008.
Employments numbers for June and July were revised higher. June was revised from 231K to 245K (+14K) and July was revised from 215K to 245K (+30K). With these revisions, employments gains in June and July were 44K higher than previously reported.
Average hourly earnings increased 8 cents or 0.32% (biggest rise in 7 months) to $25.09, a 2.2% gain from a year ago. The average work week increased 0.1 hour, to 34.6 hours. Increasing income will lead to increased spending (demand increases) which leads to increase in Consumer Price Index (CPI) (As demand increases, suppliers will increase the prices of goods and services) which then leads to an increase in inflation, getting closer to Fed’s 2% inflation target (or inflation rockets to the moon, damaging the economy).
Lower oil prices may be holding back wage increases, especially in the energy sector.
While average hourly earnings are slowly growing, recent “positive” changes in the minimum wages – higher minimum wages – will not help earnings/income, but will only mutilate the US economy. While the minimum wage increases may sound like a good thing, but it isn’t. When businesses are forced to pay higher wages to their workers, they may have to increase prices for their goods/services, leading to increase in inflation. Some businesses might lose their market share to low-paying businesses aboard. After businesses adjust their prices to offset wage increases, there’s no actual change in the “buying power” of consumers.
It’s better to let US companies make their own decisions regarding wages. Let the markets lead. Laissez-Faire.
The labor force participation did not move at all, at 62.6% for a third straight month.
So, unemployment decreased and labor force participation stayed unchanged. Here’s the dark side:
261K Americans dropped out of the labor force, pushing total US workers who are not in the labor force to a record of 94 million. The government only counts people as unemployed if they are actively looking for jobs. Those who dropped out of the labor force are not actively looking for jobs. Therefore, real unemployment rate can be and is much higher.
This report was the latest jobs report before the Federal Reserve meets this month to answer “million-dollar” question, rate-hike or not? The Fed will meet on September 16 and 17 to decide whether to raise interest rates for the first time since June 2006.
Rate-hike in June 2015? Well, that did not happen. Rate-hike in September 2015? Well, expectations for the rate-hike were lowered due to uncertainty about China and the health of global economy. But, Yes, there will be a rate-hike this month. No, not 0.25% (or 25 basis points). The Fed will raise the rates by…
…10 basis points or 0.10%…
Q2 GDP revision: 3.7%. Exp. 3.2%, First estimate 2.3%
Personal Consumption Expenditures (PCE) (Consumer spending), which accounts for two-thirds of US economic activity, grew at a 3.1% in the second quarter following 1.8% growth in first quarter.
PCE price index (inflation measurement) increased at 2.2% annualized rate after declining by -1.9% in the first quarter. Core-PCE (excluding food and energy) increased at 1.8% annualized rate after increasing only 1.0% in the first quarter.
Further revisions for the second quarter are possible when the Department Of Commerce releases its final (third) GDP update on September 25.
Global markets crash. Currency wars. What’s next? Good buying opportunity?
US markets: Markets plunged dramatically on Friday. The Dow Jones Industrial Average fell 530.94 points (3.12%), the worst one-day loss since November 2011 (on a % basis). The index is now down 10.2% (correction territory) below the May 19 closing and all-time high of 18,312, for the first time since 2011. For the week, the index is down 5.8%, the steepest decline since September 2011.
S&P 500 fell 64.84 points (3.19%), the worst one-day loss since November 2011 (on a % basis) and falling below 2,000 level for the first time since February. For the week, the index is also down 5.8%, the steepest decline since September 2011.
NASDAQ fell 171.45 (3.52%). For the week, the index is down 6.8%, the biggest weekly decline since August 2011.
European Markets: European stocks fell into correction territory on Friday. The Stoxx European 600 1.3% to 368.59. The index is down 11% from April 15 closing and all-time high of 414.06. For the week, the index is down 4.6%, the worst weekly performance since December. Other indexes fell into correction territory also. Germany’s DAX Index is down 18% from its highs. So far, 13 out of 18 western-European markets have lost 10% or more from their highs.
US oil prices fell just below $40 for the first time since February 2009, due to demand concerns and increasing supplies. US oil prices fell for their 8th consecutive week, the longest losing streak since 1986.
The CBOE Market Volatility Index (VIX) (also known as “Fear Index”) jumped 46.45% to $28.03 on Friday. For the week, the index rose 118.47% (from $12.83 to $28.03), largest % move ever in a week.
Three factors driving the free-fall of the global markets:
Growing concerns (or uncertainty) about China’s economy
US rate-hike uncertainty. Uncertainty is the market’s worst foe
Plunging oil prices
There are concerns about slowing growth in emerging economies, particularly China. Economic data from China showed manufacturing PMI in China fell to a 77-month low of 47.1 in August, down from July’s final reading of 47.8. A reading below 50 represent a contraction. About two weeks ago, China’s trade data showed that July exports declined by 8.3% year-over-year (Y/Y) due to a strong yuan and lower demand from its trading partners. Exports to the Japan, European Union, and United States fell 13%, 12.3%, and 1.3%, respectively. Exports are China’s strongest growth machine. The weakness in the fundamentals started (still is) putting pressures on policymakers. Then, a surprise move came.
On August 11 (days after the exports data), the People’s Bank of China (PBOC) made a surprising move to devalue its currency (so called “one-time” move), the renminbi (RMB) (or yuan), against the US dollar (greenback) by 1.9%, the biggest devaluation since 1994 and first devaluation since the yuan was de-pegged from the dollar in 2005. PBOC decided to lower daily reference rate – which sets the value of yuan against the greenback – to make yuan more market-oriented exchange rate.
Three reasons behind China’s move:
Weak fundamentals, including exports
Desire to be included in IMF SDR basket
Impending US rate-hike
China’s move increased concerns over the health of its economy (second largest economy in the world) and shocked the global markets which continues today. China’s devaluation signaled that the economy there must be worse than what everybody believes. Continuous slowdown as it shifts from an export-led economy to a consumer-led economy has led Chinese government (or PBOC) to help stimulate economic activity. Over the past year, they cut interest rates four times and cut RRR (Reserve Requirement Ratio) several times. The goal is to combat slowing growth by strengthening liquidity and boosting lending (so far, unsuccessful). The recent devaluation will make imports expensive and help boost exports (reminder: exports fell 8.3% Y/Y in July).
Another reason behind China’s recent move is its desire for the yuan to be included in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR), a basket of reserve currencies, in which the US Dollar, Euro, Japanese Yen, and British Pound are part of. Earlier this week, IMF decided to extend its scheduled revision of SDR basket (revision takes place every five years) by nine months (to September 30, 2016), giving China more time to make yuan (or Renminbi ) “freely usable”, a key requirement join the SDR basket.
Last reason behind China’s recent move is impending rate-hike in the US, which would support the greenback and would have consequences for China. The recent devaluation ended the era of Yuan appreciation which began in 2005 (reminder: yuan was de-pegged from the dollar in 2005). Ever since “Strong Yuan” policy began in 2005, Yuan (CNY) appreciated 28% against the US Dollar (USD), 30% against the Euro (EUR), and 65% against the Japanese Yen (JPY)
Rise of Yuan against most of its trading partners’ currencies has made its trading partners exports attractive. US rate-hike would have made China’s export rivals even more attractive. Now that China devalued its currency in the wake of falling exports (reminder: exports fell 8.3% Y/Y in July), its trading partners would want to protect their exports share. Therefore, China has fired the first shot to start currency wars.
Consequences of China’s actions:
Countries like Australia, Thailand, New Zealand, Malaysia and Canada are likely to suffer from China’s devaluation. These countries are largest exporter to China. Don’t also forget that these countries can affect other countries. Basically, it is “Domino Effect” economically.
Earlier this week, Kazakhstan – whose top trading partners are China and Russia – switch to a free float (which means that the central bank stopped managing the exchange rate), causing its currency, the tenge (KZT), to fall 25%. The move comes due to three reasons; crude prices (Kazakhstan is central Asia’s biggest crude exporter) fell 55% in the past year, Russian has allowed its currency (ruble) to depreciate significantly as commodity prices plummeted, and due to the yuan devaluation. The motivation for the move is to preserve its export competitiveness.
Vietnam has also allowed its currency, the dong, to weaken further due to the recent devaluation by its biggest trading partner, China. Who will be next to devalue their currency in this crisis; Asian Crisis Part 2.
Commodities denominated in US dollars will become more expensive to buyers in China, the world’s largest consumer of raw materials. When China’s economy slows, demand for raw materials, such as copper, Iron-ore, etc decreases and the lower demand puts downward pressure on commodity prices.
China, second-largest oil consumer, is causing oil prices to drop non-stop, which will hurt oil exporters, such as Canada (possibly leading to another rate-cut).
Falling commodity prices mean one other thing; deflationary pressures.
Slow growth and lower commodity prices most likely will lead other central banks, especially large commodity exporters to maintain their easy monetary policies for longer. Countries with large current account deficits and/or corporations with large amount of debt denominated in US dollars could see their economic/financial conditions worsen, causing them to further increase/expand their easy monetary policy (rate-cuts, for example). Not only commodity exporters and emerging countries will suffer, but also US companies.
US companies with significant exposure to China will suffer from China’s devaluation. Such companies are Wynn Resorts, Micron Technology, Yum Brands, and Apple, accounting for China sales exposure of 70%, 55%, 52% and 30%, respectively.
When I noticed China economic getting worse earlier this year, I knew Apple depended on China a lot, so I said that Apple was overvalued as more competitors were emerging and China’s economy was about to get worse. Even though Apple’s earnings came out better than expected, I went ahead on twitter and responded to Carl Icahn’s comments on the Apple and the market. He expected (maybe still expects) Apple’s stock price to double, which I did not (and I still don’t). More competitors are starting to emerge and China’s economic conditions are getting worse (debt bubble coming).
Mr. Icahn believed the market was extremely overheated and expected market bubble. I have to agree with him. I preferred (still prefer) to use the term “correction”. At this time, I believe current market sell-off is temporary and the dust will be settled in a month (good-buying opportunity). I expect “market bubble” after the Fed raises interest rates to the range of 0.70% and 0.80% (early 2017?). That’s when market sell-off will be much worse than the current situation.
I’m calling Mr. Icahn to respond to my questions; how do you think China’s action will affect global economies (or markets)? Do you still think Apple could double in price?
Now, let’s get back to how else China can affect global economies (deflationary pressures). I expect Europe’s economy and Japan’s economy to slow down.
Europe’s economy will slow down due to export demand decreasing and the uncertainty created by Greece (Yes, they did get a bailout deal, but it’s not over). That’s why I believe European Central Bank (ECB) will either lower interest rates even further or they will increase current Quantitative Easing (QE) program, pushing Euro currency lower. Current falling prices in the European markets are a golden opportunity. Lower interest rates and/or increased QE program will send European equity prices higher>>>all-time highs will be made.
Japan, China’s largest trading partner, will also suffer due to export demand decreasing. The devaluation of yuan (or, Renminbi) will make Japanese exports less competitive. Japan’s economy is still suffering despite Abenomics (similar to QE). Recent data showed GDP (Gross Domestic Product) falling at annual pace of 1.6% in 2nd quarter, due to slowing exports and lack of consumer spending. Abenomics has failed. Additional monetary easing coming? If the economy does not get any better in the next several months, I expect additional monetary easing by the Bank of Japan (BoJ).
I don’t believe the Federal Reserve will stop its plan to hike the rates, but it will slow the pace of it. On Wednesday (August 19), Fed minutes of July meeting (leaked earlier) showed that Federal Open Market Committee (FOMC) members “…judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point.” They also said that “…the recent decreases in oil prices and the possibility of adverse spillovers from slower economic growth in China raised some concerns.” US dollar has been falling ever since the release of fed minutes, as expectations for September rate-hike decreased.
Now more troubles emerged, I wonder what the Fed will say or do. There are many US economic reports that will come until the Fed’s September meeting. The reports will decide the fate of rate-hike for September. At this time, I expect the Fed to hike the rates in September by 10 basis points (or 0.10%).
If the current China situation (or Asian Crisis Part 2) gets out of control, there will be no rate-hike for the rest of year even if there’s strong US economic reports.
All comments welcomed. Thank you.
Disclaimer: The posts are not a recommendation to buy or sell any stocks, currencies, etc mentioned. They are solely my personal opinions. Every investor/trader must do his/her own due diligence before making any investment/trading decision.