Argentina's latest struggles

As discussed before, Argentina is facing deteriorating economic conditions and an international backlash from its decision to nationalize YPF. Here is the latest.

1. The EU launched its complaint with WTO.

WSJ: - EU officials say Argentina's decision last month to nationalize oil and gas producer YPF SA, a unit of Spanish oil company Repsol YPF SA, was only the most recent in a series of moves by Mrs. Kirchner's government that have harmed foreign investors and manufacturers. Friday's complaint at the WTO, the Geneva-based arbiter of trade disputes, won't mention the nationalization of YPF, which doesn't violate WTO rules, two of the EU officials said. But the nationalization has convinced European officials that more forceful action is needed to fix the deteriorating economic relationship between Europe and Argentina.

"Repsol is the straw that broke the camel's back," said one EU official familiar with the complaint. "It reflects more broadly a deepening protectionist agenda by Argentina."

2. The manufacturing sector is starting to contract. Argentina's real estate and cement purchases are typically transacted in US dollars, while salaries are in pesos - a difficult situation to sustain as the currency declines.

Marketwatch: - Argentina's manufacturing sector contracted last month, in the latest sign that high inflation and a slowing economy are taking their toll on factories in the South American nation.

Industrial output fell 0.5% from April 2011, and posted a scant 0.1% increase from March, the national statistics agency, Indec, reported Thursday.

3. The nation is now facing a possibility of a primary budget deficit. This is dangerous because foreign reserves (which would decline in a deficit situation) have in the past been used to fund Fernandez's populist agenda.

Reuters: - If government spending keeps the pace it has set so far this year, the primary balance will be pushed into the red by January. That would threaten funds needed for the welfare programs and subsidies that lie at the heart of President Cristina Fernandez's popularity.

This would come at a time of economic growth constrained by global sluggishness. The alarm sounded on Wednesday when the Economy Ministry said April's primary budget surplus was 1.06 billion pesos ($237 million), down 46 percent from the surplus posted in the same month last year.

On a related note, Sober Look has been banned from posting on Reddit/Argentina for submitting a post called "Argentina is not making many friends internationally". Reddit has been a good way to get feedback and initiate discussions on various topics. Here is the feedback on this post:

It seems some people in Argentina are refusing to face reality.

SoberLook.com

Goldman's "fiscal cliff" scenarios

As discussed earlier this month, the US is facing a "fiscal cliff", a sudden expiration of tax breaks and spending programs that could have severe consequences for the fragile US economic growth. The issue is now getting some attention in the media.

CNBC: - The United States’ economy could shrink as much as 4 percentage points in the first half of 2013 if Congress fails to address the expiration of $600 billion worth of tax breaks and jobless benefits by the end of this year, according to Goldman Sachs.

In a report issued on Tuesday, Goldman said in the worst-case scenario, the “fiscal cliff” facing the U.S. will shave almost 4 percentage points off gross domestic product (GDP) in the first half of 2013.

The fiscal cliff refers to the expiration of Bush-era tax cuts and the payroll tax holiday, as well as the end of extended unemployment benefits and the automatic spending and budget cuts mandated by Congress if lawmakers fails to reach deficit reduction goals.

According to Goldman, if the knock-on effects of a GDP contraction are considered, that is, reduced growth in one quarter weighs on the following quarter, the U.S. economy could experience a 5-percentage-point reduction in annualized quarter-on-quarter GDP.

First of all the Goldman report does not discuss what the US GDP would actually be (which is what this CNBC reporter is insinuating in the first sentence). Instead the report tries to quantify the impact of the fiscal cliff on the US economy. Second, this is Goldman's "worst case" scenario, not the "base" case. In fact, Goldman ran 3 scenarios:

1. The "base" case assumes that

• Expiring 2001 and 2003 Bush era tax cuts will be extended again (this is probably the most controversial assumption).
• The "sequester" (which kicks in because the Supercommittee was unable to reach an agreement) required cuts in discretionary spending are delayed past 2013. It would likely be replaced with longer-term spending cuts.
• Unemployment benefits will be phased down gradually after the end of 2012, rather than expire on schedule. 
• The payroll tax cut would in fact expire.
• Reductions in federal spending that are already in play will start taking effect.

2. Status quo: Everything gets extended (but the expected slowing in federal spending continues).

3. The "fiscal cliff": All the tax breaks expire and spending cuts kick in as described here.

The chart below shows the impact of each of the three scenarios on the US GDP growth. It's important to note that if the GDP growth is already negative (for example due to a spike in oil prices), the fiscal impact will make it even worse by the amounts shown in the chart (which is the point that CNBC seems to miss).

Source: GS (click to enlarge)

SoberLook.com

Will housing support growth?

Guest post by Greg Trotter

A great deal is still being said about the state of the housing market, with lingering excess inventories cited as the main reason for caution. These excess inventories are expected to still weigh on prices, particularly due to distressed sales, and have obviously pressured new housing starts. Fears of “shadow inventory” from severely delinquent borrowers and foreclosed properties sitting on bank balance sheets are of particular concern. While these concerns represent the current state of supply, what should we expect of the future?

The housing boom (from 2000) saw in excess of 2.8MM homes built over and above the 20 year average (through April 2012). However, the housing bust (from mid-2007) has seen 3.2MM fewer homes built than the 20 year average would imply. So, is the housing market under-supplied by 400k homes? Inventories, particularly “shadow inventories” would say no.

US New Privately Owned Housing Units Started by Structure Total SAAR  (click to enlarge)

Using the argument that lower new housing starts should have “eaten up” the excess from the housing boom, where has excess supply come from? The answer is lower household formation. With an abysmal job market, kids are moving back in with parents or not leaving home at all. People aren't getting married and are probably letting annoying roommates stick around. So, based on history what are these people waiting to do? The answer is “move out.” These people aren’t a reason that housing should be getting worse. They are a reason that housing is currently bad, but they should also be a reason that housing should get better. They are “shadow demand.” "

• http://soberlook.com/2012/01/story-of-household-formation-is-about.html
• https://content.putnam.com/literature/pdf/EO138.pdf

Angry Bear turns the household formation hypothesis around for a terrifying conclusion. Housing completions have completely overwhelmed household formation. Are housing completions too high, or are household formations too low? Housing starts are ½ the historical average.

• http://www.angrybearblog.com/2011/09/housing-vs-household-formation.html

What is holding “shadow demand” back? There are certainly at least two reasons, affordability and jobs. Housing affordability, by many metrics, has never been better, and some measures suggest that households have room for new debt service. That is just one side of the coin, though. The housing affordability metrics assume that borrowers have access to credit while, in reality, credit standards are very tight. And, while debt service cost may be low compared to recent history, it is held back by low interest rates—not low levels, and consumers, with worries about jobs and income growth, are likely loath to add to debt levels. On the jobs front, no one is going to kick out a roommate or move out on their own if they can’t cover the bills. While unemployment has come down from its peak, it has fallen more from people leaving the workforce than getting new jobs.

• http://seekingalpha.com/article/603971-historically-high-affordability-a-major-factor-in-housing-rebound-this-year
• http://www.ritholtz.com/blog/2011/04/cheapest-homes-in-40-years-not-even-close/

 Ratio of debt payments to disposable personal income (click to enlarge)

Household debt to personal disposable income (click to enlarge)

So, how does this mess get fixed? It requires jobs. Jobs are needed to pull “shadow demand” out of the woodwork and soak up excess inventory. If you argue that it is a problem with people wanting to rent instead of buy, there is a landlord for every renter. If you argue that no one wants the gutted and moldy houses that make up the shadow inventory, so much the better, it means more building activity. The argument here is that we are building up a supply/demand mismatch. Conventional wisdom says that it is an excess of supply, and, at today’s level of employment, that is right. However, as (if) employment improves, we could quickly move to a point of excess demand. So, if we get the economic spark, housing could be a real growth driver.

Now, here is one for the “structural decay” crowd. Yes, the idea that we have “shadow demand” to offset “shadow supply” assumes that employment improves. I’m not trying to argue that the economy has been cured of all its ills. I won’t even argue that it is definitely improving, although I believe that it is. I’m just going to argue that 1) low new housing starts have compensated for the excess supply from the boom years and 2) with improved employment, housing will support growth.

SoberLook.com

China responds to economic weakness by letting RMB depreciate

Further signs of economic slowdown in China have shown up in the HSBC China PMI index.

WSJ: - The preliminary May reading marks the seventh straight month the index has been in contractionary territory. A reading below 50 indicates contraction from the previous month, while anything above that indicates growth.

"China's real economy is getting weaker," Citi Investment economist Ding Shuang said following the release of the PMI.

"The likelihood that May industrial production and fixed-assets investment, two major gauges of economic activity, will improve is slight. The data are likely to stay weak," he added.

Ding expects growth in China's gross domestic product to slow to 7.5% in the second quarter from a year earlier, slowing from the first quarter's 8.1% expansion, which was the weakest in more than three years.

Source: HSBC

To address this slowdown, we've already seen China accelerating infrastructure projects approvals.

Reuters: - ... the government had asked for project proposals by the end of June, even for those initially earmarked for the end of the year, said the China Securities Journal, one of the country's top financial papers.

Citing government sources, the article said Beijing did not rule out bringing forward next year's projects, if it thought more investments would be needed to stimulate the economy.

But now the Chinese authorities have also allowed the Renminbi to weaken. Feeling confident about their ability to control inflation, PBoC is viewing currency weakness as a form of stimulus. It certainly makes sense for a nation addicted to exports (weaker currency will make China's exports more competitive).

CNY per one dollar (higher numbers mean weaker currency)

It's unclear how US politicians will react to this move. While the Obama administration remains tempered on this issue, this move will likely add fuel to Mitt Romney's goal to brand China a "currency manipulator". This is sure to become a point of debate in the US later this year.

SoberLook.com

Eurozone breakup risk and the currency markets

As discussed earlier, the Intrade probability of at least one nation exiting the Eurozone by the end of 2013 is now around 60%. In the past, many participants in the FX markets believed that Greece and other smaller periphery nations exiting the monetary union may be good for the euro. The idea is that the remaining economies would have stronger growth and lower overall credit risk. Because of this predominant view, the value of the euro roughly followed this probability of exit for some time.

That assumption may be true over the long term, but the contagion risk associated with such an event is significant and the immediate costs to the Eurozone are enormous.

Capital Economics: - Not only would it be uncharacteristic for currency markets to be quite so forward-looking, but even a limited euro-zone break-up which sees the exit of Greece and one or two other small countries would still have severe adverse economic and financial effects. And there would surely be, for a time at least, fears of a bigger break-up. Accordingly, it seems more likely that the markets have simply not taken break-up risks very seriously.

The FX markets are finally taking breakup risks more seriously as the spike in exit probability coincided with a sharp correction in the EUR-USD FX rate as the two indices decoupled.

Source: Capital Economics (the probability chart is from Intrade)

SoberLook.com

It's just a matter of time before declining PMI will show up in Eurozone's GDP numbers

European officials keep insisting that the euro area as a whole is not yet in a recession. That's wishful thinking because the latest PMI numbers say otherwise. PMI tends to be a leading indicator for GDP growth. PMI of 50 means no change.

Eurozone PMI (source: Markit)

This is not just driven by the periphery. While Germany has stalled...

Source: Markit

France is undergoing a contraction.

Source: Markit

It's just a matter of time before the recession becomes visible in the GDP numbers.

Capital Economics: - The fall in the euro-zone composite PMI, from 46.7 to 45.9, was sharper than the consensus forecast of a decline to 46.5 and left it consistent with quarterly falls in GDP of about 0.5%. After narrowly escaping a return to recession in Q1, it now appears very likely that the economy will experience a renewed contraction in the second quarter.

May’s fall was due to declines in both the services and manufacturing indices. And worryingly, the limited available breakdown by country revealed that the downturn is affecting the core as well as the periphery, with both the German and French composite PMIs falling further below the “no-change” level of 50.

What’s more, the previously resilient German Ifo measure of business confidence dropped much more sharply than expected. The fall from 109.9 to 106.9 reversed the gains of the previous five months and reflected weakening current conditions and business expectations across a range of sectors. Most notably, the drop in the retail index will have dampened hopes of a strong consumer recovery.

SoberLook.com

Brazil, Mexico try to stem currency declines

Brazil and Mexico finally intervened in the FX markets in an attempt to support their currencies, which have been battered by capital outflows. The risk with this sudden depreciation is inflation, something that Latin American nations have plenty of experience with.

Bloomberg: - Brazil’s real had the biggest gain in seven months and Mexico’s peso pared losses after policy makers in both countries propped up their currencies amid a selloff in emerging-market assets.

The real rose 2.8 percent to 2.0326 per U.S. dollar at the close in Sao Paulo after the central bank sold currency swap contracts at an auction for the third time in the past week. The peso fell 0.6 percent to 13.9887 per U.S. dollar, paring losses of as much as 1.2 percent after the monetary authority sold $258 million at an auction.

The real has suffered from an “aversion to risk” as it plunged 6.1 percent this month, said Carlos Hamilton, the Brazilian central bank’s director of economic policy. What concerns policy makers is excess volatility, not any particular exchange rate, Hamilton said at an event in Curitiba.

USD-BRL (Brazil real)

Here is a comment from Goldman on the topic:

GS: - In our assessment, at this stage a BRL above 2.10 generates some discomfort among the authorities as it could impact the inflation dynamics. We are of the view that rather than trying to enforce a ceiling the central bank is trying to anchor the BRL which has been weakening faster than other regional currencies. Were the external backdrop to deteriorate further and other regional commodity currencies come under pressure, the central bank may validate additional moderate and orderly BRL depreciation.

As flight of capital out of these nations continues, this will become an ongoing battle. In the long run weaker currencies will help these nations become more competitive - as long as they are able to tame inflationary pressures.

SoberLook.com

Trends in hedge fund equity holdings

Hedge funds have been known to move stock prices, sometimes dramatically raising volatility of specific shares. Here are two latest trends on hedge funds' equity holdings that may have some impact on equity volatility going forward.

1. Investment allocation in small-, mid-, and large-cap stocks for an average fund is about a third for each of these categories. So one would think that by taking the full hedge fund universe, it would be equally weighted across the three capitalization groups. But that is far from reality. Small hedge funds like small-cap stocks and large ones prefer large-cap stocks. It means that as the large funds become even bigger, the overall percentage of large cap stocks within the hedge fund universe should rise (simply because large hedge funds control a bigger portion of the total hedge fund assets). That has indeed been the case, with small caps representing only 17% of the overall hedge fund equity AUM.

Source: GS

2. Hedge funds run highly concentrated portfolios. The latest numbers from Goldman indicate that top 10 positions make up some 64% of hedge fund equity portfolios. That compares to 34% for large-cap mutual funds. Such concentrations indicate that hedge fund overall performance is driven by just a few stocks.

Source: GS

Combining 1 and 2 above tells us that certain large-cap stocks could experience dramatic moves, as hedge funds change positions in these names. Large concentrations and significant holdings could result in some outsize volatility.

SoberLook.com