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Submitted by Tyler Durden on 10/03/2015

Global Dollar Funding Shortage Intensifies To Worst Level Since 2012

The last time we observed one of our long-standing favorite topics (first discussed in early 2009), namely the global USD-shortage which manifests itself in times of stress when the USD surges against all foreign currencies and forces even the BIS and IMF to notice, was in March of this year, when we explained that "unlike the last time, when the global USD funding shortage was entirely the doing of commercial banks, this time it is the central banks' own actions that have led to this global currency funding mismatch - a mismatch that unlike 2008, and 2011, can not be simply resolved by further central bank intervention which happen to be precisely the reason for the mismatch in the first place."

Furthermore JPM conveniently noted that "given the absence of a banking crisis currently, what is causing negative basis? The answer is monetary policy divergence. The ECB’s and BoJ’s QE coupled with a chorus of rate cuts across DM and EM central banks has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections and rate cuts raising the supply of euro and other currency funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis."

To which we rhetorically added: "who would have ever thought that a stingy Fed could be sowing the seeds of the next financial crisis (don't answer that rhetorical question)."

All this was happening when the market was relentlessly soaring to all time highs, completely oblivious of this dramatic dollar shortage, which just a few months later would manifest itself quite violently first in the Chinese devaluation and sale of Treasurys, and then in the unprecedented capital outflow from emerging markets as the great petrodollar trade - just as we warned in November of 2014 - went into reverse. In fact, there are very few now who do not admit the Fed is responsible for both the current cycle of soaring volatility, or what may be a market crash (as DB just warned) should the Fed not take measures to stimulate "inflation expectations" (read: more easing).

In any event, since March we have received numerous requests for follow-up of where said funding shortage is now. So here are the latest observations on the current level of the global dollar funding shortage as measured by the Dollar fx basis, courtesy of JPM:

The dollar fx basis declined further over the past two months. The 5-year dollar fx basis weighted across six DM currencies declined to a new  low for the year and the lowest level since the summer of 2012 during the euro debt crisis.

In other words: the USD funding shortage is even worse than it was when we looked at it in March, it still is a function of conflicting central bank liquidity flows, and while not as bad as it was at its all time worst levels in late 2011, it is slowly but surely getting there with every passing week that the Fed does not ease monetary conditions. 

A brief history of the three key periods of global USD-funding shortfalls:

  • The first episode immediately after the Lehman bankruptcy coincided with a US banking crisis that quickly became a global banking crisis via cross border linkages. Financial globalization meant that Japanese banks had accumulated a large amount of dollar assets during the 1980s and 1990s. Similarly European banks accumulating a large amount of dollar assets during 2000s created structural US dollar funding needs. The Lehman crisis made both European and Japanese banks less creditworthy in dollar funding markets and they had to pay a premium to convert euro or yen funding into dollar funding as they were unable to access dollar funding markets directly.
  • The second episode of very negative dollar basis took place during the Euro debt crisis. The sovereign crisis created a banking crisis making Euro area banks less worthy from a counterparty/credit risk point of view in dollar funding markets. As dollar funding markets including fx swap markets dried up, these funding needs took the form of an acute dollar shortage. European banks and companies that had dollar assets to fund had to pay a hefty premium in fx swap markets to convert their euro funding into dollar funding. Those European banks and companies that were unable to do so, were forced to liquidate dollar assets such as dollar denominated bonds and loans to reduce their need for dollar funding
  • The third phase of very negative dollar basis started at the end of last year. Monetary policy divergence has for sure played a role during the end of 2014 and the beginning of this year. The ECB’s and BoJ’s QE has created an imbalance between supply and demand across funding markets. Funding conditions have become a lot easier outside the US with QE-driven liquidity injections raising the supply of euro and yen funding vs. dollar funding. This divergence manifested itself as one-sided order flow in cross currency swap markets causing a decline in the basis. And we did see these funding imbalances in cross border corporate issuance.

More from JPM:

Similar to the beginning of this year, the decline in the dollar fx basis is raising questions regarding shortage in dollar funding. This is because the fx basis reflects the relative supply and demand for dollar vs. foreign currency funds and an even more negative basis currently points to more intense shortage of USD funding relative to the beginning of the year.

Figure 5 shows that the current negativity of the dollar fx basis represents the third major episode since the Lehman crisis. Before the Lehman crisis the fx basis was remarkably stable hovering around zero as funding markets were well balanced. After the Lehman crisis, funding markets experienced persistent imbalances with an almost structural shortage of dollar funding.

This is how it looks now:

The conclusion:

In all, continued monetary policy divergence between the US and the rest of the world as well as retrenchment of EM corporates from dollar funding markets are sustaining an imbalance in funding markets making it likely that the current episode of dollar funding shortage will persist.

What does this mean in simple terms? Think back to what David Tepper said several weeks ago on CNBC when, contrary to popular opinion, he admitted he was bearish on risk assets mostly as a result of the "reserve streams" going in two different ways. This is precisely what the dollar shortage as quantified by the negative dollar basis is telling us: the policy divergence between the "tight" Fed and the ultra loose ECB and BOJ is starting to reach extreme levels, and will likely continue until the basis blows out to its theoretical limit of -50bps as set by the Fed-ECB swap line.

At that point either the Fed will be forced to admit it was beaten by the market, and either cut rates (to negative) while perhaps unleashing even more QE to offset the monetary imbalance with the rest of the world, or it will once again engage in even more swap lines with foreign central banks as the dollar funding shortage moves beyond simply synthetic and into an actual shortage of USD "bills" all in electronic credit format of course, because as we further explained last week, it is simply impossible to satisfy all global USD-denominated claims.

 

MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Nov. 1st, 2015 - Nov 7th, 2015      
BOND BUBBLE     1
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates     2
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates 10-29-15 GLOBAL RISK SIGNALS 2
GEO-POLITICAL EVENT     3
CHINA BUBBLE     4
CHINA BUBBLE     4

 

One Analyst Says China's Banking Sector Is Sitting On A $3 Trillion Neutron Bomb

Tue, 03 Nov 2015

To be sure, we’ve long contended that official data on bad loans at Chinese banks is even less reliable than NBS GDP prints. Indeed, the lengths Beijing goes to in order to obscure the extent to which banks’ balance sheets are in peril is truly something to behold and much like the deficient deflator math which may be causing the country to habitually overstate GDP growth, it’s not even clear that China could report the real numbers if it wanted to. 

We took an in-depth look at the problem in “How China's Banks Hide Trillions In Credit Risk: Full Frontal”, and we’ve revisited the issue on a number of occasions noting in August that according to a transcript of an internal meeting of the China Banking Regulatory Commission, bad loans jumped CNY322.2 billion in H1 to CNY1.8 trillion, a 36% increase. Of course that’s just the tip of the iceberg. In other words, that comes from a government agency and although the scope of the increase sounds serious, it still translates into an NPL ratio of just 1.82%. Here’s a look at the “official” numbers (note that when one includes doubtful accounts, the ratio jumps to somewhere in the neighborhood of 3-4%):

Source: Fitch

There are any number of reasons why those figures don’t even come close to approximating reality. For instance, there’s Beijing’s habit of compelling banks to roll over bad loans, and then there’s China’s massive (and by “massive” we mean CNY17 trillion) wealth management product industry which, when coupled with some creative accounting, allows Chinese banks to hold some 40% of credit risk off balance sheet.

Well as time goes on, and as market participants scrutinize the data coming out of the world’s second most important economy, quite a few analysts are beginning to take a closer look at the NPL data for Chinese banks. Indeed, if Beijing continues to move toward “allowing” defaults to occur (even at SOEs) and if China’s transition from smokestack economy to a consumption and services-driven model continues to put pressure on borrowers from the manufacturing sector, the situation is likely to deteriorate quickly. If you needed evidence of just how precarious things truly are, look no further than a recent report from Macquarie which showed that a quarter of Chinese firms with debt are currently unable to cover their annual interest expense (as you might imagine, it's even worse for commodities firms). 

Just two weeks after we highighted the Macquarie report, we took a look at research conducted by Hong-Kong based CLSA. Unsurprisingly, it turns out that Chinese banks' bad debts ratio could be as high 8.1%, a whopping 6 times higher than the official 1.5% NPL level reported by China's banking regulator. 

We called that revelation China's "neutron bomb" but it turns out we may have jumped the gun. According to Hong Kong-based "Autonomous Research", the real figure may be closer to 21% when one takes into account the aforementioned shadow banking sector. Here's more from Bloomberg:

Corporate investigator Violet Ho never put a lot of faith in the bad loan numbers reported by China’s banks.

Crisscrossing provinces from Shandong to Xinjiang, she’s seen too much -- from the shell game of moving assets between affiliated companies to disguise the true state of their finances to cover-ups by bankers loath to admit that loans they made won’t be recovered.

The amount of bad debt piling up in China is at the center of a debate about whether the country will continue as a locomotive of global growth or sink into decades of stagnation like Japan after its credit bubble burst. Bank of China Ltd. reported on Thursday its biggest quarterly bad-loan provisions since going public in 2006.

Charlene Chu, who made her name at Fitch Ratings making bearish assessments of the risks from China’s credit explosion since 2008, is among those crunching the numbers.

While corporate investigator Ho relies on her observations from hitting the road, Chu and her colleagues at

Autonomous Research in Hong Kong take a top-down approach. They estimate how much money is being wasted after the nation began getting smaller and smaller economic returns on its credit from 2008. Their assessment is informed by data from economies such as Japan that have gone though similar debt explosions.

While traditional bank loans are not Chu’s prime focus -- she looks at the wider picture, including shadow banking -- she says her work suggests that nonperforming loans may be at 20 percent to 21 percent, or even higher.


“A financial crisis is by no means preordained, but if losses don’t manifest in financial sector losses, they will do so via slowing growth and deflation, as they did in Japan,” said Chu. “China is confronting a massive debt problem, the scale of which the world has never seen.”

As a reminder, here's a look at the scope of the "problem" Chu is describing:

 

And here's a bit more on special mention loans and the ubiquitous practice of "evergreening":

Slicing and dicing the official loan numbers, Christine Kuo, a senior vice president of Moody’s Investors Service in Hong Kong, focuses on trends in debts overdue for 90 days, rather than those classified as “nonperforming.” Another tactic some analysts use is to add nonperforming debt to “special mention” loans, those that are overdue but not yet classified as impaired, yielding a rate of 5.1 percent.

Banks’ bad-loan numbers are capped by “evergreening,” the practise of rolling over debt that isn’t repaid on time, according to experts including Keith Pogson, a Hong Kong-based senior partner at Ernst & Young LLP. Pogson was involved in restructuring debt at Chinese banks in 1998, when their NPL ratios were as high as 25 percent.

So let's just be clear: if 8% is a "neutron bomb", a 21% NPL ratio in China is the asteroid that killed the dinosaurs. Here's why: 

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion. 

That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven't done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall. 

In the end, we would actually venture to suggest that the real figure is probably far higher than 20%. There's no way to get a read on how the country's vast shadow banking complex plays into this but when you look at the numbers, it's almost inconceivable to imagine that banks aren't staring down sour loans at least on the order of a couple of trillion. 

To the PBoC we say, "good luck plugging that gap" and to the rest of the world we say "beware, the engine of global growth and trade may be facing a pile of bad loans the size of Germany's GDP."

We close with the following from Kroll's senior managing director in Hong Kong Violet Ho (quoted above):

"A credit report for a Chinese company is not worth the paper it’s written on.”

 

Did Something Just Snap In China: Total SOE Debt Rises By $1 Trillion In One Month

Tue, 03 Nov 2015

We found something unexpected when skimming through the website of China's finance ministry.

While most China pundits keep close track of China's monthly loan creation and, especially these days, its Total Social Financing number to get a sense of what, if any, credit is being created outside of conventional lending channels within China's shadow banking system, one just as critical please to keep track of Chinese credit is the monthly report on national state-owned and state holding enterprises. 

Such as this one from October 22, which reports that as of September 30, total liabilities of state-owned enterprises had risen to 77.7 trillion yuan. Why is this notable? Because the monthly update just preceding it,reported a total debt figure of "only" 71.8 trillion yuan: a whopping increase of almost CNY 6 trillion, or USD $1 trillion, in just one month.

This is the biggest monthly increase by a massive margin among China's SOE by orders of magnitude, and yet just to get a sense of the magnitude of debt held at China's SOEs, even this record monthly increase is not even 10% of the total debt held by China's state-owned enterprises which stood at CNY78 trillion or USD $12 trillion at the end of September, more than the total Chinese GDP.

What can explain this snap? There has been very little commentary on this particular surge aside from a report posted on Wall Street.cn, and translated by Chiecon, which reports the following:

China’s state owned enterprises added almost 6 trillion yuan (around 1 trillion dollars) of debt in September, described by Luo Yunfeng, an analyst at Essence Securities, as “an unprecedented increase in leverage”. This means that not only is the government abandoning its deleverage policy, it is actually increasing leverage.

According to Luo “it’s possible that debt that was originally classified as government debt, has been reallocated as SOE debt”.

This might be a reflection of how the government plans to tackle its massive debt. Luo mentions that one of the obstacles to managing government debt is that it remains difficult to draw a line between government and SOE debt. The crux of of current reform plans to increase the role of market forces is aimed at resolving this issue.

If it really is the case of shifting government debt to SOEs, then it represents a step forward for this reform, and the prospect of revaluing credit risk. Another implication, it seems unlikely there will be a pause in government debt increase over the fourth quarter.

This raises the more important question of what will be the impact of this enormous debt? Over the past few years credit expansion has surpassed economic growth, and with the governments aggressive leverage, will this lead to a greater waste of resources?

Ironically, "shifting" the debt - no matter how troubling - would be by far the more palatable explanation. Because if somehow China had quietly "created" $1 trillion in debt out of thin air parked subsequently on SOE balance sheets, that would suggest that things in China are orders of magnitude worse than anyone can possibly imagine.

Still, if China did not create this debt now, it will eventually:

This raises the more important question of what will be the impact of this enormous debt? Over the past few years credit expansion has surpassed economic growth, and with the governments aggressive leverage, will this lead to a greater waste of resources?

[W]ith China experiencing slowing economic growth, and no turnaround on the horizon, its seems likely the Chinese government will continue to increase leverage. In September, China Merchants Securities stated that since Chinese government debt leverage ratio is still low, lower than the US, Europe and Japan, there is still more room for leverage.

It's low? Really? Because according to the following McKinsey chart total Chinese debt was $28.2 trillion as of Q2 2014 (it has since risen well over $30 trillion), and represents nearly 300% debt/GDP.

But there is another implication. If China's is indeed merely stuffing government debt on SOE balance sheets as the report suggests...

Haitong Securities said at the start of the year that in order to prevent systemic risk the focus over the next few years will be on government leverage. Based on the experience of other countries, monetary easing almost certainly follows an increase in government leverage, with interest rates in the long term trending to zero.

... then China, while ultimately having to engage in QE, will last out the current regime as long as possible, offloading government debt in ever greater amounts to SOE until finally their debt capacity is maxed out.

Then, and only then, will China unleash the world's last remaining debt monetization episode, whereby the PBOC will proceed to openly monetize the roughly $3-4 trillion in total debt China creates every year. At that point the "Minsky Moment" of not only China, but the entire world, will have arrived.

JAPAN - DEBT DEFLATION     5

EU BANKING CRISIS

   

6

GLOBAL GROWTH - Shrinking Revenue Growth Rate

   

8 - Shrinking Revenue Growth Rate

Submitted on 11/04/2015 Submitted by Gail Tverberg via Our Finite World blog,

How The Global Debt Bubble Is Crushing Commodity Prices

Submitted by Gail Tverberg via Our Finite World blog,

Why is the price of oil so low now? In fact, why are all commodity prices so low? I see the problem as being an affordability issue that has been hidden by a growing debt bubble. As this debt bubble has expanded, it has kept the sales prices of commodities up with the cost of extraction (Figure 1), even though wages have not been rising as fast as commodity prices since about the year 2000. Now many countries are cutting back on the rate of debt growth because debt/GDP ratios are becoming unreasonably high, and because the productivity of additional debt is falling.

If wages are stagnating, and debt is not growing very rapidly, the price of commodities tends to fall back to what is affordable by consumers. This is the problem we are experiencing now (Figure 1).

Figure 1. Author's illustration of problem we are now encountering.

Figure 1. Author’s illustration of problem we are now encountering

I will explain the situation more fully in the form of a presentation. It can be downloaded in PDF form: Oops! The world economy depends on an energy-related debt bubble.

*  *  *

Let’s start with the first slide, after the title slide.

Slide 2

Slide 2

Growth is incredibly important to the economy (Slide 2). If the economy is growing, we keep needing to build more buildings, vehicles, and roads, leading to more jobs. Existing businesses find demand for their products rising. Because of this rising demand, profits of many businesses can be expected to rise over time, thanks to economies of scale.

Something that is not as obvious is that a growing economy enables much greater use of debt than would otherwise be the case. When an economy is growing, as illustrated by the ever-increasing sizes of circles, it is possible to “borrow from the future.” This act of borrowing gives consumers the ability to buy more things now than they would otherwise would be able to afford–more “demand” in the language of economists. Customers can thus afford cars and homes, and businesses can afford factories. Companies issuing stock can expect that price of shares will most likely rise in the future.

Without economic growth, it would be very hard to have the financial system that we have today, with its stable banks, insurance companies, and pension plans. The pattern of economic growth makes interest and dividend payments easier to make, and reduces the likelihood of debt default. It allows financial planners to set up savings plans for retirement, and gives people confidence that the system will “be there” when it is needed. Without economic growth, debt is more of a last resort–something that might land a person in debtors’ prison if things go wrong.

Slide 3

Slide 3

It should be obvious that the economic growth story cannot be true indefinitely. We would run short of resources, and population would grow too dense. Pollution, including CO2 pollution, would become an increasing problem.

Slide 4

Slide 4

The question without an obvious answer is “When does the endless economic growth story become untrue?” If we listen to the television, the answer would seem to be somewhere in the distant future, if a slowdown in economic growth happens at all.

Most of us who read financial newspapers are aware that more debt and lower interest rates are the types of stimulus provided to the economy, to try to help it grow faster. Our current “run up” in debt seems to have started about the time of World War II. This growing debt allows “demand” for goods like houses, cars, and factories to be higher. Because of this higher demand, commodity prices can be higher than they otherwise would be.

Thus, if debt is growing quickly enough, it allows the sales price of energy products and other commodities to stay as high as their cost of extraction. The problem is that debt/GDP ratios can’t rise endlessly. Once debt/GDP ratios stop rising quickly enough, commodity prices are likely to fall. In fact, the run-up in debt is a bubble, which is itself in danger of collapsing, because of too many debt defaults.

Slide 5

Slide 5

The economy is made up of many parts, including businesses and consumers. The consumers have a second role as well–many of them are workers, and thus get their wages from the system. Governments have many roles, including providing financial systems, building roads, and providing laws and regulations. The economy gradually grows and changes over time, as new businesses are added, and others leave, and as laws change. Consumers make their decisions based on available products in the marketplace and they amount they have to spend. Thus, the economy is a self-organized networked system–see my post Why Standard Economic Models Don’t Work–Our Economy is a Network.

One key feature of a self-organized networked system is that it tends to grow over time, as more energy becomes available. As its grows, it changes in ways that make it difficult to shrink back. For example, once cars became the predominant method of transportation, cities changed in ways that made it difficult to go back to using horses for transportation. There are now not enough horses available for this purpose, and there are no facilities for “parking” horses in cities when they are not needed. And, of course, we don’t have services in place for cleaning up the messes that horses leave.

Slide 6

Slide 6

When businesses start, they need capital. Very often they sell shares of stock, and they may get loans from banks. As companies grow and expand, they typically need to buy more land, buildings and equipment. Very often loans are used for this purpose.

As the economy grows, the amount of loans outstanding and the number of shares of stock outstanding tends to grow.

Slide 7

Slide 7

Businesses compete by trying to make goods and services more efficiently than the competition. Human labor tends to be expensive. For example, a sweater knit by hand by someone earning $10 per hour will be very expensive; a sweater knit on a machine will be much less expensive. If a company can add machines to leverage human labor, the workers using those machines become more productive. Wages rise, to reflect the greater productivity of workers, using the machines.

We often think of the technology behind the machines as being important, but technology is only part of the story. Machines reflecting the latest in technology are made using energy products (such as coal, diesel and electricity) and operated using energy products. Without the availability of affordable energy products, ideas for inventions would remain just that–simply ideas.

The other thing that is needed to make technology widely available is some form of financing–debt or equity financing. So a three-way partnership is needed for economic growth: (1) ideas for inventions, (2) inexpensive energy products and other resources to make them happen, and (3) some sort of financing (debt/equity) for the undertaking. 

Workers play two roles in the economy; besides making products and services, they are also consumers. If their wages are rising fast enough, thanks to growing efficiency feeding back as higher wages, they can buy increasing amounts of goods and services. The whole system tends to grow. I think of this as the normal “growth pump” in the economy.

If the “worker” growth pump isn’t working well enough, it can be supplemented for a time by a “more debt” growth pump. This is why debt-based stimulus tends to work, at least for a while.

Slide 8

Slide 8

There are really two keys to economic growth–besides technology, which many people assume is primary. One key is the rising availability of cheap energy. When cheap energy is available, businesses find it affordable to add machines and equipment such as trucks to allow workers to be more productive, and thus start the economic growth cycle.

The other key is availability of debt, to finance the operation. Businesses use debt, in combination with equity financing, to add new plants and equipment. Customers find long-term debt helpful in financing big-ticket items such as homes and cars. Governments use debt for many purposes, including “stimulating the economy”–trying to get economic growth to speed up.

Slide 9

Slide 9

Slide 9 illustrates how workers play a key role in the economy. If businesses can create jobs with rising wages for workers, these workers can in turn use these rising wages to buy an increasing quantity of goods and services.

It is the ability of workers to afford goods like homes, cars, motorcycles, and boats that helps the economy to grow. It also helps to keep the price of commodities up, because making these goods uses commodities like iron, steel, copper, oil, and coal.

Slide 10

Slide 10

In the 1900 to 1998 period, the price of electricity production fell (shown by the falling purple, red, and green lines) as the production of electricity became more efficient. At the same time, the economy used an increasing quantity of electricity (shown by the rising black line). The reason that electricity use could grow was because electricity became more affordable. This allowed businesses to use more of it to leverage human labor. Consumers could use more electricity as well, so that they could finish tasks at home more quickly, such as washing clothes, leaving more time to work outside the home.

Slide 11

Slide 11

If we compare (1) the amount of energy consumed worldwide (all types added together) with (2) the world GDP in inflation-adjusted dollars, we find a very high correlation.

Slide 12

Slide 12

In Slide 12, GDP (represented by the top line on the chart–the sum of the red and the blue areas) was growing very slowly back in the 1820 to 1870 period, at less than 1% per year. This growth rate increased to a little under 2% a year in the 1870 to 1900 and 1900 to 1950 periods. The big spurt in growth of nearly 5% per year came in the 1950 to 1965 period. After that, the GDP growth rate has gradually slowed.

On Slide 12, the blue area represents the growth rate in energy products. We can calculate this, based on the amount of energy products used. Growth in energy usage (blue) tends to be close to the total GDP growth rate (sum of red and blue), suggesting that most economic growth comes from increased energy use. The red area, which corresponds to “efficiency/technology,” is calculated by subtraction. The period of time when the efficiency/technology portion was greatest was between 1975 and 1995. This was the period when we were making major changes in the automobile fleet to make cars more fuel efficient, and we were converting home heating to more fuel-efficient heating, not using oil.

Slide 13

Slide 13

If we look at economic growth rates and the growth in energy use over shorter periods, we see a similar pattern. The growth in GDP is a little higher than the growth in energy consumption, similar to the pattern we saw on Slide 12.

If we look carefully at Slide 13, we see that changes in the growth rate for energy (blue line) tends to happen first and is followed by changes in the GDP growth rate (red line). This pattern of energy changes occurring first suggests that growth in the use of energy is a cause of economic growth. It also suggests that lack of growth in the use of energy is a reason for world recessions. Recently, the rate of growth in the world’s consumption of energy has dropped (Slide 13), suggesting that the world economy is heading into a new recession.

Slide 14

Slide 14

There is nearly always an investment of time and resources, in order to make something happen–anything from the growing of food to the mining of coal. Very often, it takes more than one person to undertake the initial steps; there needs to be a way to pay the other investors. Another issue is the guarantee of payment for resources gathered from a distance.

Slide 15

Slide 15

We rarely think about how all-pervasive promises are. Many customs of early tribes seem to reflect informal rules regarding the sharing of goods and services, and penalties if these rules are not followed.

Now, financial promises have to some extent replaced informal customs. The thing that we sometimes forget is that the bonds companies offer for sale, and the stock that companies issue, have no value unless the company issuing the stock or bonds is actually successful.  As a result, the many promises that are made are, in a sense, contingent promises: the bond will be repaid, if the company is still in business (or if the company is dissolved, if the amount received from the sale of assets is great enough). The future value of a company’s stock also depends on the success of the company.

Slide 16

Slide 16

Governments become an important part of the web of promises. Governments collect their assessments through taxes. As an economy grows, the amount of government services tends to increase, and taxes tend to increase.

The roles of governments and businesses vary somewhat depending on the type of economy of a country. In a sense, this type of variation is not important. It is the functioning of the overall networked system that is important.

Slide 17

Slide 17

There was a very large run up in US debt about the time of World War II, not just in the US, but also in the other countries involved in World War II.

Adding the debt for World War II helped pull the US out of the lingering effects of the Depression. Many women started working outside the home for the first time. There was a ramp-up of production, aimed especially at the war effort.

What does a country do when a war is over? Send the soldiers back home again, without jobs, and the women who had been working to support the war effort back home again, also without jobs? This was a time period when non-government debt ramped up in the US. In fact, it seems to have ramped up elsewhere around the world as well. The new debt helped support many growing industries at the time–helping rebuild Europe, and helping build homes and cars for citizens in the US. As noted previously, both energy use and GDP soared during this time period.

Slide 19

Slide 19

I haven’t found very good records of debt going back very far, but what I can piece together suggests that the rate of debt growth (total debt, including both government and private debt) was similar to the rate of growth of GDP, up until about 1975. Then, debt began growing much more rapidly than GDP.

Slide 20

Slide 20

The big issue that led to a big increase in the need for debt in the early 1970s was an increase in the price of oil. Oil is the single largest source of source of energy. It is used in many important ways, including making food, transporting coal, and extracting metals. Thus, when the price of oil rises, so does the price of many other goods.

As we noted on Slides 11, 12, and 13, it is the growing quantity of energy consumption that is important in providing economic growth. The natural tendency with high energy prices is to cut back on energy-related consumption. Increasing debt, if it is at a sufficiently low interest rate, helps counteract this natural tendency toward less energy usage. For example, the availability of debt at a low interest makes it possible for more consumers to purchase big-ticket items like houses, cars, and motorcycles. These products indirectly lead to the growing consumption of energy products, because energy is used in making these big-ticket items and because they use energy in their continuing operation.

Slide 21

Slide 21

Many people have been concerned about what they call “peak oil”–the idea that oil supply would suddenly drop because we reach geological limits. I think that this is a backward analysis regarding how the system works. There is plenty of oil available, if only the price would rise high enough and stay high for long enough.

Much of this oil is non-conventional oil–oil that cannot be extracted using the inexpensive approaches we used in the early days of oil production. In some cases, non-conventional oil is so viscous it needs to be melted with steam, before it will flow freely. Some of the unconventional oil can only be extracted by “fracking.” Some of the unconventional oil is very deep under the ocean. Near Brazil, this oil is under a layer of salt. If prices would remain high enough, for long enough, we could get this oil out.

The problem is that in order to get this unconventional oil out, costs are higher. These higher costs are sometimes described as reflecting diminishing returns–more capital goods are needed, as are more resources and human labor, to produce additional barrels of oil. The situation is equivalent to the system of oil extraction becoming less and less efficient, because we need to add more steps to the operation, raising the cost of producing finished oil products. The higher price of oil products spills over to a higher cost for producing food, because oil is used in operating farm equipment and transporting food to market. The higher cost of oil also spills over to the cost of almost anything that is shipped long distance, because oil is used as a transportation fuel.

You will remember that increased efficiency is what makes an economy grow faster (Slide 7, also Slide 37). Diminishing returns is the opposite of increased efficiency, so it tends to push the economy toward contraction. We are running into many other forms of increased inefficiency. One such type of inefficiency involves adding devices to reduce pollution, for example in electricity production. Another type of inefficiency involves switching to higher-cost methods of generation, such as solar panels and offshore wind, to reduce pollution. No matter how beneficial these techniques may be from some perspectives, from the perspective of economic growth, they are a problem. They tend to make the economy grow more slowly, rather than faster.

The standard workaround for slow economic growth is more debt. If the interest rate is low enough and the length of the loan is long enough, consumers can “sort of” afford increasingly expensive cars and homes. Young people with barely adequate high school grades can “sort of” afford higher education. With cheap debt, businesses can afford to buy back company stock, making reported earnings per share rise–even though after the buy-back, the actual investment used to generate future earnings is lower. With sufficient cheap debt, shale companies can create models showing that even if their cash flow is negative at $100 per barrel oil prices ($2 out for $1 in) and even more negative at $50 per barrel ($4 out for $1 in), somehow, the companies will be profitable in the very long run.

The technique of adding more debt doesn’t fix the underlying problem of growing inefficiency, instead of growing efficiency. Instead, as more debt is added, the additional debt becomes increasingly unproductive. It mostly provides a temporary cover-up for economic growth problems, rather than fixing them.

Slide 22

Slide 22

A common belief has been that as we reach limits of a finite world, oil prices and perhaps other prices will spike. In my view, this is a wrong understanding of how things work.

What we have is a combination of rising costs of production for many kinds of goods at the same time that wages are not rising very quickly.  This problem can be temporarily hidden by a rising amount of debt at ever-lower interest rates, but this is not a long-term solution.

We end up with a conflict between the prices businesses need and the prices that workers can afford. For a while, this conflict can be resolved by a spike in prices, as we experienced in the 2005-2008 period. These spikes tend to lead to recession, for reasons shown on the next slide. Recession tends to lead to lower prices again.

Slide 26

Slide 26

The image on Slide 26 shows an exaggeration to make clear the shift that takes place, if the price of oil spikes. When the price of one necessary part of consumers’ budgets increases–namely the food and gasoline segment–there is a problem. Debt payments already committed to, such as those on homes and automobiles, remain constant. Consumers find that they must cut back on discretionary spending–in other words, “Everything else,” shown in green. This tends to lead to recession.

Slide 27

Slide 27

If we look at oil prices since 2000, we see that the period is marked by steep rises and falls in oil prices. In Slides 27 – 29, we will see that changes in the price of oil tend to correspond to changes in debt availability and cost.

In 2008, oil prices rose to a peak in July, and then dropped precipitously to under $40 per barrel in December of the same year. Slide 27 shows that the United States began its program of Quantitative Easing (QE) in late 2008. This helped to lower interest rates, especially longer-term interest rates. China and a number of other countries also raised their debt levels during this period. We would expect greater debt and lower interest rates to increase demand for commodities, and thus raise their prices, and in fact, this is what happened between December 2008 and 2011.

The drop in prices in 2014 corresponds to the time that the US phased out its program of QE, and China cut back on debt availability. Here, the economy is encountering less cheap debt availability, and the impact is in the direction expected–a drop in prices.

If we go back to the steep drop in oil prices in July 2008, we find that the timing of the drop in prices matches the timing when US non-governmental debt started falling. In my academic article, Oil Supply Limits and the Continuing Financial Crisis, I show that this drop in debt outstanding takes place for both mortgages and credit card debt.

Slide 29

Slide 29

The US government, as well as other governments around the world, responded by sharply increasing their debt levels. This increase in governmental debt (known as sovereign debt) is part of what helped oil and other commodity prices to rise again after 2008.

Slide 30

Slide 30

We often hear about the drop in oil prices, but the drop in prices is far more widespread. Nearly all commodities have dropped in price since 2011. Today’s commodity price levels are below the cost of production for many producers, for all of these types of commodities. In fact, for oil, there is hardly any country that can produce at today’s price level, even Saudi Arabia and Iraq, when needed tax levels by governments are considered as well.

Producers don’t go out of business immediately. Instead, they tend to “hold on” as best they can, deferring new investment and trying to generate as much cash flow as possible. Because most of them have no alternative way of making a living, they often continue producing, as best they can, even with low prices, deferring the day of bankruptcy as long as possible. Thus, the glut of supply doesn’t go away quickly. Instead, low prices tend to get worse, and low prices tend to persist for a very long period.

Slide 31

Slide 31

In 2008, we had an illustration of what can go wrong when the economy runs into too many headwinds. In that situation, the price of oil and other commodities dropped dramatically.

Now we have a somewhat different set of headwinds, but the impact is the same–the price of commodities has dropped dramatically. Wages are not rising much, so they are not providing the necessary uplift to the economy. Without wage growth, the only other approach to growing the economy is debt, but this reaches limits as well. See my post, Why We Have an Oversupply of Almost Everything (Oil, labor, capital, etc.)

There is some evidence that the Great Depression in the 1930s involved the collapse of a debt bubble. It seems to me that it may very well have also involved wages that were falling in inflation-adjusted terms for a significant number of wage-earners. I say this, because farmers were moving to the city in the early 1900s, as mechanization led to lower prices for food and less need for farmers. I haven’t seen figures on incomes of farmers, but I wouldn’t be surprised if they were dropping as well, especially for the many farmers who couldn’t afford mechanization. Wages for those who wanted to work as laborers on farms were likely also dropping, since they now needed to compete with mechanization.

In many ways, the situation that led up to the Great Depression appears to be not too different from our situation today. In the early 1900s, many farmers were being displaced by changes to agriculture. Now, wages for many are depressed, as workers in developed economies increasingly compete with workers in historically low-wage countries. Additional mechanization of manufacturing also plays a role in reducing job opportunities.

If my conjecture is right, the Great Depression may have been caused by problems similar to what we are seeing today–wages that were too low for a large segment of the economy, thus reducing economic growth, and a temporary debt bubble that tended to cover up the wage problem. Once the debt bubble collapsed, demand for commodities of all types collapsed, and prices collapsed. This problem was very difficult to fix.

Slide 32

Slide 32

When we add more debt to the economy, users of debt-financing find that more of their future income goes toward repaying that debt, cutting off the ability to buy other goods. For example, a young person with a large balance of student loans is unlikely to be able to afford buying a house as well.

A way of somewhat mitigating the problem of too much income going toward debt repayment is lowering interest rates. In fact, in quite a few countries, the interest rates governments pay on debt are now negative.

Slide 33

Slide 33

If the cost of producing commodities continues to rise, but the price that consumers can afford to pay does not rise sufficiently, at some point there is a problem. Instead of continuing to rise, prices start to fall below their cost of production. This drop can be very sharp, as it was in 2008.

The falling price of commodities is the same situation we encountered in 2008 (Slide 27); it is the same situation we reached at the beginning of the Great Depression back in 1929. It seems to happen when wage growth is inadequate, and the debt level is not growing fast enough to hide the inadequate wage growth. This time around, we are also challenged by the cost of producing commodities rising, something that was not a problem at the time of the Great Depression.

Slide 34

Slide 34

If we think about the situation, having prices fall behind the cost of production is a disaster. We can’t get oil out of the ground, if prices are too low. Farmers can’t afford to grow food commercially, if prices remain too low.

Prices of assets such as the value of farmland, the value of oil held by leases, and the value of metal ores in mines will fall. Assets such as these secure many loans. If an oil company has a loan secured by the value of oil held by lease, and this value falls permanently, there is a significant chance that the oil company will default on the loan.

The usual belief is, “The cure for low prices is low prices.” In other words, the situation will fix itself. What really happens, though, is that everyone is so afraid of a big crash that all parties make extreme efforts to avoid a crash. In fact, there is evidence today that banks are “looking the other way,” rather than taking steps to cut off lending to shale drillers, when current operations are clearly unprofitable.

By the time the crash does come around, it is likely to be a huge one, affecting many segments of the economy at once. Oil exporters and exporters of other commodities will be especially affected. Some of them, such as Venezuela, Yemen, and even Iraq may collapse. Financial institutions are likely to find themselves burdened with many “underwater loans.” The usual technique of lowering interest rates to try to aid the economy doesn’t look like it would work this time, because rates are already so low. Governments are not in sufficiently good financial condition to be able to bail out all of the banks and others needing assistance. In fact, governments may fail. The fall of the former Soviet Union occurred when oil prices were low.

Once there are major debt defaults, lenders will want to wait to see that prices will stay consistently high for a period (say, two or three years) before extending credit again. Thus, even if commodity prices should bounce back in 2017, it is doubtful that producers will be able to find financing at a reasonable interest rate until, say, 2020. By that time, depletion will have taken its toll. It will be impossible to make up for the many years of low investment at that time. Production is likely to continue falling, even if prices do rise.

The indirect impact of low oil and other commodity prices is likely to be a collapse in our current debt bubble. This collapsing bubble may lead to the failures of banks and even governments. It seems quite possible that these indirect impacts will affect us most, even more than the direct loss of commodities. These impacts could come quite quickly–in the next few months, in some cases.

Slide 35

Slide 35

Stocks, bonds, pension programs, insurance programs, bank accounts, and many other things of a financial nature seem to be very “solid” things–things that we can expect to be here and grow, for many years to come. Yet these things, directly and indirectly, depend on the ability of our system to produce goods and services. If something goes terribly wrong, we may find that financial assets have little more value than the pieces of paper that represent them.

Slide 36

Slide 36

I won’t try to explain Slide 36 further.

Slide 37

Slide 37

Slide 37 illustrates the principle of increased efficiency. If a smaller amount of resources and human labor can be used to create a larger amount of end product, this is growing efficiency. If more and more resources and labor are used to produce a smaller amount of end product, this is growing inefficiency.

The other part of the story is that simply automating processes is not enough. Instead, the economy must also produce a sufficiently large number of jobs, and these jobs must pay high enough wages that the workers can afford to buy the output of the economy. It is really the health of the whole interconnected system that is important.

Slide 38

Slide 38

Our low price problems are here now. That is why we need very cheap non-polluting energy products now, in large quantity, if there is any chance of fixing the system. These energy products must work in today’s devices, so we aren’t faced with the cost and delay involved with changing to new devices, such as cars and trucks that use a different fuel than petroleum.

Slide 39

Slide 39

Regarding Slides 39 and 40, we are sitting on the edge, waiting to see what will happen next.

The US economy temporarily seems to be in somewhat of a bubble, now that it does not have QE, while several other countries still do. This bubble is related to a “flight to quality,” and leads to a higher dollar, relative to other currencies. It also leads to high stock market valuations. As a result, the US economy seems to be doing better than much of the rest of the world.

Slide 40

 

Regardless of how well the US economy seems to be doing, the underlying problems of rising costs of producing commodities and prices that lag below the cost of production are still present, making the situation unstable. Wages continue to lag behind as well. We should not be too surprised if the economy starts taking major downward steps in the next few months.

 

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11-04-15 STUDIES
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Submitted by Tyler Durden on 10/31/2015

Goldman's 4 Word Summary Of Q3 Earnings Season: "Adequate Earnings, Dismal Sales"

Haven't bothered to check in on the third quarter earnings season (which at this rate will mark the first two back-to-back quarters of earnings declines since 2009, aka an earnings recession)? Then here is the 4 word summary from Goldman Sachs: "adequate earnings, dismal sales."

With results from 341 companies (77% of total market cap) in hand, the 3Q reporting season thus far can be summed up as simply as “adequate earnings, dismal sales.” Earnings have been in line with history, with 48% of firms surprising on the bottom line (above the historical average of 46%), for an average EPS surprise of 4% versus the historical average of 5%. On the other hand, sales results have been disappointing, a function of slowing economic growth and a stronger dollar. Just 21% of companies beat consensus revenue estimates by more than one standard deviation, well below the 10-year average of 32%. Excluding Energy, 49% of companies has surprised on EPS, while 20% has surprised on the top line.

If companies beat on earnings do they also beat on revenues?

Stocks delivering positive sales surprises have been more likely to surprise on earnings, but a top-line shortfall has not necessarily led to a bottom-line miss. 21% of firms has posted positive 3Q sales surprises, while 14% of stocks beat on both the top and bottom line, meaning firms that beat on sales were also likely to beat on earnings (see Exhibit 1). Stocks surprising on both the top and bottom-line include AMZN, JNPR, NOC. Interestingly, 71% of companies that beat on earnings either negatively surprised on revenue, or reported sales results in-line with expectations, suggesting that margins have surprised to the upside thus far.

So as corporate teams seek to push margins even higher in the coming quarters, there will be even more layoffs in the coming quarters, and even more disappointing employment numbers... which is great news for a "lower for longer" addicted market.

What is the cause of the ongoing revenue slowdown, aside from lack of capital investment of course? The strong dollar is the biggest culprit, a dollar which keeps getting stronger.

FX headwinds and a slowing US economy have caused positive and negative revenue surprises to diverge significantly from historical averages. Through the first 22 days of 3Q earnings season, only 21% of companies has positively surprised on revenue, nearly 12 percentage points below the 10-year average at this point in the earnings season. Around one third of S&P 500 companies have disappointed on revenue, significantly above the 21% average (see Exhibit 2).

Historically, as positive sales surprises become scarce, investors are more likely to reward beats on the top line (see Exhibit 3). This trend has been evident during 3Q reporting season. 73% of companies surprising on revenue outperformed the S&P 500 the day following the announcement, the second best hit-rate in the past decade. 3Q sales for NKE, which was aided by surprisingly strong revenue growth in China, beat consensus expectations and subsequently outperformed the S&P 500 by nearly 900 bp during the following day. In contrast, companies surprising on earnings have outperformed the market 64% of the time.

For those wondering if the weak top line number means a slowing economy, the answer is yes.

Disappointing sales results reflect below-average 3Q economic growth. GDP growth equaled just 1.5% in 3Q. Solid growth from  consumer-facing sectors was offset by a drag from inventories. While real personal consumption expenditures increased by 3.2%, inventory accumulation subtracted 1.4 percentage points from growth.

It's not bad news for all though: the biggest companies will survive and will likely get even bigger.

Company results thus far suggest the largest S&P 500 companies have weathered the challenging growth environment better than their smaller counterparts. 58% of S&P 500 market cap has positively surprised on earnings versus an equal-weighted average of 48%, implying better-thanexpected results from larger companies. In fact, 66% of the 50 largest companies in the S&P 500 has beat earnings expectations versus 45% for the remainder of the index. 32% of the 50 largest companies beat on sales versus 19% for the remainder of the S&P 500 (See Exhibit 4).

... something the market has noticed and rewarded.

Better-than-expected earnings results for larger companies have coincided with large-cap outperformance. As measured via the Russell 1000 versus the Russell 2000, large-cap stocks have outperformed small-cap stocks by 257 bp since the end of 3Q. Looking beneath the surface, Consumer Discretionary and Health Care sectors in the Russell 1000 have crushed the Russell 2000 sector indexes, both by more than 400 bp.

Finally here is the full sector and industry performance broken down in various periods:

* * *

Finally, this is where Goldman sees the S&P trading in 1 year: "We expect the S&P 500 will likely trade at 2075 in 12 months (-0.7%).

 

COMMODITY CORNER - AGRI-COMPLEX   PORTFOLIO  
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2014 - GLOBALIZATION TRAP 2014

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2013-2H

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