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82

South Korea: World Growth Must Wait!

One of the brightest stars in terms of global growth unexpectedly faded, with South Korean GDP falling by 0.3% in Q1. Posting its worst performance in almost a decade

The economy grew by 1.0% in Q4, 2018 alongside an expected a rebound of 0.3% in the subsequent quarter. Hopes were dashed however due to weak foreign demand for South Korean exports and diminishing domestic consumption. Retail sales declined sharply in February due to the early celebration of the Lunar New Year. Apart from the seasonal factor however, there was also a structural weakening when compared to the average value for January-February with the same period last year.

When assessing the implications for the global economy, it should be noted that the country exported fewer semiconductor elements, refined petroleum products and passenger cars. Exports declined in February and fell short of forecasts in March, indicating a continuing trend towards weakening external demand during these two months. Sources of weak foreign demand arose from the largest trading partners, such as China, USA, Hong Kong and Japan, which is all well documented in their domestic data. Channels of transmission foreign demand slack into domestic consumption were capacity utilization, which contracted in March, deterring from expansion on business investments, as well as an increase in the ratio of inventories-to-shipments of the exporters.

Source: Korean Development Institute

Industrial production in February fell by 1.4% MoM, the service sector showed zero growth. In the medium-term trend, assessing the change in indicators in annual terms, the situation also looks alarming. Waning momentum in manufacturing and mining arose became especially distinct in early 2019 while the services sector has been stagnating for a long time.

Shares of companies producing semiconductor elements, amid the decline in exports, raise doubts about the rationality of valuation, as the price is rising while EPS falls

The South Korean government has pledged to increase fiscal momentum with an additional package of spending of $5.9 billion, in addition to the record budget set for 2019. According to their calculations, this will lead to additional GDP growth of 0.1% and creation of 73,000 jobs. With the failure of the first quarter, the government’s targets for 2.6% to 2.7% GDP growth are beginning to look excessively ambitious, unless, of course, a miracle occurs in export activity.

The country, with a high share of economic and implicit political power belonging to industrial conglomerates called Chaebol, ranks 11th in terms of the size of the economy and has been growing at one of the highest rates after the Great Depression.

83

Fight fire with fire: Chinese banks issue more loans to combat effects of bad debts

After a crushing blow inflicted by Google (shares fell by 6% on the earnings report) Nasdaq futures suffered from additional pressure after Chinese PMI report release, which showed that manufacturing activity in April failed to develop the March impulse.

The rebound in March set the stage for expectations that Chinese economy will enter the second quarter with the claim on recovery after dismal winter, but April data were a big disappointment. Both productive and services sector have torn the groundwork of March, broad activity indices decreased from 50.5 to 50.1 and from 54.8 to 54.3, respectively. The estimate of production activity from Caixin, which adds more weigh to small enterprises in the index formula, also decreased from 50.8 to 50.2 points, contrary to the forecast of 50.9 points.

The decline embraced all components of the index what brought additional damage to hawkish beliefs on the markets. The leading index of new orders declined slightly, remaining in the expansion zone. However, the index of new export orders fell below 50 points, indicating a cooling in external demand.

The output component fell along with the urban unemployment component. In March, the unemployment rate navigated to the 74-month low, before the labor market cooled in April. The inventory index returned to negative territory, the goods delivery time index strengthened, indicating an acceleration of capital turnover for producers.

The pressure in prices of manufactured goods and other costs declined showed corresponding index, which of course means a less favorable outlook for consumer inflation. The balance of incentives for tightening vs. additional credit easing for the Chinese government should remain at the same level, or perhaps slightly shift in favor of counter-cyclicality (more easing).

A wait-and-see attitude may not be completely comfortable to the government when taking into account curious fact that the weak economy in 1Q, the massive infusion of liquidity (4.6 trillion yuan in January) coincided with increased ratio of bad loans to the highest level almost for three years

At the same time, despite the slowdown in the economy, which is usually accompanied by the reduction of attractive borrowers and the growth of defaults, Chinese banks, in unison with the Central Bank, almost doubled the issuance of loans in the first quarter compared to Q4 2018

A brilliant example of what a low level of independence in the decisions have large Chinese banks. Fight fire with fire!

The lagging of China’s banking sector shares from the ShComp broad index (19% vs. 23% YTD) may just be a concern about the increase of bad loan provisions, which, of course, will have a negative impact on EPS.

According to a survey by China Orient Asset Management (one of four state-owned companies managing bad debts), 45% of the 202 surveyed managers of Chinese banks believe that bad loans will update the record in 2019.

The implications for the rest of the world are the implicit boost to risk appetite due to the fact that the Chinese economy should remain afloat, because quickly stopping support for banks, drowning in bad credit, can be hardly included in the government plans.

84

More than simply a trade truce

The signs of softening stance of the White House in talks with China before the two leaders met at the G-20 summit (Trump’s phone call to Xi, reports about “extended ” meeting), to the general surprise, were not empty speculations, but a forerunner to extending the truce. The results of the meeting between Trump and Xi set a new vector of cooperation between the two states, as Trump accepted some Chinese demands, such as extending pause in tariff escalation and easing of pressure on Huawei. Markets welcomed this decision by increasing the demand for risky assets, the dollar strengthened, the yield on 10-year notes rose, and SPX futures began trading with a positive gap at around 2975 points.

And if the tariff truce was within the range of expected scenarios, then the removal of some restrictions on Huawei prompted China to return to the negotiating table, which considered attacks on the Chinese telecom giant as forcing to negotiate with a “gun pointed to its head”. China, in exchange for easing sanctions on Huawei agreed to increase purchases of agricultural products in unspecified amount. Its manufacturers in the United States suffer huge losses, hit by the millstones of the tariff war.

The chance of a rate cut by 50 bp in July keeps declining, according to futures trading with interest rate as an underlying asset, but the market remains confident that the Fed will lower the rate in July by at least 25 bp.

Asian stock markets got the biggest relief from the Trump-Xi decision. The Japanese Nikkei jumped by 2.1%, the Chinese CSI 300 by 2.6%, as the pause in the exchange of tariffs will allow firms to expand the horizon of production planning, which should add confidence to Chinese firms in decisions to boost hiring and capital investments.

The official index of manufacturing activity in China fell to 49.4 points in June, remaining in the contraction territory for the third month, the data showed on Monday. The activity index of China’s factories, calculated by Caixin, dropped to 49.4 points, the worst since January of this year. Manufacturing PMI includes several sub-indices, such as output, new orders, input and output prices, delivery time of raw materials by suppliers, inventories, employment, etc. Despite the decline in the component of new orders (from 49.8 to 49.6 points), and hiring (from 47.0 to 46.9 points) the positive part of the report was a rebound in activity of small enterprises from 47.8 to 48.3 points.

Recall that small enterprises in China endured greatest pain from the tariff war since the combination of slowdown in growth and credit crunch led to credit tightening especially to this type of firms. Banks are willing to lend to large enterprises, seeking to maintain “healthy” assets on the balance sheet because of increasing probability of default by corporate borrowers. By this, they effectively block the channel of cheap liquidity opened by the Central Bank, intended for small firms.

It is not known whether the Chinese authorities will keep pause before new stimulus measures (favoured by the outcome of the Osaka meeting), but with the deterioration of the manufacturing sector, the likelihood of expanding support measures is increasing, which should support risk appetite not only in the Chinese stock market, but also abroad in the form of lower demand for “safe havens”.

European data increased pressure on the euro. Activity indices in production in Italy, France and Germany continued to fall. Unemployment in Germany fell by 1K, the unemployment rate in the Eurozone fell more strongly than expectations to 7.5%. EURUSD is heading to 1.13 level, losing almost half of percent today.

85

Saudi Arabia Under Pressure as the “Oil Market Goes Green”

Oil prices renewed their decline, maintaining the bearish tone set on Monday. US producers are gradually resuming oil production in the Gulf of Mexico after Hurricane Barry, in what serves as the basis for downbeat expectations for API and EIA inventory updates this week.

The rebound of Chinese economy in June, particularly in industrial production and retail sales, left a light imprint of buying activity in oil prices on Monday. However, it failed to gain a foothold, as the forecast for global economic growth (and therefore oil consumption) remains flimsy. This is further evidenced by the dovish stance of the ECB and Fed, ready to combat recession, while American oil producers are ramping up production, maintaining concerns about the glut.

On January 1, 2020, the International Maritime Organization will enforce new standards for ship fuel, designed to significantly reduce emissions of harmful gases into the atmosphere. This will be one of the biggest shifts in the oil market, as ships burn about 3 million barrels of high sulfur oil every day. These new standards will obviously create an excess of “dirty” fuels on the market and increased demand for standards-compliant fuels.

The allowable sulphur content is planned to be reduced from the current 3.5% to 0.5%. The average sulfur concentration now stands at 2.7% with a very low percentage of ships currently sticking to the new emission norms. The profits of refineries that focus on refining dirty oil will be under pressure, and this is especially true for companies in Saudi Arabia. Below is the matrix of oil grades in two ways – by density and sulfur content:

Also, for ships that are not going to switch to clean fuel, it is possible to use special installations that reduce the content of harmful substances in emissions.

The market is also under pressure due to discouraging reports from the EIA, which sees no end in sight to the potential for growth in US oil production. According to the latest forecasts, production in seven major fields will grow by 49K in August to a record 8.55 million barrels per day. The total production in the United States now exceeds 12 million barrels and is expected to rise further.

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On Monday, the volume of suspended capacity in the Gulf of Mexico was 1.3 M barrels per day. On a selected day from Sunday to Monday, producers restored production to 80K barrels per day however, the recovery rate is expected to increase. Capacity utilization on some platforms reaches only 31%. Workers of more than 280 drilling platforms were evacuated but they are expected to return to their jobs in a few days after the storm leaves the region.

Risk Warning: Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.

86

US and Vietnam: from “Best Friends” to Trade Rivals?

Next possible leg of the trade war may affect countries that have emerged victorious at the expense of first victims. This assumption is explained by the fact that losing the accumulated trade and economic advantage is more expensive for any economy than simply missing it out – and Trump understands this perfectly well. Already very attractive for the US president is the ability to knock out concessions from China’s small neighbour, Vietnam, which is seen as one of the main beneficiaries of the transformation of the supply chains in the trade between the US and China

Trump just needs to make a threat, but can Vietnam avoid this or a new trade front with an East Asian country is only a matter of time?

First, it is worth remembering that in May, the US Treasury Department included Vietnam in the list of potential currency manipulators, which gives Trump a formal pretext for imposing tariffs on Vietnamese goods if the fact of deliberate devaluation is proved. This threat has already led to the introduction of 400% of the tariffs on steel imports from Vietnam, which was produced in South Korea or Taiwan. Thus, the role of the country as an “unwitting accomplice” is being blocked, also serving as a warning that the connivance of the authorities will be punished specifically with tariffs on Vietnamese goods.

And there is a reason for this. For example, there are allegations that Chinese goods are “rebranding” in Vietnam and exported to the United States under the guise of Vietnamese goods. The rise of exports from China to Vietnam and from Vietnam to the United States indicates that there may be a phenomenon that US officials call “transshipment”

As can be seen, China’s exports of key goods to the United States have shrunk along the “short route” and have grown along the “long route” through Vietnam.

If the United States introduces 25% tariffs on imports from Vietnam, considering that the severity of misconduct is commensurate with Chinese, then according to some estimates, this could lead to a reduction in export volumes by 25% and a loss of 1% of GDP. The United States continues to be Vietnam’s main trading partner, and vice versa, the share of US exports to Vietnam, especially in terms of agricultural products, has risen sharply

Last month, Trump stunned the Vietnamese authorities with statements that Vietnam was “the worst abuser in the trade of everybody” and “fairness in trade with Vietnam may even be less than with China.” Back in 2016, after entering the presidency, Trump made similar complaints, but the contract for Boeing purchases of several billion dollars and the trend to strengthen alliances with China’s neighbours, in the opinion of the Vietnamese authorities, have become a reliable dam protecting the country from criticism of the POTUS. But it was not there. Trump expressed discontent with the explosive growth of Vietnam’s trade surplus with the United States, which in the first five months of this year reached $21.6 billion, almost doubling compared to the same period last year.

Several sources claim that Vietnam made several promises to Washington related to trade, and Trump’s recent criticism can only accelerate their implementation. For example, the development of a law on the creation of three free economic zones, which, according to fears of local firms, could go under the control of China, was suspended indefinitely, demonstrating to Washington that the trend of rapprochement with a neighbour was interrupted. Nevertheless, Vietnam is also working on a “spare airfield”, having entered into the Trans-Pacific Agreement (from which the United States left) and signed a free trade agreement with the European Union. Together they can mitigate damage from possible US sanctions.

Dynamics of transshipment operations, where Vietnam serves as a gasket between China’s exporters and US importers. The lack of repression and conniving routes – loopholes is likely to provoke a new wave of criticism from Trump.
Vietnam surplus with the United States. The main item of US exports to Vietnam is agricultural products (4 billion dollars in 2018). If purchases will grow at a faster pace, it can be assumed that countries have agreed on something.
Cooperation in the military sphere. In terms of concrete numbers, this should be increased purchases of American weapons and equipment. This should be a more reliable signal of preference for cooperation with the United States to balancing between the interests of superpowers (i.e. US and China and probably Russia).

87

Market discounts retail sales data focusing on the Fed comments as July meeting looms

Greenback posted surprisingly muted response to strong US retail sales on Tuesday, despite of actual figures printing almost twice higher than the estimates. Some traders went on vacation, the rest opted to focus on the Fed’s comments, so the mix of lowered trading volumes and weakened importance of the “hard data” only helped Dollar to sustain gains slightly above 97 level during the trading session on Wednesday.

Retail sales in the control group grew by 0.7%, more than twice as high as expectations (0.3%), retail sales metrics including/not including goods with volatile prices indicated a steady rise of consumer spending in June. Car sales for the second month in a row make a positive contribution to sales, probably due to a seasonal increase in summer trips.

Powell, speaking in Paris, attempted to refine his subtle guidance to July meeting, keeping market focus on the risks of decline in inflation expectations and their “deanchoring”, fall in market-based compensation for inflation, which require more policy accommodation. At the same time, the Fed opts to discount traditional fundamental data, showing its concern the expectations. Powell’s comments boosted the odds of 50 bp rate cut to 31%.

At the same time, Powell managed to convince the market that the Fed will be able to support inflation. Market-based metrics of inflation expectations have turned into growth from the end of June:

It can be seen from the chart that the main risks are currently perceived to stem from ​​US bilateral trade relations as the inflation expectations tumbled exactly after the announcement of new tariffs on China goods in May. This was also repeatedly stated by Powell. On the other hand, the decline inflation expectations in May could be a market foresight of the new round of credit easing in response to exacerbation of tariff tensions, in which case the Fed turns out to be led, reacting to short-term market whim, instead of spotting genuine trend in the economy.

However, for the late phase of expansion, which the US economy is supposedly in, the “hard” data tends to lag (since crises start with a sharp change in expectations in response to a shock), therefore, the Fed needs to “diversify” the sources of information in order to stick to the proclaimed “data dependency” policy in early 2019.

In my opinion, the rate cut by 50 bp is difficult to consider a commensurate “precautionary measure” in response to economic changes, where retail sales and the labour market are growing at a fairly steady pace. A strong stimulus signal from the ECB next week will reduce the risks of a further “slowdown in growth abroad” (one of the reasons for the Fed’s concerns, along with the trade war), and US GDP data on Friday may contain a positive surprise as shown by NFP and retail sales. All this may limit dollar sales.

88

Policy Bias in China: Fighting with Credit Leverage or Adding more Stimulus?

A key gauge of the debt burden in Chinese economy exceeded 300% of GDP, the Institute of International Finance reported. Beijing was forced to maintain the trajectory of undesirable debt growth, increasing monetary and fiscal support in response to shocks in foreign trade, weakening foreign demand and activity in production and services sectors. Big tax cuts and following decline in state revenues has led to the need to ease restrictions on the issue of special purpose bonds by municipal governments in order to keep a stable pace of investment in infrastructure projects. This fueled growth of the national debt to 50.5% of GDP in 1Q 2018
Chinese government increased quotas on the issuance of special purpose bonds by 59% compared with 2018. But in May local governments filled the quota by only 40%, issuing debt at quite an even pace. Recall that such bonds are paid off with the project revenues, and not from the taxes collected. Raising funds for unprofitable projects and higher risk credit on such bonds imply that local governments are risking facing with increase in borrowing costs in case they make an investment mistake.

The liabilities of the three main types of economic agents – the state, firms and households amounted to 303% of GDP in the first quarter of 2019, compared with 297% in the same period last year. The IIF report also showed that the debt burden grew at an accelerated pace in many countries after the trade tensions escalated.

While the authorities’ efforts to combat financing through informal channels (i.e., shadow banking) led to decline in much-inflated corporate debt in the non-financial sector from 158.3% to 155.6%, borrowing in other sectors has increased. Changes in the size liabilities can uncover more underlying processes if divided in four broad components: government debt, household debt, the financial sector, and the non-financial sector. By comparing changes of debt in each sector with the same period last year and the values ​​for given period with safe standards globally, we can try to make a qualitative conclusion about the policy bias: towards fighting leverage or increasing stimulus.

Below is a diagram showing the debt-to-GDP ratio by sector for the first quarter of 2019, as well as a change from the same period last year

The most rapidly growing debt was household debt (from 49.7% to 54%), and debt in the non-financial sector, which is the “main customer” of shadow money markets, slightly decreased from 158.3% to 155.6%. Three of four sectors (except non-financial one) are having quite safe levels of debt when comparing it with world average. Despite conflicting rumors about the course of fiscal and monetary intervention, Chinese authorities, as can be seen, managed to combine prudently stimulus measures with restrictions on shadow financing (reducing debt burden in the riskiest sector and increase it in those where it is reasonable).

At the same time, the value of China’s total debt in absolute terms exceeded $40 trillion dollars, which is almost 15% of the global debt.

89

Fed Williams’ “Brilliant Failure” in Communication Sparked jolt on the Markets

After it became clear that the Fed is going to cut rates in July, market expectations had a room to develop only towards the most bearish outcome (50 bp cut), pressuring dollar and pushing safe heavens and bonds higher. Yet another run-of-the-mill John Williams speech on Thursday became a sheer surprise, aiding bearish rumors to thrive with the following “recipe” to combat next recession:

“First, take swift action when faced with adverse economic conditions”

“Second, keep interest rates lower for longer.”

And third, adapt monetary policy strategies to succeed in the context of low r-star and the ZLB.”

(it is not entirely clear what Williams meant by adapting).

The first two statements were enough to promptly change the market consensus to the rate cut by 50 bp. However, the Fed representative later issued a statement a la “it was a joke” as the unwelcome jump in market expectations prematurely limited the room for maneuver. There are still two weeks before the FOMC meeting, taking into account the incoming data, the unpredictable Trump, the ECB decision and other events, eventually only 25 bp cut can be justified, which will disappoint markets and cause volatility. These are completely unnecessary policy costs for the Fed and Williams in this regard was too much outspoken and unusually plain in his statements.

Williams sounded so ominous that the odds for 50 bp rate cut jumped from 30 to 70%! The Fed spokesman “ran to the first reporter he could find” to report a communication failure, stating that “Williams recapped 20 years of academic research in his speech. It was not about his views in monetary policy and upcoming decisions” Well, if this is so, then Williams simply has an “outstanding ability” to pick time and topic for speech. Or… was it intended open mouth operation?

As a result, the chances of two outcomes of the July meeting became equal, but the imprint on the foreign exchange market and safe assets remained. Gold reached a five-year high, trading on Friday at around $1,445 per troy ounce, the yield on 10-year US T-notes was down to 2.026%. The reaction of the dollar was less pronounced, a small amplitude of the fall says that there is no place to run. Oil is rising due to exacerbating tensions in the Strait of Hormuz and expectations of the Fed’s easing policy, but one should keep abreast of US negotiations with Iran, the news about which appeared recently. Therefore, the rally in oil prices may be fragile, as it is now due solely to temporary factors. The cryptocurrency market also rose, following the rally in fixed income markets of developed economies, but Congress’s reluctance to share monetary power with the Facebook cryptocurrency project suggests that the legal status of decentralized cryptocurrencies as a fundamental growth driver can be forgotten for the near term.

90

IEA’s Birol: Oil consumption forecast can be revised to the downside in the coming months

The International Energy Agency (IEA) cut forecast for oil consumption in 2019 due to flattening growth of the global economy and persisting risks from trade standoff between US and China, said Fatih Birol, the head of organization.

The agency expects consumption to fall to 1.1 million barrels per day and may deliver even gloomier revision of the projections if the global economy, and especially China, shows further weakening, Birol said.

The IEA was much more upbeat last year predicting an increase in demand by 1.5 million b/d in 2019 but updated projections contained much more pessimistic figures weighed largely by global trade risks.

«China is experiencing the slowest economic growth for the past three decades, as well as some developed economies … if the global economy figures are even worse than we expect, then in the coming months we can even revise our figures again,” said Birol in Reuters interview.

According to Birol, the demand for oil were adversely affected by the trade war between United States and China at a time when the markets have been drowning in oil due rising shale oil production in the United States.

It is expected that in 2019, US oil production will increase by 1.8 million barrels per day – less than 2.2 million barrels per day in 2018, Birol said, but “these volumes will go to the market, where demand growth is decreasing “.

According to him, the IEA is concerned about rising tensions in the Middle East, especially around the Strait of Hormuz, an extremely important shipping route connecting the Gulf oil producers with markets in Asia, Europe, North America and other countries.

91

US and Vietnam: from “Best Friends” to Trade Rivals?

Next possible leg of the trade war may affect countries that have emerged victorious at the expense of first victims. This assumption is explained by the fact that losing the accumulated trade and economic advantage is more expensive for any economy than simply missing it out – and Trump understands this perfectly well. Already very attractive for the US president is the ability to knock out concessions from China’s small neighbour, Vietnam, which is seen as one of the main beneficiaries of the transformation of the supply chains in the trade between the US and China

Trump just needs to make a threat, but can Vietnam avoid this or a new trade front with an East Asian country is only a matter of time?

First, it is worth remembering that in May, the US Treasury Department included Vietnam in the list of potential currency manipulators, which gives Trump a formal pretext for imposing tariffs on Vietnamese goods if the fact of deliberate devaluation is proved. This threat has already led to the introduction of 400% of the tariffs on steel imports from Vietnam, which was produced in South Korea or Taiwan. Thus, the role of the country as an “unwitting accomplice” is being blocked, also serving as a warning that the connivance of the authorities will be punished specifically with tariffs on Vietnamese goods.

And there is a reason for this. For example, there are allegations that Chinese goods are “rebranding” in Vietnam and exported to the United States under the guise of Vietnamese goods. The rise of exports from China to Vietnam and from Vietnam to the United States indicates that there may be a phenomenon that US officials call “transshipment”

As can be seen, China’s exports of key goods to the United States have shrunk along the “short route” and have grown along the “long route” through Vietnam.

If the United States introduces 25% tariffs on imports from Vietnam, considering that the severity of misconduct is commensurate with Chinese, then according to some estimates, this could lead to a reduction in export volumes by 25% and a loss of 1% of GDP. The United States continues to be Vietnam’s main trading partner, and vice versa, the share of US exports to Vietnam, especially in terms of agricultural products, has risen sharply

Last month, Trump stunned the Vietnamese authorities with statements that Vietnam was “the worst abuser in the trade of everybody” and “fairness in trade with Vietnam may even be less than with China.” Back in 2016, after entering the presidency, Trump made similar complaints, but the contract for Boeing purchases of several billion dollars and the trend to strengthen alliances with China’s neighbours, in the opinion of the Vietnamese authorities, have become a reliable dam protecting the country from criticism of the POTUS. But it was not there. Trump expressed discontent with the explosive growth of Vietnam’s trade surplus with the United States, which in the first five months of this year reached $21.6 billion, almost doubling compared to the same period last year.

Several sources claim that Vietnam made several promises to Washington related to trade, and Trump’s recent criticism can only accelerate their implementation. For example, the development of a law on the creation of three free economic zones, which, according to fears of local firms, could go under the control of China, was suspended indefinitely, demonstrating to Washington that the trend of rapprochement with a neighbour was interrupted. Nevertheless, Vietnam is also working on a “spare airfield”, having entered into the Trans-Pacific Agreement (from which the United States left) and signed a free trade agreement with the European Union. Together they can mitigate damage from possible US sanctions.

Thus, the chances of introducing trade tariffs against Vietnam will directly depend on

Dynamics of transshipment operations, where Vietnam serves as a gasket between China’s exporters and US importers. The lack of repression and conniving routes – loopholes is likely to provoke a new wave of criticism from Trump.
Vietnam surplus with the United States. The main item of US exports to Vietnam is agricultural products (4 billion dollars in 2018). If purchases will grow at a faster pace, it can be assumed that countries have agreed on something.
Cooperation in the military sphere. In terms of concrete numbers, this should be increased purchases of American weapons and equipment. This should be a more reliable signal of preference for cooperation with the United States to balancing between the interests of superpowers (i.e. US and China and probably Russia).

92

Reserve Currency Status as a Factor for Medium-term Dollar Decline

The status of reserve currency should be necessarily supported by an economic power of the issuing country as it makes possible for the currency to assume key functions of money – a means of payment and store of value (protection of purchasing power). Within one country, the money is empowered with these functions via monopolisation of the money supply by single body (state) as well as enforcement of their use, covered in the notion of “legal tender”. If we talk about world economy where different currencies exist and no enforcement can be carried out, other natural mechanisms are instead at work, namely

The dominant share of the country’s GDP in world output and product diversity. The more goods or services you can buy for a reserve currency, and the wider their range, the greater the chance that this currency will become a transnational means of payment. All previous economies, which currencies held the status of reserve, met this criterion, but, oddly enough, only temporarily

Low and stable price level growth. Low inflation provides a better protection of purchasing power relative to other currencies, which makes savings in it more attractive;
Efficient capital markets, which provides a quick and cheap transformation of savings into investments.
From the standpoint of inflation, there are no wide inflation gaps between world powers, like persistently high inflation in US Dollar and low in the Euro what makes Euro more attractive & puts pressure on dollar as reserve currency, as the inflation slackening became global issue. Same with capital markets, US still rocks. But if we talk about economic growth, technological advancement and competition, the dollar losing the role as global means of payment is becoming an increasingly relevant topic for discussion. The July note of Morgan Stanley’s investment strategy, entitled “Exorbitant dollar privileges are coming to an end?” was dedicated precisely to the factor of reserve status in the mid-term outlook of the dollar.

The brief conclusion is that MS analysts have lost faith in the dollar, believing that it will soon lose the status of reserve currency (which will cause its decline in the medium term) due to structural changes and cyclical impediments. After one hundred years of dollar domination, investors have accumulated significant positions in dollars, but feel quite comfortable with this overweight. Diversification makes sense if investors put more weight on Asian currencies and EM, however, to keep it safe, the underlying assets may remain the same, but investment instruments will be denominated in other currencies, which will balance out the FX proportions.

This is the current and recommended currency composition of MS client portfolios

The bank’s analysts point out that the accelerated growth rate of China’s GDP at purchasing power parity, as well as the improving balance between low and high value added sectors, create the necessary basis for increasing the share of the yuan in world calculations once the country takes more decisive steps to liberalise the monetary regime

Over 70 years, China’s GDP has more than quadrupled to 20%, compared with 25% of the United States. The growth of other Southeast economies, such as India, means that the number of transactions in a currency other than the dollar will grow, reducing the relative share of the dollar in the total volume of global transactions. Between 2015 and 2030, the growth of middle-class consumption is estimated at 30 trillion dollars and only 1 trillion dollars will be spent by the middle class of Western economies.

The latest data on central bank reserves show that the share of dollar reserves in the assets of the Central Bank has steadily decreased since 2008

However, while the share of global transactions involving the dollar is at a very high level – 85%, the US share in global GDP is only 25%. Strengthening the US position in the oil market suggests that payments for primary products – energy will also be carried out in dollars, which is a strong counter argument to the arguments of JP Morgan, predicting quite swift changes.

What are your thoughts about future dollar dominance? Have your say in the comments section below.

93

ECB Increases Focus on the Side-effects of NIRP, Warranting new Depths in Negative Rates

ECB’s statement and Draghi’s remarks at the press conference on Thursday set the stage for exploring new bottoms of NIRP, QE and other mitigation measures. But not surprisingly, they did not justify the wildest expectations of euro bears.

Overnight interest rate swaps gave a 50% chance of a rate cut yesterday, but the ECB opted to put off active operations until September. Exploring new depths of negative rates is associated with a rise in imbalances, marginal costs, side effects and possibly unknown surprises, so the ECB needs time to “cover its back” with a thought-out package of measures, rather than acting straightforwardly by cutting rates.

The key side effect is of course greatly reduced profitability of the banking sector. Although banks’ ROE rose from 3% in 2016 to 6% in 2018, profitability is below the long-term cost of capital, estimated by banks at about 8-10%. There were costs of immediate rate cut like further pressure of the yield curve and banks’ net interest margin and they are likely exceeding the costs of “delay” of rate cuts till September. Otherwise, the ECB would follow the Fed’s path, which is expected to preemptively cut the rate by 0.25% next week. The same conclusion can be drawn from the stock index of the banking sector STOXX 600, which, in case of ECB tepid attitude to banks profitability issues, is ready to retest the multi-year bottom:

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The package to ease pressure on the banking sector is likely to include a progressive deposit rate (tiering), a new QE package, which can “strengthen” the assets of banks holding bonds on their balance sheets. Exempting a portion of bank reserves from the ECB “deposit tax” may be needed for those countries where costs of maintaining excess reserves are quite high relative to net profits, such as in the case of Germany

According to the ECB, rates will remain at current levels or below at least until the second half of 2020. “A considerable mass of inflation expectations is moving towards lower inflation”, Draghi said at a press conference. “We don’t like it, so we are determined to act.” Discussions about deposit tiering, which the ECB brings up to the public knowledge indicate that the rates can go much lower, since the only thing holding back the Central Bank in this way are side effects.

As a result, the market prices in a rate cut by 10 basis points in September and almost 25 basis points at the end of next year

“Diverse” package of easing measures, which Draghi promoted to our attention, gives rise to a very wide rumors in the market about the extent of the bearish surprise in September. Even in the absence of weak economic and sentiments data, considerable moral effort will be required to rely on the rise of the euro. If, of course, the Fed won’t surprise us next week, cutting rate by 50 basis points and urge to prepare for the worst, which is unlikely.

94

High-tech shares drive growth on the Chinese stock market

Major stock indices in China rose on Friday, posting weekly gains thanks to the high-tech firms’ rally, while investors welcomed the potential progress in US-China trade negotiations. Shares of most companies in the new technology platform, STAR Market, fell on Friday in a take-profit move, posting significant gains in the first week of trading.

CSI 300 blue chip index rose 0.2% to 3.858.57 points as the Shanghai Composite Shanghai Stock Exchange Index also advanced by 0.2%, to 2.944.54 points. For the week, CSI300 scored 1.3%, while SSEC climbed 0.7%. Investors remain focused on the development of Sino-US trade negotiations.

The White House announced on Wednesday, that High-ranking US officials will visit China on Tuesday, July 30, for talks “aimed at improving trade relations between the US and China,”. Tech stocks led the weekly increase. IT-index CSI rose by 5%, while the index, which tracks the main telecommunications companies, gained 3%.

95

Preview of the Fed Meeting: Hard Data vs. Soft Data Puzzle for the Fed

In the last two or three FOMC meetings, it was increasingly harder for the officials to communicate their decisions properly to the markets. Teetering market expectations fed by conflicting economic and sentiment signals have been especially vulnerable to Fed’s communication mistakes. Recall Fed’s Williams speech about possible response to recessions which market took as a clear guide for a rate cut by 50 basis points. Thankfully, Fed’s spokesman was quick to issue disproof which averted disaster.

The economy and expectations (especially corporate sentiments) are sending conflicting signals, pulling the blanket of monetary policy to each other what makes it difficult for the Fed to be consistent, predictable and adhere to the line of its own medium-term forecasts. It is unknown from where the next shock will appear, which may either prolong the expansion or drive the economy into crisis.

Based on the premise of “data dependence” in determining the policy course, as Powell recalled at the previous meeting, the data for the last month can shed light about possible Fed decision this week. In the following table I compiled recent soft and hard data (statistical data and surveys), two multidirectional vectors which puzzle the Fed:

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The big surprise, what complicates matters for the Fed is the acceleration of GDP, retail sales and jobs growth in July. The tax cuts were supposed to run out of steam in 1Q – 2Q of 2019, moreover, the trade war should have quickly depleted this driver of growth. Over the past three months, there has been some improvement in orders for durable goods and capital goods while sales of existing houses have also stabilized.

Surveys of company managers, on the contrary, indicate a fall in optimism in the outlook for demand and investments. So far, these fears “miraculously” haven’t translated into the employment figures, which is growing at relatively robust pace. The growth of layoffs and the slowdown in creating new jobs usually follow in response to declining sales but based on the current state of employment this is clearly not the case. However, Powell has previously stressed that employment, while remaining an important factor in macroeconomic stability, is pushed to the background in terms of forecasting ability. Prolonged decline in unemployment and the weak inflation response in wages and consumer prices show that any obvious connection between them has been lost. Since the pursuit of inflation targets remains the primary task for the Fed, soft monetary policy can now occur simultaneously with the strengthening of the labor market.

By cutting the rate, the Fed will also have to get rid of the stigma of “Trump’s puppet”, since the possible easing of credit conditions will follow precisely Trump’s numerous reproaches that the Fed is holding rates too high.

Important point of the July meeting is the absence of updates on the dot plot, i.e. signal about the long-term plans of the officials. This speaks in favour of dry wordings a la “act as appropriate”, since Powell will have to explain only the “statement” in which officials usually interpret past changes.

Another factor restraining ability to ease policy – inflated stock market which recently renewed historical peaks. It is likely that Powell will again add the phrase about a slightly “stretched valuations”, which also rules out “big rate cut” scenario without obvious recession risks.

There are two days left before the meeting, however futures continue to price high chance of easing by 50 bp. – at 23%. With such expectations the rate cut by 25 bp and reiteration of “patient” stance with scant explanations should be a bullish surprise, what is my current baseline scenario. In this case, we should expect a positive dollar response to the meeting.

96

BoJ Takes Pause in opening New Season of “Cheap Money”, Complicating Decision for the Fed

Bank of Japan left the amount of monetary stimulus unchanged at the meeting on Tuesday, however, it signaled its readiness to cut rates and ramp up bond purchases significantly if the risks associated with global growth materialize in the domestic economy.

The bank’s decision carries little, if any surprise for the Yen as BoJ has been least successful in forecasting and pushing inflation to the target among its peers and the baseline case for its actions is unlimited assistance to the economy.

But with ECB hitting pause button once more before opening the “new season” of cheap money increases the likelihood that the Fed will take only a modest step towards easing, by only 25 basis points. However, the chance for aggressive rate cut by 50 bp continued to increase, reaching 27.1% on Tuesday. There is a growing conviction among investors that retail sales, GDP, employment and other “lagging” indicators should now worry the Fed less than a drop in corporate optimism and a squeeze of investment. Aggressive rate cut should be the necessary shock that can outweigh caution and distrust, fueled by trading tensions.

Years of low interest rates have eroded the margins of the banking sector in Japan, which brings the Japanese Central Bank to the limit of using non-traditional instruments, apart from inflation being immune to rapid expansion of money supply. For the Central Bank, it is also important to “preserve the ammunition” in the absence of Yen appreciation, which also paves the way for less dovish wordings. If the Fed’s decision causes a strengthening of the yen, the Bank of Japan may expand the horizon of policy guarantees (aka forward guidance) or allow the yields of 10-year bonds to move in a wider range, as was done earlier.

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BoJ’s policy stance in July hardly differs from June, but a new line appeared in the statement, which says that the Central Bank is ready to increase stimulus without any hesitation, if the chances that the inflationary momentum is lost, will grow. This is actually rephrasing of the notorious “whatever it takes” wording of Draghi we heard in 2013. But Yen has so far developed resilience to the dovish stunts of the BoJ.

The Japanese yen strengthened against the dollar by a quarter percent due to increased demand for safe assets, as well as return of Japanese investors “home” before the extremely uncertain outcome of tomorrow’s Fed meeting. Together with the yen, gold and the Swiss franc rose by 0.61% and 0.16%, respectively.

97

Trump Wasn’t Lying When he said that “China needs the deal more than me”

It seems that Trump wasn’t lying when he said that “China needs the deal more than me.” This time the distress signal came from the industrial sector in China, where profits declined at the fastest pace in eight months in October, what also didn’t live up to expectations of the seasonal autumn “bump”:

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Industrial profits fell 9.9% year on year, data showed on Wednesday. It was only worse in January-February of this year, when profits naturally fall due to the celebration of the Lunar New Year. In September, profit also turned out to be negative – -5.3%.

The “poisonous mix” for firms was deflation of production prices and rising borrowing costs, despite the efforts of the PBOC. This suggests that external demand for final goods fell, which affected the demand of these enterprises and also for intermediate goods, i.e. for raw materials. Credit impulses of the Central Bank, as a result, cannot get through “bottlenecks”, for example, increased risks of default on firms’ debts, which leads to a tightening of credit ratings. The “traditional channel” of shadow lending (that is, bypassing banks) cannot come to the rescue because of the government crackdown.

The production price index, which changes precede the changes in corporate profit, fell to the lowest level for three years in October. This was also reflected in the manufacturing PMI, where the downtrend has been going on for six months. The subcomponent of export orders has been declining for 17 consecutive months.

Last Tuesday, the NBK played in the big league and lowered the medium-term financing rate, for the first time in several years, since a consistent 7-fold decrease in the reserve ratio has little effect in terms of economy support.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 72% and 71% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

98

Gold – Does History Repeat Itself?

Gold price has extended buying momentum on Tuesday, developing the takeoff from $1,500 seen on Monday. I guess the explanation for the move lies primarily in the following chart:

As you might expect, I’m talking about inflation expectations in the United States. I also raised this topic in my yesterday post. Since last Friday, average expected inflation over the next five years has jumped from 0.86% to 1.23%. It is well known that gold and the inflation factor in pricing of the dollar are inversely related, which is based on the simple idea that an asset that loses its purchasing power should become cheaper in relation to the asset that retains it.

The latest jump in gold can be explained by the following factors:

Fundamentally determined weak prospects and an increased expected variance of returns on risky assets;
Rising concerns of inflation outbreak in the United States thanks to “unlimited” asset purchases by the Fed, which also expanded the range of securities to include corporate and municipal bonds and is now basically in “whatever it takes” mode;
Basic supply/demand change: expectations an increase in the money supply in the economy contributed to the currency weakness against other majors (including gold) which outweighed demand driven by “flight into cash” motive;
If you look at how gold behaved during and after the previous crisis, there are some parallels that we can draw:

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At that time, there were debates whether QE would lead to an acceleration in price growth or not, i.e. at the beginning of QE, there were expectations of this, which was priced in accordingly in the price of gold. I emphasize that QE’s novelty as a policy measure at that time was a volume of guaranteed bond purchases (the Fed achieves its interest rate targets by the same open market operations – treasury purchases that change supply of bank reserves). The novelty of the current measures, in my opinion, is in their volume again, which has potential to lead to similar gold response.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

99

Narrowing Range in Oil Could Suggest Sweeping Move on the Cards

Stock market euphoria, which is also expressed by a global dollar dump, does not resonate with crude oil: WTI trades in a narrowing range around the $23 mark, remaining unimpressed by the dollar weakness and rebound in risk assets:

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Such a pattern usually precedes a strong move and there are some reasons to expect the market to lose its temper. Government actions around the world are increasingly saying that countries are making bets on the experience of Wuhan in suppression of the outbreak – organizing home quarantine for at least two weeks. This is accompanied by serious short-term economic losses, including a drop in demand for fuel and a decrease in manufacturing and production activity because of forced decreased labor supply. This week the second most populated country in the world and the largest oil consumer, India, announced a 21-day full quarantine, which is likely to force experts to revise consumption forecast even more to the downside.

Data on Thursday showed that the number of initial unemployment claims in the US rose to a significant 3.3M. The response of the stock market showed that the downside surprise was quickly absorbed. The number of confirmed cases worldwide increased by 13.43% on Thursday compared with the previous day after several days of consistent decrease in the growth rate.
The head of the IEA Fatih Birol said that global oil demand is now “in a free fall”, and the glut is deepening due to the price war between Russia and Saudi Arabia. According to him, 3 billion people are locked down, as a result, oil demand may fall by 20 million barrels per day (almost 20%). Goldman gave similar depressing figures for March and April (10.5M b/d and 18.7M b/d) and it is clear that bigger and longer lockdowns should shave off more near-term consumption demand. That’s why “updated” EIA forecasts offer even gloomier view. In the near-term prices may be supported by the decision of the US government to restart economy earlier as Trump promised. Rumors about the move should be kept on the radar.

Oil trader Vitol Group expects that demand drop will accelerate over the next three months and will not fully recover this year.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

100

Investors Eye Unemployment Claims as the key Proxy of Stress of the US economy

Oil

Today we’ve seen relatively robust upward swing in oil as the market did not wait for negative news but were offered solid support thanks to a number of positive catalysts, including:

  • Rumors that China has started to fill strategic reserves taking advantage of the low oil price. The volume, duration, speed of purchases was not made public, so the news played out as a very general bullish catalyst.
  • Trump tweeted that Saudi Arabia and Russia may again commit themselves to coordination of oil supply. The deal, according to Trump, may take place in the coming days, which is consistent with reports that Trump held phone talks with President Putin during which they “discussed oil market.” It also became known that Trump invited US oil producers to the White House to discuss the situation, in addition, Texas companies turned to the state administration to discuss possible output cuts.
  • The Baltic Exchange data shows that the cost of transportation of US oil to China reached $10 per barrel, i.e. half the price of a barrel of the American benchmark WTI.

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Cheaper grades of oil in the US are currently trading at absurd prices for producers which is increasing chances that the market may soon be surprised with substantial output curbs.

  • At the same time, Saudi Arabia is not going to stop – kingdom production reportedly exceeded 12.5 million b/d, which, however, is not a surprise for the market.

U.S. dollar

The focus is now on the growth of unemployment due to self-isolation measures, with initial unemployment claims as the key proxy indicator. The estimated March reading is 3.7M (+ 400K compared to the March 21 print), but risks are skewed to the upside, since the number of regions where self-isolation regime have been introduced is rising rapidly while it is difficult to calculate precise figures due to difficulties of Labor Department in processing a huge inflow of applications. More than 80% of Americans are now in some way affected by quarantine measures.

Huge spending package from the government which includes unemployed benefit of $680 per week (or 17 per hour for 40-hour week) may contribute to the growth of “intended unemployment” which is an unwelcome consequence of emergency fiscal stimulus that can hamper rebound of labor supply after quarantine measures are lifted. Dollar is expected to move lower after the release pricing in growing weakness of the US economy.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

101

Is it Late to go Long in Gold? Real Interest Rate Path in the US Suggests “no”

The first signs of consistency appear in the decrease of the number of confirmed cases of Covid-19. The whole near-term market optimism hinges on that trend so it’s worth to keep a watchful eye on it. Following the abrupt daily drop in the number of new cases from peak 98135 to 75956 on April 5, it fell the second day in a row to 68608, extending relief rally in world stock markets today:

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Asian stocks have ended session in green, key European indices advanced by an average of 5%. US stock index futures have been also trading higher on Tuesday. Thanks to upbeat sentiments in the oil market, it is very likely that the bullish momentum in EM including Russia will be extended for the rest of today’s trading session. The ruble is expected to continue to strengthen with the main goal of 75 rubles per dollar, passing intermediate support without much effort.

Some questions are caused by the rise of gold coexisting with the rally of stocks which are considered to be the asset classes reacting to opposite market sentiments. But taking a look at the dynamics of TIPS yield (yield on inflation-protected treasury bonds), we can see that the real interest rate in the US seems to play a big role in gold pricing currently.

The real interest rate (nominal rate minus expected inflation) and gold are inversely related, since the decrease in the first reflects the deterioration of investment alternatives in the economy and decrease in the purchasing power of money (inflation), while gold serves as protection for all of this.

The nominal interest rate is likely to linger for longer near the zero level due to cautious Fed unwilling to touch the interest rate, while enormous fiscal incentives from the government should have strong inflationary effect (due to the fact that the money will also fall into the hands of the poor which have much higher propensity to consume). The real interest rate will probably decrease further and based on the dependence above, the likelihood of gold extending the rally is pretty high, making it attractive medium-term bet.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.