Speculative activity in WTI

Crude oil technicals are not looking great, as the speculative accounts are becoming increasingly net long WTI futures. This is “fast money” chasing a quick Iraq-driven spike. What if it doesn't happen?

While the Iraq risks are quite real, the market remains well supplied and significant price declines are quite possible.

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The skills mismatch remains a fixture in US labor markets

The Beveridge Curve, a scatter plot of job openings vs. the unemployment rate, continues to show a structural shift in US job markets.

See this for the definition of the U-5 unemployment rate 

A large part of this shift is the skills mismatch. Companies are increasingly looking for skilled and experienced workers and are having a tough time filling those openings. If you are in retail for example, you will have no problems getting part and full time workers to stock the shelves in your store or run the cash register. On the other hand finding someone with the skills to run a store, even a really small one, is becoming more of a challenge. You'll get dozens of resumes to be sure, but very few with the right qualifications.

One can see this effect in the small business survey data, as more firms are having a tough time filling openings. The US has millions of unemployed or "marginally attached" workers, yet these are not the workers companies want.

Some would say that the reason firms are not getting the workers they want is poor pay. But if you are unemployed - and those of us who have been there know - low pay generally beats the unemployment benefits. Furthermore, at least across small businesses, pay is on the rise. No, it's nothing like it was before the recession, but those days are long gone.

Source: NFIB

Another sign of the American skills mismatch is small business consistently complaining about the quality of labor - something that was much less of an issue a year ago.

Source: NFIB

We can see other examples of this broadening skills gap here and here.

Wages for skilled workers will rise faster than the national average as demand grows. Unfortunately those with limited skills will continue to struggle with stagnant wages and limited opportunities. The days when unskilled workers could easily get a well-paying job in construction are not coming back for some time. Welcome to the New Normal.

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South Africa's increasing economic uncertainty

When looking at risks across some of the larger emerging markets nations, South Africa stands out, with a number of analysts and rating agencies increasingly ringing alarm bells. Here are some key risk factors to consider:

1. The recent labor strikes, particularly in the mining sector, have been devastating to the nation's economy. And more strikes are on the way.

VoA: - A strike by 220,000 engineers and metalworkers has dealt major blow to South Africa's economy.

The labor dispute has been marked by violent clashes between police and striking workers and reports of looting and intimidation by union members.

The strike comes just a week after settlement of a five-month-long strike by platinum workers. The walkout cost three main platinum mining firms $2.25 billion in lost revenue

General Motors South Africa halted operations last week because a strike at the parts supplier paralyzed it production (see story). Unions are becoming increasingly militant, with communist-based rhetoric often sounding like what we had heard in Zimbabwe. "Wealth redistribution" language is catching on.

2. The nation's debt levels - both private and public - are rising faster than it peers. With weak currency, this problem is expected to only worsen in the nearterm.

Source: Fitch Ratings

3. Simultaneously banks are tightening credit in fear of rising defaults, as the consumer comes under pressure.

Source: Barclays Capital

4. The consumer situation has not been helped by rising inflation, which is a direct result of the South Africa's currency depreciating over 30% during the past two years. Inflation has exacerbated demands for higher wages, leading to some of the labor strikes we see today.

5. The nation's unemployment rate (officially at 25%) has worsened, and some are calling the current labor situation a "ticking bomb".

US News: - The unemployment figures for South Africa's youth are staggering. Officially, youth unemployment (ages 15-34) has gradually risen to 36 percent. Many believe that real unemployment among that population is closer to 50 percent. Only 37 percent of the youth labor force has a high school degree. Of those who failed to get a high school degree, unemployment is at 47 percent, officially. A decade ago, a person with a high school degree had a 50 percent chance of getting a job. Today, that figure is 30 percent. Census estimates are that more than 3.2 million young South Africans between the ages of 15-24 are neither employed or engaged in education or job training. According to South Africa's Labour Force Survey for the last quarter of 2013, two-thirds of all unemployed South Africans were under the age of 35. This is a ticking time bomb in the belly of the nation.

To be sure, South Africa, a nation of incredible beauty and abundant mineral resources, remains a mining powerhouse. Yet after years of underinvestment, its energy infrastructure is increasingly inadequate to support the economy - with constant brownouts/blackouts becoming a part of life. Skilled professionals continue to leave the country in droves, generating a significant "brain drain". And land redistribution programs have brought up concerns over a Zimbabwe-style land reform. Moreover, a recent drive by some populist politicians to nationalise the country's mines raises the risk of declining investment and further economic deterioration.

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Merkel goes to China to halt German economic slowdown

The yield spread between US treasuries and German government bonds hit a new high last week (see chart). Was this divergence in rates simply a response to the ECB action last month (see post) in combination with stronger jobs data in the US or is there more to it?

Part of the answer has been softer than expected economic data out of Germany. The nation that had pulled the euro area out of its recession has been experiencing some headwinds. Germany's recent expansion has been partially driven by exports - both to the Eurozone and to elsewhere. And while the nation's domestic demand remains relatively strong (see German retail PMI), weakness in exports is beginning to show.

Source: Barclays Research

Signs of this growth moderation have been visible for some time now, including the manufacturing PMI report (see chart), softening economic sentiment (chart below), and even weaker employment figures (see story). Most economists did not anticipate this, and some have attributed it to weaker growth in China.

Source: Zentrum für Europäische Wirtschaftsforschung GmbH (ZEW)

To be sure, German economic growth remains strong on a relative basis. Many also expect a better second half, as China's economy picks up (see chart). Some of this optimism comes from the fact that the US consumer is finally tapping those credit cards (see chart) and driving up imports (see chart). Moreover, the German government remains heavily focused on business expansion abroad, particularly given the recent slowdown (what a novel idea - a business-focused administration).

Xinhua: - Angela Merkel is paying another visit to China this weekend - her 7th trip to the Asian powerhouse as German Chancellor, leading a high-level economic delegation.

German analysts believed Merkel's trip is aimed at keeping the dynamic in the current Sino-German relations going further. Given that the bilateral economic relationship has quickly developed, economy is widely regarded as the focus of the chancellor's visit.

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The Bank of Japan's QE program diverges sharply from other central banks

Many investors seem unaware of just how large Japan's QE program has been relative to other central banks. While the Fed, the ECB, and the BOE have roughly converged to the same level (as a proportion of their GDP), the Bank of Japan's balance sheet is more than double that of its counterparts abroad.

Source: BIS

The official goal of course is to stimulate credit growth to the private sector by lowering longer term rates and boosting excess reserves in the banking system. The 10-year Japanese government bonds now yield 0.57% and the reserves have indeed spiked.

Source: BOJ

But while we've seen small improvements in bank lending, credit growth in Japan remains tepid.

The primary reason for this trend has to do with the lack of demand for credit. Both households and companies are loathe to take on debt. One can't blame them of course - taking on fixed liabilities with looming risks of deflation is dangerous (imagine watching your assets depreciate, while liabilities remain fixed.) And as we saw in the US (see chart), other than during periods of frozen credit markets, quantitative easing has not been shown to be very effective in stimulating credit expansion.

As a prerequisite to get people to borrow, one needs a stable inflation rate. And while the BOJ has achieved higher inflation, question linger about its stability. A great deal of the price increases has been achieved by weakening the yen (see post). The yen depreciation however has been halted, with USD/JPY exchange rate remaining remarkably stable.

Chart shows US dollar appreciating against the yen (yen depreciating) during 2012-2013

In order to have a sustainable inflation rate, Japan needs stable economic growth that supports wage increases. But economists continue to question the nation's ability to maintain momentum.

CNBC: - "Economic activity has indeed picked up since the QE program began early last year, but there are now serious warning signs that this progress may not be maintained," Adam Slater, senior economist at Oxford Economics wrote in a report.

In the short video below Takuji Okubo questions a number of assumptions regarding the economy and wages in Japan.

All this will come to a head in October of this year, when growth and in particular the inflation rate will be benchmarked against the BOJ's target levels. If the projections are unsatisfactory, as some expect, the BOJ will be forced to accelerate the quantitative easing program. The already massive divergence between BOJ's balance sheet and that of the other major central banks will increase further.

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Some thoughts on slowing house price appreciation in the US

As discussed earlier (see post), home price increases in the US are slowing. One of the reasons for the slowdown is the continuing weakness in wage growth. The latest data seem to indicate that in spite of the overall improvements in job creation, wage growth remains subdued - hovering around 2% per year over the past 3 years or so.

And wage growth is a key determinant in home price valuation. Merrill Lynch for example shows that current home prices may already be above where they should be, based on Merrill's "fair value" index (that is driven to a large extent by wages).

Source: BofA

The other issue holding back home prices from accelerating is credit. Credit conditions for mortgages remain relatively tight and in fact have worsened for non-traditional mortgages.

That's why it remains challenging for the housing sector to maintain momentum, as we see residential construction spending stall.

Of course this is the situation for the nation as a whole. Underneath all this we have quite a bit of variability. Skilled workers are more likely to have higher paying jobs, are able to get mortgages, and are buying homes. House prices in certain areas are rising much faster than what we see in the national averages. In many cases there are simply not enough homes. Yet in other areas, the situation remains stagnant in terms of wages, credit, and the housing market. This divergence, although not visible at the national level, is growing.

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Window dressing with the Fed's reverse repo program

If you are a bank or even a money market fund, you probably want your financials to show the maximum amount of your overnight liquidity placed with the Fed's RRP rather than with other banks. Your balance sheet looks less "risky" this way. And since most financial reporting is done at quarter end (with mid-year and year-end being the most important dates), you want to place your cash with the Fed on the last day of the quarter for one night and then take it out. And that’s exactly what’s taking place currently.

Why not leave your liquidity with the Fed for a longer period? Because the Fed's current RRP rate pays 5 basis points, while the private repo market is paying about double that. Of course as cash is pulled out of the repo markets for quarter-end and moved to the Fed or elsewhere, rates in the private markets rise. Once the liquidity comes back to the private markets at the start of the new quarter, the repo rates return to normal.

Source: DTCC

The larger the RRP program becomes, the stronger this quarter-end effect will be. Welcome to the wonderful world of window dressing.

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Reasons for the spike in M&A activity

As predicted back in April (see post), US M&A activity accelerated in Q2, resulting in the most active first half since 2007.

WSJ: - Indeed, there have been 20 merger deals valued at more than $10 billion this year, the biggest total for the period since the first half of 2007, according to Dealogic. Most bankers, whose near-term views of the market are informed by the pipeline of unannounced deals they are working on, are optimistic the second half will be strong too. Many cite the possibility the big-deal boom—which has been largely confined to the telecommunications, media and technology and health-care sectors—will broaden.

Reasons for the spike vary from low financing rates and easy access to debt capital markets to strong equity prices, with shares used as acquisition "currency". Limitations to internal costs cutting also drove companies to consolidate externally.

WSJ: - There are a number of currents driving the increase in deal activity, bankers say. Among them: low interest rates, which make it relatively easy to borrow cash for acquisitions; lofty stock prices, which give companies a strong currency to pay for deals; and encouragement from shareholders, who have been lately bidding up the stock prices of companies that have made takeover bids. What is more, companies did a lot of internal restructuring during the M&A lull—building up big cash piles in the process—and there is less of that to do now, bankers say. That means that, in many cases, companies must search externally for cost-cutting opportunities, like acquisitions of rivals with overlapping operations that can be shed

Source: MergerMarket

The greatest reason for increased M&A activity however has been the decline in uncertainty (see chart). While many economists, bloggers and the media continue to ignore this factor, policy uncertainty - more than any specific policy - has been the key drag on economic activity in general and deal making in particular.

WSJ: - ... unlike in recent years, when a seemingly endless parade of ... concerns presented themselves, starting with the financial-markets meltdown and leading up to the European debt crisis and budget battles in Washington. At least for now, such impediments to deal making are largely dormant, they say.

Gregg Lemkau, the co-head of global M&A at Goldman Sachs said that, in recent years, when he would pitch possible deals to clients, they would often say: "Good idea—come back in six months and we'll discuss it."

"There was always some looming event, real or contrived, that companies wanted to wait to get past," added Mr. Lemkau. Now, he said, "There's no obvious macroeconomic event out there that people are waiting to get beyond."

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