Ilargi: Risk Times Risk Equals Fear

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth, Cross posted from Automatic Earth

Financial risk is springing up from so many sides and nooks and angles and crannies by now that the overall picture has become chaotic. And needless to say, anyone invested in anything detests chaos; it instills fear. If you can no longer oversee from which angle which risk might pop up, selling looks like a good move, and that’s what we see happening. The Nikkei closed down again earlier today, and European markets are doing them one better (aka worse). There is a long list of European countries, both in the EU and outside of it, that experience de facto deflation, offset in many cases only by higher taxation.

There’s an equally long list of emerging markets that see a rapid outflow of foreign currencies, so rapid in fact that panic has either already set in or is on the doorstep. Russia’s vow to engage in “unlimited” protection of the ruble might actually work, but even if it does, it’ll be a lone wolf. If energy prices too are brought down by the general mood in financial markets, however, Putin may yet be in trouble of Olympic dimensions. Russian GDP growth of just 1.3% doesn’t bode well in that regard.

Emerging nations, like all nations, have invested in and planned for a future based on experiences over the past 5-10 years. Until very recently, that meant robust growth numbers, in turn based upon investments from abroad. As this investment crumbles, so will growth, and so will the entire growth-based plan. And then what? Elect a new president, and another one 2 months after, as Argentina did in the early 2000s? There’s no telling how people will react in all these different places, but it probably won’t be pretty.

China is an emerging economy of such proportions that it has developed character traits of its own. If it can’t maintain a 7% or thereabouts growth rate, the entire economic machinery will start sputtering, and if this lasts, crash into a wall. Bill Pesek at Bloomberg cites a report with some pretty stunning numbers. Granted, it’s based on a survey of just 28,000 households and 100,000 individuals, in an economy of some 300-400 million households, but still. Amongst the findings he describes:

• … roughly 65% of China’s household wealth is sitting in real estate.

• 90% of households in nation of more than 1.3 billion people already own homes.

• 42% of demand for properties came from buyers who already owned at least one.

In other words, there is a gigantic oversupply of homes in China. They have been built by an equally gigantic industry (construction, financing) that will soon be forced to slow down if not grind to a halt. Then, home prices must fall. Supply and demand, even in China. This would lead to massive chaos, since 65% of all wealth is in these homes. Which was caused, one on one, by Beijing’s decision to force down interest rates on bank deposits. Once prices start falling, you could get a huge selling frenzy, an enormous amount of unrest, and a frantic search for other places to invest. Now, you can think that Beijing will prop it all up with all they have, but how would that work in practice? China’s overall outstanding debt is already well on its way to the moon.

Among developed countries, Japan is moving to the front when it comes to risks. It reports rising consumer price inflation, and that is cheered like they’ve won the Super Bowl, but despite the trillions poured into the economy by PM Abe, spending doesn’t rise much, and it’s not hard to figure out that the main or even only reason “inflation” rose is because Japan’s payments for energy imports have gone up.

Abe knows he’ll have to convince employers to raise wages now, especially since a new sales tax is coming in April, but then when you see automakers (huge employers), predict a 10% drop in sales for 2014, you know they’re not going to be the ones raising wages. So who is? And so yes, that could put a lot of pressure on government bonds, and eventually on the government itself. Abenomics is a huge gamble, and the reasons for optimism have never been entirely clear. For one thing, the same sort of gamble (a bit smaller, granted) failed miserably before, in the early days of the 20-odd year deflation.

And yeah, maybe when both China and Japan experience real economic mayhem, they’ll be more likely to start blaming each other, and occupying each other’s barren rocks. But things will have to get a lot worse before that becomes even an outside risk. Both will first have to find a way to stabilize matters to some extent at home.

Other than China, Japan and the emerging nations, I wouldn’t be at all surprised if financial markets would turn to Australia, and to a lesser extent New Zealand, next, as they have more or less “monocultured” their economies for exports to China. If and when China’s building boom slows down, and that’s just a matter of time, Australia will begin to feel the impact immediately. Not a great prospect down under.

• China Can’t Afford to Let Its Housing Bubble Pop

Among the many reasons to dismiss President Xi Jinping’s pledges to transform China’s growth model, Gan Li may offer the best: an epic housing bubble that can’t be allowed to pop. Gan, a professor at Southwestern University of Finance and Economics in Chengdu, Sichuan and at Texas A&M University in College Station, Texas, recently crunched some disturbing numbers on the level and distribution of household income and wealth. After examining survey results from 28,000 households and 100,000 individuals, Gan believes that roughly 65% of China’s household wealth is sitting in real estate.

An astounding 90% of households in nation of more than 1.3 billion people already owns homes. In the first half 2012, he found, about 42% of demand for properties came from buyers who already owned at least one. Many of these homes and apartments, it goes without saying, were bought in the midst of one of history’s biggest real estate booms and bubbles.

“The Chinese housing market is clearly oversupplied,” Gan told Tom Orlik, a Bloomberg economist based in Beijing. “Existing housing stock is sufficient for every household to own one home, and we are supplying about 15 million new units a year. The housing bubble has to burst. No one knows when.”

When is does, the damage to household wealth will reverberate across the second-biggest economy, devastate consumption and increase risks of social unrest. In other words, it’s something the Communist Party can’t allow to happen. While Xi’s promises to tolerate less gross domestic product growth as he weans China off its addiction to exports, the pressure to sustain property prices will take precedence over reform.

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When I saw Amazon’s disappointing numbers yesterday and the subsequent drop in its shares by 10% at one point, my first thought was: how does that fit in with the official US 3.2% GDP growth number? Holiday sales are a large part of Q4 consumer spending, which is responsible for 70% of GDP, and store sales were definitely “disappointing”. Now we see Amazon didn’t make up for the loss of sales in physical stores, and Amazon is huge in online sales. So is that 3.2% number perhaps a little exaggerated? A few hours later I saw that Megan McArdle had similar reflections:

• Amazon’s Bad Omen for the U.S. Economy

Amazon.com Inc.’s shares fell almost 10% a few minutes past 4 p.m., after the company dropped some disappointing earnings news. The title of the company’s news release is cheerily optimistic: “Amazon.com Announces Fourth Quarter Sales up 20% to $25.59 Billion.” And its operating income actually beat estimates — $510 million, compared with $489.9 million. But fourth-quarter sales of $25.6 billion were considerably below estimates of $26.08 billion, and earnings per share were 51 cents instead of the 69 cents that analysts had been expecting.

That’s not just disappointing for Amazon; it’s also not great news for the U.S. economy. When retail foot traffic and sales were disappointing in December, the standard explanation was that people must be moving their purchases online. Obviously, they weren’t — at least, not nearly as much as analysts expected. Given how dominant Amazon is in e-commerce, this should cause most of us to revise our expectations of fourth-quarter retail sales, as well as growth in gross domestic product. And not in a good direction.

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A bit of a long quote, but a good overview of where problems are right now. Even Mexico is starting to get nervous.

• Central banks step in again as emerging currencies resume rout (Reuters)

The Russian rouble hit record lows against the euro on Thursday and currencies in South Africa and Hungary hit multi-year troughs in the latest wave of an emerging market asset sell-off threatening global economic stability. India’s finance ministry also said the country would take any steps necessary to ensure financial market calm.

Russia’s central bank pledged to make unlimited interventions if the rouble’s exchange rate strays outside of its target corridor. Romania indirectly intervened to prop up the leu. Faced with the same kind of risk-averse mood among investors, Hungary cut back a sale of 12-month Treasury bills in which yields were driven up by almost 67 basis points.

Fears about emerging economies intensified after moves this week by Turkey, South Africa and India failed to halt a wholesale capital flight. The Federal Reserve’s decision to withdraw more of its monetary stimulus and weak Chinese data added to the concerns. “The pressure on these currencies has been relentless and it seems like places like South Africa, Hungary and Turkey are trying to force policymakers to bring real rates to much higher levels,” said Manik Narain, emerging market strategist at UBS. “Rate hikes have been effectively rejected by the currency markets … Institutional investors have remained faithful (but) it may be that some of these positions are starting to crack.”

Russia’s central bank said it would launch unlimited FX interventions if the rouble’s exchange rate strays outside of the corridor it targets against a dollar-euro currency basket. Earlier, the Russian rouble hit a record low of 48.21 per euro on Thursday and also fell to the lowest level since March 2009 against the dollar. The five-year Russian bond yield hit a 16-month high, with the yield rising 70 basis points this week alone. Romania’s central bank intervened indirectly in the market to support the currency, bringing the leu up around 0.4% against the euro.

Hungary’s forint fell 1% to a fresh two-year low of 312.65 per euro, extending losses made after the country’s central bank delivered a surprise 15 basis points rate cut last week. Budapest was forced to cut its 12-month bill sale by 15 billion forint ($66.30 million) at Thursday’s auction, with the average yield jumping 67 bps from the previous sale just two weeks ago.

The Turkish lira fell more than 1% to 2.2810 per dollar, approaching record lows set earlier this week and fully erasing gains made after the central bank surprised the market with a whopping 425 basis point rate hike. Local stocks lost 1.3%. The lira’s one-month implied volatility shot above 20% on Wednesday, its highest in nearly 5 years.

The South African rand also ignored a surprise 50 basis point hike from the central bank on Wednesday, hitting a fresh five-year low of 11.38 per dollar. The yield on benchmark government bonds jumped 36 bps to 7.36%.

Pressure is mounting on other central banks to act to counter inflation and support their currencies, including Mexico. The peso hit 18-month lows last week and the country’s inflation has shot up well above the central bank’s limit this month. The central bank said on Wednesday it is weighing whether monetary policy needs adjusting.

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The turning point for emerging economies is when they have to spend more in foreign reserves then comes in. A lot of them are at or close to that point. And they will see more money leaving, and less getting invested going forward. What’s next? Capital controls? Devaluations? Austerity? New presidents? All of the above?

• Emerging Market Rout May Signal ‘Sudden Stop’ (Bloomberg)

Brazil, South Africa, Turkey and Ukraine are the emerging markets most at risk of a “sudden stop,” in the view of Morgan Stanley.

That’s defined as a halt or even a reversal in capital flows into a country, slashing access to international financial markets for an extended period and weakening the economy. The term is often linked to 1995 work by Rudi Dornbusch, the late international economics professor at the Massachusetts Institute of Technology in Cambridge.

Mexico, Indonesia, India and Thailand are also in some jeopardy of such a phenomenon as investors turn sour on emerging markets, London-based economists Manoj Pradhan and Patryk Drozdzik said in two reports to clients over the past week. They wrote as central banks in India, Turkey and South Africa raised interest rates to shore up confidence in their currencies.

The Morgan Stanley authors evaluated the risk by looking at factors such as the reliance on capital inflows and credit, the size of the current account deficit, the legroom for policy and exposure to China. In the case of Brazil, for example, capital inflows account for almost half the money entering the country, total external debt is more than the size of foreign exchange reserves, the current account shortfall is almost 4% of gross domestic product, inflation is around 6% and government debt is about 70% of GDP.

The countries most in danger now face questions over how they will fund their budget and trade gaps and whether they can pivot to new sources of expansion, the economists said. Investors should monitor the processes of reducing debt and political splits. Ukraine, Turkey and Thailand have all witnessed social unrest.

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Turkey has learned this week that devaluation can come back to bite you in the face. The lira’s weakening more as we speak. Prices for imported – luxury – items shoot up. The best the Turks have going for them is the extent to which they are a domestic economy. Automobiles and widescreen TVs are not basic necessities.

• Currency devaluation ‘easy’ answer to emerging market crisis (RT)

The emerging market currency crisis is being propelled by policymakers who are “seeking the easy answer” by devaluing their currency, which is an unsustainable global model, Saxo Bank CEO Steen Jacobsen told RT. The spectacular loss of value in emerging market currencies – the South African rand, the Russian ruble, the Indian rupee, and the Turkish lira- is a result of government’s tightening monetary policy, which has even further driven down the value against the euro and dollar.

Governments face huge monetary policy decisions in the third and final stage of the global financial crisis which kicked off in 2008 with America’s sub-prime mortgage crisis and spilled into Europe, but simultaneous devaluation of currencies in the hope of driving up exports can’t be universally applied, says the Saxo Bank chief. “We are in the final part of this cycle. Which comes next is probably the mandate for change. We all need to change, the export-driven business model isn’t sustainable,” Jacobsen told RT in an interview at his Moscow office. [..]

“Policymakers are always seeking the easy answer, and the easy answer right now is weakening the currency. But by doing that you have to remember that the only reason anyone buys into an emerging market is because you expect the currency to appreciate. Pursuing devaluation long term will hurt the appetite of long term investors,” Jacobsen explained.

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Moody’s already has the warning out on Japan government bonds. With the amount of sovereign debt the country has outstanding (244% of GDP), this one could bite badly.

• Abe Doomsday Risk Prompts Moody’s Warning on Government Bonds (Bloomberg)

Moody’s Investors Service says Japan’s biggest banks need to cut bond holdings and boost loans to protect their balance sheets from potential losses should Prime Minister Shinzo Abe’s stimulus spur yield surges.

Lenders’ stockpiles of sovereign debt were at 138.9 trillion yen ($1.35 trillion) in November, after peaking at a record 171 trillion yen in March 2012, Bank of Japan data show. Unprecedented buying of JGBs by the BOJ is allowing lenders such as Sumitomo Mitsui Financial Group Inc. to decrease holdings of the securities, while the world’s lowest interest rates constrain profits in lending.

Sumitomo Mitsui, Japan’s second-biggest bank by market value, cut Japanese government bond holdings by 56%, or 11.5 trillion yen, at its main lending unit in the nine months to December, as domestic loans rose 4.3% last year. The BOJ, which has driven 10-year yields down to 0.62%, estimated in October that a one-percentage-point increase in JGB yields would cause the biggest banks to incur 2.9 trillion yen in unrealized capital losses.

“Banks need to rebalance their portfolios away from JGBs,” Graeme Knowd, a Tokyo-based associate managing director at Moody’s who overseas financial institutions, said in a phone interview. “If it turns out that Abenomics hasn’t worked and only ended up leaving Japan with a bigger pile of debt,” a “doomsday scenario for JGBs” isn’t “a zero probability scenario,” he said.

BOJ Governor Haruhiko Kuroda’s board is trying to boost inflation to 2% by buying more than 7 trillion yen of JGBs a month. Consumer prices excluding fresh food rose 1.3% in December from a year earlier, the statistics bureau said today, advancing faster than the median forecast of 32 economists surveyed by Bloomberg News for a 1.2% increase.

Abe’s stimulus program of fiscal spending and monetary easing helped weaken the yen by 18% against the dollar last year. Currency depreciation tends to boost import prices while increasing exporters’ overseas earnings. The yen fell 0.1% to 102.84 per dollar as of 10:16 a.m. in Tokyo.

At the same time, rising energy import costs and growing public liabilities totaling more than 1 quadrillion yen are increasing the nation’s default risk. Japan’s debt load is the world’s largest as a proportion of gross domestic product at 244%, according to an International Monetary Fund estimate. Credit-default swaps on JGBs have risen 13 basis points this month, the most among the 22 sovereigns tracked by Bloomberg.

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The effects of PM Abe’s all or nothing gamble will come knocking big time this spring. In April the new sales tax. Hopefully for Abe, rising wages before then. But it doesn’t look good. Japan has deflation because the velocity of money -spending – is way down. How that could revive in this economy is hard to see.

• Japan’s Inflation Accelerates as Abe Seeks Wage Gains (Bloomberg)

Japan’s inflation accelerated in December, industrial output gained and a measure of demand for workers strengthened, signaling gains for Prime Minister Shinzo Abe’s campaign to end two decades of stagnation.

Prices excluding fresh food increased 1.3% from a year earlier, the statistics bureau said today in Tokyo, above a median estimate of 1.2% in a Bloomberg survey of 32 economists. Industrial production rose 1.1% from the previous month, while the number of jobs for every seeker rose to 1.03, exceeding 1 for the first the time since October 2007.

The economy’s next tests are spring wage negotiations among major employers and workers, and an April sales-tax increase that threatens to hurt consumer spending. Without pay gains that compensate for inflation – so far driven by higher energy bills due to a weaker yen and Japan’s nuclear shutdown – households face falling purchasing power.

“Consumers will be hit in the pocket from rising prices and the upcoming sales-tax hike,” said Masamichi Adachi, a senior economist at JPMorgan Chase & Co. in Tokyo. “The onus is now on companies to convert their profits into wage increases and capital spending.”

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This is the clincher, probably. When sales are down 10%, you’re not going to raise salaries 5-10%.

• Japan auto group sees demand down 9.8% this year (WSJ)

Japan Automobile Manufacturers Association said Thursday that auto demand in Japan is expected to drop 9.8% in 2014 as the sales tax increase in April will dent consumer sentiment. The decline will be the first and sharpest drop in three years after auto demand remained nearly flat last year with a 0.1% rise.

JAMA expects auto demand to total 4.85 million vehicles this year, down from 5.38 million last year. This will be the lowest volume since 2011 when the industry was hit by an earthquake and tsunami. The association expects the reverse impact from the rush of car-buying ahead of the rise in Japan’s sales tax rate to 8% from the current 5% in April to pull demand for the full year.

The expected weaker demand means little chance for car makers to lift domestic production led by domestic demand. The downbeat outlook comes as Prime Minister Shinzo Abe is asking Japanese companies to raise wage and invest more in the home market.

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Nice one from The Slog. A BOE paper that talks about bonds the government never ever has to make good on, if it sees fit. So no matter what it does, it can’t go bust, only bondholders can. That should attract a ton of buyers!

• Britain’s Central Bank Resorts To Alchemy, Having First Of All Gone Mad (The Slog)

I am indebted to a source for alerting me to the content of the Bank of England Financial Stability Paper No 27. This little read won’t be found anywhere on the bestsellers’ lists, but it isn’t in any way a secret. What it demonstrates in tone and conclusions, however, should be appreciated by everyone who thinks this interregnum is just another blip, and we are turning corners once more on our way to the sunny uplands of growth. [..]

The linear thinking contained in Financial Stability Paper No 27 tries to ignore the now almost ubiquitous room-dwelling suburban elephant, but the very nature of how debt issuance should be ‘reformed’ proves beyond any reasonable doubt that Nellie of the large trunk has been spotted alright. The word ‘reform’ so often applied to bank practices (and then blown away by their lobbyists throughout the West) is, when used in this context, yet another example of Winston Smith at his best in the Ministry of Truth.

The reform suggested consists of two changes to debt issuance – new types of Bond. Here’s the first:

‘Contractual reforms offer a means to improve the crisis resolution toolkit in a way that is transparent and more predictable to the market. Our proposed formulation of sovereign cocos* is primarily designed to help tackle sovereign liquidity crises. They would automatically extend the maturity of bonds when a sovereign borrows from the official sector’

* A coco is a convertible bond in which the price of the underlying stock must reach a certain level before conversion is allowed.

This is supply-side thinking taken to the final madness: an attempt, pure and simple, to abolish default. The ‘idea’ being floated here is that the coco safety-stop against having to pay up when the issuer can’t afford to has bolted onto it the issuer potentially never having to pay up. ‘Extend maturity’ is another way of saying ‘kick can down the road’.

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Like quite a few other countries, Germany has a hard time connecting renewable reality to green dreams in its profit based political and economic system.

• Weak Returns Cripple German Renewables (Spiegel)

Investments in renewable energy were supposed to be a sure thing, with wind park operators promising annual returns of up to 20%. More often than not, however, such pledges have been illusory — and many investors have lost their principal to boot. [..] Indications are mounting, however, that green capitalism will not be able to meet all expectations. In courts around the country, complaints are mounting from wind park investors who haven’t received a dividend disbursement in years or whose parks went belly up. Consumer protection activists are complaining that many projects are poorly structured and lack transparency.

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Yesterday it was baby penguins, today the mighty and mysterious monarchs. Going going …

• Mexico reports dramatic drop in Monarch butterflies (AP)

The stunning and little-understood annual migration of millions of Monarch butterflies to spend the winter in Mexico is in danger of disappearing, experts said Wednesday, after numbers dropped to their lowest level since record-keeping began in 1993. Their report blamed the displacement of the milkweed the species feeds on by genetically modified crops and urban sprawl in the United States, extreme weather trends and the dramatic reduction of the butterflies’ habitat in Mexico due to illegal logging of the trees they depend on for shelter.

After steep and steady declines in the previous three years, the black-and-orange butterflies now cover only 1.65 acres (0.67 hectares) in the pine and fir forests west of Mexico City, compared to 2.93 acres (1.19 hectares) last year, said the report released by the World Wildlife Fund, Mexico’s Environment Department and the Natural Protected Areas Commission. They covered more than 44.5 acres (18 hectares) at their recorded peak in 1996.

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Going, going, nice going there, Oz. Destroy the Great Barrier for a coal plant. Something tells me these people are not going to listen no matter what you tell them. They listen only to other means of communication.

• Australia OKs plan to dump tons of sediment on Great Barrier Reef (AP)

The government agency that oversees Australia’s Great Barrier Reef on Friday approved a plan to dump vast swathes of sediment on the reef as part of a major coal port expansion — a decision that environmentalists say will endanger one of the world’s most fragile ecosystems.

The federal government in December approved the expansion of the Abbot Point coal port in northern Queensland, which requires a massive dredging operation to make way for ships entering and exiting the port. About three million cubic metres of dredged mud will be dumped within the marine park under the plan.[..]

But outraged conservationists say the already fragile reef will be gravely threatened by the dredging, which will occur over a 184-hectare area. Apart from the risk that the sediment will smother coral and seagrass, the increased shipping traffic will boost the risk of accidents, such as oil spills and collisions with delicate coral beds, environment groups argue.