Note: Also posted on Seeking Alpha. It can be found here.
April FOMC Meeting Minutes: “It likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”
Last Friday: 38K jobs created in May, the fewest since September 2010. Way way lower than 123K jobs gained (that number is revised….hold your breath) in April. Way way lower than 159K gain expected.
Labor market was seriously injured in May. The United States added only 38,000 new jobs, the fewest in almost six years. Things get worse. Prior two months reading were revised lower by 59,000. There were 123,000 jobs added in April down from initial estimate of 160,000. Nonfarm payroll for March was revised to 186,000 from 208,000.
Yet, unemployment rate surprisingly dropped by 0.3% to 4.7%, the lowest since November 2007. Hold on a second. How can unemployment rate drop so much if employment decreased so much? More people left the labor force, as confidence in the labor market is cooling down.
The labor force participation rate decreased by 0.2% to 62.6%, near 38-year low, unwinding about two-thirds of the rise between last September and March. A record 94,708,000 Americans were not in the labor force in May, 664,000 more than in April.
The report has evaporated the chance of a rate-hike this month from the Federal Reserve. Before the report, the federal funds futures were pricing in 55% chance of a rate-hike. Now, that is less than 5%.
The next probable rate-hike prediction is December. As I mentioned in early January, the Federal Reserve will lower back rates this year. Let’s dig deep into the jobs report.
About 35,000 job losses can be connected to a 45-day Verizon strike, which began on April 13. The workers returned to work on Wednesday, June 1st, after unions reached a deal with the telecommunications company on compensation and job security.
Since they were not working and was on a strike, they were counted as unemployed. Without the “Verizon strike effect,” May nonfarm payroll would have shown 73,000 gain, still way below from the prior month and expectations.
Information services employment, which Verizon workers would fall under, declined by 34,000 jobs in May, the first decline since November 2015. The Bureau of Labor Statistics (BLS) even highlighted the impact of the strike, “employment in information decreased due to a strike.” “About 35,000 workers in the telecommunications industry were on strike and not on company payrolls during the survey reference period,” said BLS in the report.
This is not the first time Verizon workers went on a strike. In both 2000 and 2011, information services employment dropped as Verizon workers demanded more benefits. The month after the strikes, the sector’s employment numbers rebounded.
These 35,000 Verizon workers will be added back to the June’s nonfarm payrolls.
The agreement between the unions and the company gives Verizon workers 10.9% increase in pay over four years (contract expired on August 3, 2019), as well as other benefits. That pay raise is way more than stagnant wages across the country.
Average hourly earnings rose by 5 cents (0.2%) to $25.59, following 9 cents (0.4%) increase in April. On a year-over-year (Y/Y) basis, the wage growth was flat for two months, growing by 2.5%.
Unemployment at 4.6% is within the range the Fed considers “full employment.” The average unemployment rate from 1948 (oldest data I could find) to last month is 5.8%. This leads me to believe the unemployment rate is below its natural rate, 5.8%. Then, why is not inflation higher?
According to Phillips curve, inflation should be higher. Inflation has been hovering around 0% and 1% since the end of 2014. So, why is the Phillips curve not really working?
If there’s a recession later this year or next year (as some people are forecasting) and the inflation rate is the same as now, we will have a deflationary problem. This time, the deflationary problem will be much worse than they were before. At this time, I am not forecasting anything on recession. If there is one, it will be very interesting how the central banks react to the deflationary pressures, considering the fact that they are running out of ammunition.
I believe Phillips curve is not really working today due to unemployment engineering (like companies do with non-GAAP) and globalization. Workers should not be counted as unemployed because they didn’t look for work in the past four weeks. Instead, it should be three months or more. It gives them more time to think and flush out their savings, if they even have one. Such discouraged workers should be included in the calculation process of unemployment.
Mostly important, globalization has played a big part in the crisis of Phillips curve. Since the financial crisis and light-speed innovation of technology, many companies found ways and more ways to reduce the costs. Since they are battling for customers, they are reducing their prices, keeping inflation low. The trade agreement, Trans-Pacific Partnership (TPP), will keep or even lower inflation further.
The countries included in TPP (China is excluded) account for 36.2% of global economic output and 25.6% for world trade. By eliminating taxes on exports, companies with intense competition, will reduce their prices further. For example, TPP eliminates import taxes up to 70% on U.S. automotive product exports to TPP countries.
The prices of drugs, on the hand other, will continue to increase. TPP increases the protection of drug patents and copyrights, reducing the availability of cheap generics.
Back to the jobs report. Private sector added only 25,000 jobs, the fewest since February 2010. April’s private sector gain was revised down to 130,000 from 171,000. March’s gain was slightly revised down to 167,000 from 184,000. Constructions payrolls dropped by 15,000, the most since December 2013 and the second consecutive month of decline.
The goods producing sector, which includes mining, manufacturing, and construction, shed 36,000 jobs, the most since February 2010. Mining employment continued its downward trend as plunging oil prices penetrated the operations of energy companies, shedding 10,000 jobs in May. Mining employment have dropped by 207,000 since peaking in September 2014, with three-quarters of the losses in support activities.
Temporary-help service jobs shrank by 21,000 and are down by 64,000 so far this year.
Retail employment rose 11,400 (Shopping for summer?) after losing jobs in April for the first time since December 2014. Health care added the most jobs, with 45,700. Over the year, health care jobs jumped by 487,000 (Thanks, Obamacare?).
Diffusion index – which measures the breadth of employment across the private sector – collapsed to 51.3%, the lowest since February 2010. A reading of 50 represents that as many industries gained employment as lost employment. If it’s 0, employment of all industries decreased. If it’s 100, employment of all industries increased. That is down from 53.8% in April and 56.3% in March and from the recent peak of 71.2% in November 2014.
Further, the number of people employed for part time for economic reasons (involuntary part-time workers), climbed by 468,000 to 6.4 million, the highest since August and the largest jump since September 2012. This level, in addition to other numbers above, suggests slack still in the labor market. It is still high by historical standards.
These workers are included in the alternative measures of underutilization (U-6) that remained unchanged at 9.7% in May.
There are nearly 1.9 million workers who have been unemployed for more than 26 weeks, down from 2.1 million in April. It’s the lowest since July 2008, but is still high by historical standards.
Three-month average of total nonfarm is down to 116,000 from 181,000 in April. It’s the lowest since July 2012 and is down from 203,000 three-month average during he same period last year. The three-month average of total private is nosedived to 107,000 from 173,000 in April.
The Federal Open Market Committee will meet on June 14-15. They will keep rates on hold, unless they don’t listen to the market like in December. Again, I continue to believe the Fed will lower back rates this year.
The labor market remains in hospital with serious injuries.
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.”
12….11…10…9….IGNITION SEQUENCE START….6….5….4….3….2….1….0….ALL ENGINES RUNNING….LIFTOFF….WE HAVE A LIFTOFF!
The Fed finally raised rates after nearly a decade. On December 16, the Fed decided to raise rates – for the first time since June 2006 – by 0.25%, or 25 basis points. It was widely expected by the markets and I only expected 10bps hike. Well, I was wrong on that.
The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25% to 0.50%, up from 0% to 0.25%. In the statement, the policy makers judged the economy “has been expanding at a moderate pace.” Labor market had shown “further improvement.” Inflation, on the other hand, has continued to “run below Committee’s 2 percent longer-run objective” mainly due to low energy prices.
Remember when the Fed left rates unchanged in September? It was mainly due to low inflation. What’s the difference this time?
In September, the Fed clearly stated “…survey—based measures of longer-term inflation expectations have remained stable.”
Now, the Fed clearly states “…some survey-based measures of longer-term inflation expectations have edged down.”
So…umm…why did they raise rates this time?
Here is a statement comparison from October to December:
On the pace of rate hikes looking forward, the FOMC says:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
They clearly stated one of the things they look for, which is inflation expectations. But, they also did state that “inflation expectations have edged down.”
It seems to me that the Fed did not decide to raise rates. The markets forced them. Fed Funds Futures predicted about 80% chance of a rate-hike this month. If the Fed did not raise rates, they would have lost their credibility.
I believe the Fed will have to “land” (lower back) rates this year, for the following reasons:
Growing Monetary Policy Divergence
On December 3, European Central Bank (ECB) stepped up its stimulus efforts. The central bank decided to lower deposit rates by 0.10% to -0.30%. The purpose of lower deposit rates is to charge banks more to store excess reserves, which stimulates lending. In other words, free money for the people so they can spend more and save less.
ECB also decided to extend Quantitative Easing (QE) program. They will continue to buy 60 billion euros ($65 billion) worth of government bonds and other assets, but until March 2017, six months longer than previously planned, taking the total size to 1.5 trillion euros ($1.6 trillion), from the previous $1.2 trillion euros package size. During the press conference, ECB President Mario Draghi said the asset eligibility would be broadened to include regional and local debt and signaled QE program could be extended further if necessary.
ECB might be running out of ammunition. ECB extending its purchases to regional and local debt raises doubts about its program.
Not only ECB is going the opposite direction of the Fed. Three weeks ago, Bank of Japan (BoJ) announced a fresh round of new stimulus. The move was hardly significant, but it is still a new round of stimulus. The central bank decided to buy more exchange-traded fund (ETF), extend the maturity of bonds it owns to around 7-12 years from previously planned 7-10 years, and increase purchases of risky assets.
The extensions of its QE are beginning to become routine or the “new normal”.
The move by BoJ exposes the weakness of its past actions. It suggests the bank is also out of ammunition. Already owning 52% or more of the Japan’s ETF market and having a GDP-to-Debt ratio around 245%, it is only a matter of time before Japan’s market crashes. Cracks are already beginning to be shown. I expect the market crash anytime before the end of 2019.
So, what are the side-effects of these growing divergence?
For example, the impact of a US dollar appreciation resulting from a tightening in US monetary policy and the impact of a depreciation in other currencies resulting from easing in its monetary policies. Together, these price changes will shift global demand – away from goods and services produced here in the U.S. and toward those produced abroad. In others words, US goods and services become more expensive abroad, leading to substitution by goods and services in other countries. Thus, it will hurt the sales and profits of U.S. multinationals. To sum up everything that is said in this paragraph, higher U.S. rates relative to rates around the global harms U.S. competitiveness.
Emerging markets were trouble last year. It is about to get worse.
International Monetary Fund (IMF) decided to include China’s currency, renminbi (RMB) or Yuan, to its Special Drawing Rights (SDR) basket, a basket of reserve currencies. Effective October 1, 2016, the Chinese currency is determined to be “freely usable” and will be included as a fifth currency, along with the U.S. dollar, euro, Japanese yen, and pound sterling, in the SDR basket.
“Freely useable” – not so well defined, is it?
Chinese government or should I say People’s Bank Of China (PBOC), cannot keep its hands off the currency (yuan). It does not want to let market forces take control. They think they can do whatever they want. As time goes on, it is highly unlikely. As market forces take more and more control of its exchange-rate, it will be pushed down, due to weak economic fundamentals and weak outlook.
China, no need to put a wall to keep market forces out. Let the market forces determine the value of your currency. It is only a matter of time before they break down the wall.
In August, China changed the way they value their currency. PBOC, China’s central bank, said it will decide the yuan midpoint rate based on the previous day’s close. In daily trading, the yuan is allowed to move 2% above or below the midpoint rate, which is called the daily fixing. In the past, the central bank used to ignore the daily moves and do whatever they want. Their decision to make the midpoint more market-oriented is a step forward, but they still have a long way to go.
China saw a significant outflows last year. According to Institute of International Finance (IFF), an authoritative tracker of emerging market capital flows, China will post record capital outflows in 2015 of more than $500 billion. The world’s second largest economy is likely to see $150 billion in capital outflow in the fourth quarter of 2015, following the third quarter’s record $225 billion.
Ever since the devaluation in August, PBOC has intervened to prop yuan up. The cost of such intervention is getting expensive. The central bank must spend real money during the trading day to guide the yuan to the level the communists want. Where do they get the cash they need? FX reserves.
China’s foreign-exchange reserves, the world’s largest, declined from a peak of nearly $4 trillion in June 2014 to just below $3.5 trillion now, mainly due to PBOC’s selling of dollars to support yuan. In November, China’s FX (forex) reserves fell $87.2 billion to $3.44 trillion, the lowest since February 2013 and largest since a record monthly drop of $93.9 billion in August. It indicates a pick-up in capital outflows. This justifies increased expectations for yuan depreciation. Since the Fed raised rates last month, I would not be surprised if the capital flight flies higher, leading to a weaker yuan.
Depreciation of its currency translates into more problems for “outsiders,” including emerging markets (EM). EMs, particularly commodities-linked countries got hit hard last year as China slowed down and commodity prices slumped. EMs will continue to do so this year, 2016.
The anticipation of tightening in the U.S. and straightening dollar put a lot of pressure on EM. EM have seen a lot of significant capital outflows because they carry a lot of dollar denominated debt. According to the October report from IFF, net capital flows to EM was negative last year for the first time in 27 years (1988). Investors are estimated to pull $540 billion from developing markets in 2015. Foreign inflows will fall to $548 billion, about half of 2014 level and lower than levels recorded during the financial crisis in 2008. Foreign investor inflows probably fell to about 2% of GDP in emerging markets last year, down from a record of about 8% in 2007.
Also contributing to EM outflows are portfolio flows, “the signs are that outflows are coming from institutional investors as well as retail,” said Charles Collyns, IIF chief economist. Investors in equities and bonds are estimated to have withdrawn $40 billion in the third quarter, the worst quarterly figure since the fourth quarter of 2008.
A weaker yuan will make it harder for its main trading partners, emerging markets and Japan, to be competitive. This will lead to central banks of EM to further weaken their currencies. Japan will have no choice but to keep extending their QE program. And to Europe. And to the U.S. DOMINO EFFECT
Why are EMs so important? According to RBS Economics, EMs have accounted for 50%-60 of global output and 70% of global economic growth each year since the 2008 crisis.
Some EM investors, if not all, will flee as U.S. rates rise, compounding the economic pain there. Corporate debt in EM economies increased significantly over the past decade. According to IMF’s Global Financial Stability report, the corporate debt of non-financial firms across major EM economies increased from about $4 trillion in 2004 to well over $18 trillion in 2014.
When you add China’s debt with EM, the total debt is higher than the market capitalization. The average EM corporate debt-to-GDP ratio has also grown by 26% the same period.
The speed in the build-up of debt is distressing. According to Standard & Poor’s, corporate defaults in EM last year have hit their highest level since 2009, and are up 40% year-over-year (Y/Y).
According to IFF (article by WSJ), “companies and countries in EMs are due to repay almost $600 billion of debt maturing this year….of which $85 is dollar-denominated. Almost $300 billion of nonfinancial corporate debt will need to be refinanced this year.”
I would not be surprised if EM corporate debt meltdown triggers sovereign defaults. As yuan weakens, Japan will be forced to devalue their currency by introducing me QE which leaves EMs with no choice. EMs will be forced to devalue their currency. Devaluations in EM currencies will make it much harder (it already is) for EM corporate borrowers to service their debt denominated in foreign currencies, due to decline in their income streams. Deterioration of income leads to a capital flight, pushing down the value of the currency even more, which leads to much more capital flight.
“Firms that have borrowed the most stand to endure the sharpest rise in their debt-service costs once interest rates begin to rise in some advanced economies. Furthermore, local currency depreciations associated with rising policy rates in the advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately. At the same time, lower commodity prices reduce the natural hedge of firms involved in this business.”
According to its Global Financial Stability report, EM companies have an estimated $3 trillion in “overborrowing” loans in the last decade, reflecting a quadrupling of private sector debt between 2004 and 2014.
Rising US rates and a strengthening dollar will make things much worse for EMs. Jose Vinals, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, said in his October article, “Higher leverage of the private sector and greater exposure to global financial conditions have left firms more susceptible to economic downturns, and emerging markets to capital outflows and deteriorating credit quality.”
I believe currency war will only hit “F5” this year and corporate defaults will increase, leading to the early stage of sovereigns’ defaults. I would not be surprised if some companies gets a loan denominated in euros just to pay off the debt denominated in U.S dollars. That’s likely to make things worse.
Those are some of the risks I see that will force the Fed to lower back the rates. I will address more risks, including lack of liquidity, junk bonds, inventory, etc, in my next article. Thank you.
The total job gains for August and September were revised 12,000 higher. August was revised 17K higher to 153K from 136k, and September was revised -5K lower to 137K from 142K. Over the last 12 months, employment growth had averaged 230K per month, vs. 222K in the same-period of 2014. In 2014, average monthly payrolls was 260K. This year, it is 206K. Not only jobs gains for October were strong, but also unemployment and wages.
The unemployment rate dipped 0.1% to 5%, its lowest level since April 2008. Average hourly earnings rose by 9 cents an hour to $25.20. It rose 2.5% year-over-year (Y/Y), the best level since July 2009. For most of the “recovery”, wages has been flat. The increase in earnings is significant for two reasons. More money for employees means more spending (don’t forget debts), which accounts two-thirds of the economy. Second, wage growth might suggest that employers are having trouble finding new workers (should I say “skilled” workers) and they have to pay more to keep its workers and/or to get new skilled workers. This could draw more people back into the labor market, increasing the participation rate. Without the right skills, good luck.
The labor force participation rate remained unchanged at a 38-year (1977) low of 62.4%. The long-term decline in the participation rate is due to the aging of the baby-boom generation and loss of confidence in the jobs market. There hasn’t even been a rebound in participation rate of prime-age Americans (between the ages of 25 and 54).
More than 122 million Americans had full-time jobs at the end of October, the highest since December 2007 (121.6 million).
Immediately after the jobs report, the probability of a rate-hike in December lifted. Fed funds futures currently anticipates about 65% chance of a rate hike next month vs. about 72% immediately after the report and about 55% before the report.
Federal Reserve Chairwoman, Janet Yellen, lately has been saying that December’s Federal Open Market Committee (FOMC) meeting was “live” for a potential rate-hike. While this jobs report is positive, I believe it is too early to jump in on conclusions.
The policymakers should not be too quick to act on one report. In September, the Fed left rates unchanged mainly due to a low inflation. Inflation is still low and we will get a fresh look on Tuesday (November 17) when Consumer Price Index (CPI) is released.
Right after the jobs report, the dollar skyrocketed and was 40 cents away from hitting $100 mark. It’s currently at $98.88 and there is a very high chance it will go above $100 until December 15, the first day of FOMC meeting.
If the November job numbers does not surprise to the upside (released in December 4), inflation stays low, and the dollar keeps strengthening, I do not believe the Fed will hit the “launch” button for a rate-hike liftoff.
Last Wednesday (October 7, 2015), I had a chance to meet Ben Bernanke, former chairman of the Federal Reserve and the most powerful man in the world (well, was).
Not that I got a handshake, but got to ask a question.
So how did I get to meet him? It was part of WSJ Pro Central Banking events.
Recently, Wall Street Journal introduced a subscription service, “WSJ Pro”. It debuted with WSJ Pro Central Banking. Its parent company, Dow Jones, describes it as a “premium suite of industry and subject-specific content services, combining news, data, and events in a single membership platform.” The key word is “events”. “Events” is what I love about the subscription. “Events” in other words mean, meeting high-profile people and networking with people in the financial industry.
I had a free access for a while, but now that’s gone. During my trial, I registered for two events, “Breakfast Interview Series: William Dudley” and “Breakfast Interview Series: Ben Bernanke”. I was lucky enough to be chosen to go to both of them.
The event with William Dudley, President of the Federal Reserve Bank of New York, took place on September 28. Did not get a chance to ask a question. Nevertheless, great event. Full video of the interview can be found here.
The event with Ben Bernanke took place on October 7. I was so excited for this particular event. Well, who doesn’t want to meet Ben Bernanke? I woke up on 4:30 in the morning and left my house at 6:45 AM. I got to the location of the event by about 7:50. When I checked in, I got an autographed copy of Mr. Bernanke’s new book, “The Courage to Act.” Signed, Sealed, Delivered.
It wasn’t until 8:30 AM when Mr. Bernanke entered the room, getting me and others excited. Along with him, there was WSJ’s Chief Economics Correspondent, Jon Hilsenrath, who also interviewed William Dudley the week before.
During the Q&A session, I got a chance to ask a question. I was so excited and confident. I strongly believed that I was not nervous at all. But, that wasn’t the case.
When I got handed the microphone, I instantly went blind. I forgot most of what I was going to say. It was like Warren Buffett, my idol, interviewing me for a job.
The first word out of my mouth was “student”, when I actually should have stated my name. Asking a question to a person like Ben Bernanke got me so nervous, I mumbled and rambled during my question. My question basically was, “If you were the president, what would you do about the taxes, corporate taxes, which is too high?”
Full video of the interview can be found here. I can be heard asking the question at 42:30.
I asked it because I strongly believe U.S. corporate taxes are too high, causing inversions. Although I got a reasonable answer, I believe I would have gotten better answer if I asked the question in a different way.
My first encounter with a high-profile person made me so nervous, yet taught me a big lesson. It significantly improved my confidence and ability to ask a question (to a high-profile person) without being so nervous. Who’s the next high-profile person I will meet? Janet Yellen?
A short video of Mr. Bernanke leaving the “stage”
A picture of Mr. Bernanke leaving the “stage”
I will forever remember this day, October 7, 2015.
Thank you, Wall Street Journal.
UPDATE: At the event when I was asking the question,
Last Friday (October 2), jobs report for September came out way weaker than expected. Non-farm payrolls report shows 142K jobs were added, vs 200K expectations. Unemployment rate stood unchanged at seven-year low of 5.1%. Not only that, but wage gains stalled, labor force shrank, and July and August gains were revised lower.
July job gains were revised lower to 223K from 245K (-22K) and August job gains were revised lower to 136K from 173K (-37K), totaling downward revisions of 59K. Average jobs gains for third quarter is now at 167K, lower than the 2014 average of 260K. So far, job growth has averaged 198K a month this year, compared with an average gain of 260K a month the previous year.
Unemployment rate stayed at 5.1% only because people stopped looking for work. In other words, they lost confidence in the labor market. 350K people dropped out of the labor force which took labor force participation rate fell to 62.4%, the lowest in 38 years (1977), from 62.6% in the previous three months.
Wages also showed weakness. Average hourly earnings fell by a penny to $25.09 after rising 9 cents in September. The average workweek declined by 0.1 hour to 34.5 hours.
There are increased worries that global slowdown is weighing on the domestic economy. The repulsive jobs report knocked down the chances of a rate-hike for this year. Federal Funds Rate (FFR) shows less than 10% and less than 35% chance of rate hike in October and December, respectively. Regardless of weak jobs growth, I still expect 0.10% rate-hike this month. But, I don’t expect 25 basis points for the year. If 0.25% were nothing, the Fed would have raised it already. The Federal Open Market Committee (FOMC) will meet on Tuesday-Wednesday, October 27-28.
Weak jobs report seems to point out a weak third quarter GDP growth following a strong rebound in the 2nd quarter. According to final GDP report released on September 25, second quarter grew at an annual pace of 3.9%, vs previous estimate of 3.7%. Advance (1st estimate) GDP report for the third quarter will be released on Thursday, October 29.
Energy sector continues to struggle. The mining industry – which includes oil and natural-gas drillers — lost 10K jobs last month, totaling 102K losses of jobs since December 2014. Energy companies continue to layoff workers since low energy prices are hurting companies. Energy companies like Chesapeake Energy and ConocoPhillips continues to reduce its workforce and its operations, and cut capital expenditures to offset higher costs.
Earlier in September, the Job Openings and Labor Turnover Survey (JOLTS) report showed that there were 5.8 million job openings in July, a series (series began in December 2000) record and higher than 5.4 million in May, as employers cannot find qualified workers.
It’s likely to get worse in the longer-term because of higher minimum wages. If employers pay higher wages, more people, especially teenagers, are likely to drop out and work. If states and companies continue to raise minimum wages, jobs that require skills such as programming, etc, will not be filled in the United States, but in countries with higher amount of education. That’s why recent minimum wage increases will batter, not help, the U.S. economy in the longer-term.
Reactions to the jobs report:
US markets fell immediately after the report, but rebounded later. 10-year Treasury yield fell below 2%, to the lowest level since April. US Dollar plunged, but recuperated about half of the losses later.
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.
Before we go any further, let’s review what two types of GDP, nominal-dollar terms and real-dollar terms. Current (or nominal-dollar) GDP tallis the value of all goods and services produced in the U.S. using present prices. On the other hand, Real (or chained-dollar) GDP counts only the value of what was physically produced. To clarify the point, suppose a hat-making factory announces that it made $1 million selling hats this year, 11% more than last year. The $1 million represents nominal company sales (or current dollar). However, something is missing. From this future alone, it’s unclear how the factory achieved the extra income. Did it actually sell 11% more hats? Or did it sell the same number of hats as the year before but simply raised prices by 11%? If the factory made more money because it increased the price tag by 11%, then in real (constant-dollar) terms, the true volume of hats sold this year was no greater than last year, at $900,000.
It’s vital to know if the economy grew because the quantity of products sold was greater or whether it was largely the result of price hikes, or inflation. (Source: “The Secrets of Economic Indicators” by Bernard Baumohl)
Real GDP increased at a annualized rate of 2.3%, vs expectations of 2.5%. This is a major acceleration from the first quarter when real GDP increased 0.6% (expansion), revised from -0.2% (contraction). The economy bounced back after a slow start in the beginning of the year.
While first quarter was revised upwards, 2011-2014 was revised lower. The economy grew 1.6% in 2011, down from the 2.3% initial reading; 2.2% in 2012, up from the 1.5% initial reading; 1.5% in 2013, down from 1.7%; and 2.4% in 2014, down from 2.7%. From 2011 to 2014, growth was essentially weaker. The economy expanded by an average annual rate of 2%, below initial reading of 2.3%.
Growth in the second quarter was boosted by consumer spending. Consumer spending grew at a 2.9% rate from a 1.8% in the first quarter. That is a very good sign because real personal consumption expenditures (PFE) AKA consumer spending, accounts for 70% of total GDP. If people are not spending, it spells serious trouble for the economy.
Real exports increased 5.3% in the second quarter, compared to 6% fall in the first quarter. First quarter’s significant drop was due to west port slowdown. The strong dollar has hurt exports but its effects have eased recently…for now. Port delays in the first quarter freed up exports and temporarily increased exports.
Business investment fell 0.6% in the second quarter, from previous 1.6% increase in the first quarter, as energy companies continue to scale back projects amid low oil prices.
Recently, crude oil prices have fallen back to the Earth. On Monday, August 3, crude oil prices hit just above $45 (currently below $45). It will continue to hurt energy companies, causing them to scale back projects and lay-offs. Low gasoline prices, however, would lead consumers to spend money. It’s better to pay off debts first before spending money on “wants”.
ECI, a broad measure of workers’ wages and benefits, increased 0.2%, smallest gain since records began in the second quarter of 1982, following 0.7% increase in the first quarter. Wages and salaries, which accounts of 70% of compensation costs, also increased 0.2% in the second quarter, the smallest gain on record.
The report suggests that slack remains in the labor market. The unemployment rate fell to 5.3% in June – the lowest level since April 2008 – close to the Fed’s target of 5% to 5.2%, which the Fed policy makers consider consistent full employment.
S&P 500’s reaction to both GDP and ECI reports.
Dollar’s reaction to both GDP and ECI reports.
The Federal Reserve are counting on rising wages to boost both the economy and inflation (2% target). On Wednesday, July 29, the Fed said it won’t start lifting rates until there is “some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”
The Fed will meet on September 16 and 17. I still believe the Fed will raise rates. If employment, inflation and wage reports are not very strong until September meeting, the Fed might raise the rates by little as 0.10% (10 basis points), instead of 0.25%.
I believe the disappointment of ECI is temporary as more companies are starting to increases wages and more people are slowly entering jobs market. I also believe that GDP continues to be strong. In fact, I believe current Q2 GDP will be revised higher. Preliminary (2nd estimate) of Q2 GDP will be released on Thursday, August 27.
On Friday (August 7), important reading data of US economy will be released, non-farm payrolls AKA jobs report. My guess for employment and unemployment rate is 285K and 5.4%, respectively. I believe wages will stay flat at this time and accelerate in the next few months.
I will take advantage of any pullback in the greenback (US Dollar). Greenback has a room to strengthen more. Currency pairs such as USD/JPY, USD/CAD, I would be long, and I would be short EUR/USD. If you have any questions, feel free to contact me and/or leave comments below. Thank you.