Macro - Ominous Decade

"Fascism is capitalism in decay." - Vladimir Lenin

Following Greek's submission and the acceptance by French Constitutional court of the controversial surveillance law aimed at broadening eavesdropping of terrorism suspects, despite protests from privacy advocates with France seeing at the same time a "farming revolt", in conjunction with Spain's new public security law introduced in July limiting freedom of speech and curbing the right to peacefully protest with the introduction of fines ranging between €100 ($111) and €600,000, we reminded ourselves of the "Ominous Decade" (Década Ominosa) when it came to choosing this week's analogy. 

The "Ominous Decade" was the traditional term used for the last 10 years of the reign of King Ferdinand VII of Spain dating from the abolition of the Spanish Constitution of 1812, from the 1st of October 1823 to his death on the 29th of September 1833. Following the liberation of Spain from Napoleonic domination, King Ferdinand VII first act on his return was the dissolution of the two chambers of the Spanish Parliament which marked the period of the "Ominous Decade" which saw harsh censorship re-established and the complete suppression of the liberal opposition (which fled the country). This "Ominous Decade" saw an endless series of riots and attempts of "revolutions", such as that of Torrijos, funded by English liberals on the 11th of December 1831. Given the turn taken by recent events in Europe and with European Commission president Jean-Claude Juncker quote in February this year: 

"There can be no democratic choice against the European treaties." - Jean-Claude Juncker

We are indeed wondering if, Europe has not entered its own "Ominous Decade" hence our chosen title. 

We are also wondering if, after all, Vladimir Lenin's quote was not correct, and we could opine in the light of recent laws passed in various countries that indeed, Joseph Schumpeter seminal 1942 book "Capitalism, Socialism and Democracy" was indeed right when assuming that the decay in capitalism is indeed somewhat leading to some new form of "fascism". Schumpeter argued that capitalism's collapse from within will come about as majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and eventually destroy the capitalist structure but we ramble again...

When it comes to forward returns and current valuations levels and the "rosy tainted" environment painted by some sell-side pundits, in this week's conversation we will discuss into further details the return of the deflationary forces (hence our recent return in taking a long US duration exposure partly via ETF ZROZ) and "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know). Back in September 2012 we asked ourselves at the time the following question:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?" - Macronomics, September 2012.

Synopsis:

• Some "Zemblanity" facts in the transportation market
• Forget Greece, China is sending a weak global growth message
• If China is stalling then it makes sense to "short" exposed European car makers 
• Final chart: Credit and Equities parting ways

• Some "Zemblanity" facts in the transportation market

For those who have been following our musings, you will not be surprised that we view the transportation market, particularly shipping as a leading deflationary indicator as well as a credit indicator (lower shipping = credit tightening = deflationary trend). When it comes to the "real economy" and "Ominous Decade" risk, in true "Zemblanity" fashion, transportation is telling us that the much vaunted recovery story remains illusive and marks the return of the deflationary forces we think.

On that point we agree with Bank of America Merrill Lynch's take from their Cause and Effect note from the 13th of July entitled "Who do you believe?":

"Some inconvenient facts
The transportation market, which is more closely linked to the world economy, does not share this optimism. Global shipping freight rates, down 40% so far this year, are showing no signs of recovery. Our latest trucking survey shows sentiment at the year-low. Rail traffic remains very weak and rail stocks are down nearly 20% year to-date.
The million dollar question is whether what appears to be increasing growth optimism among rates investors is justified. The transportation market, which is much more closely linked to the global economy, apparently does not think so:
Global container freight rates, which have been falling this year, are showing few signs of stabilization, let alone recovery. The bellwether China export containerized freight index is down 40% so far this year (Chart 7) and is now below the trough associated with the height of the Eurozone crisis in 2012:

Falling freight rates seem to reflect more weak demand than excess capacity. World trade volume growth, which in Q1 contracted at the fastest pace since the end of the financial crisis, recovered weakly in April (Chart 8).

Inbound loaded containers into the Port of Los Angeles and Long Beach, having surged in March following the end of the strike, was down in April and flat in May (Chart 9).

Trucking is also faring poorly. The latest BofA Merrill Lynch proprietary biweekly Truck Shipper Survey shows shippers’ 3 month outlook falling below 60 for only the second time in 2015 (Truck Shipper Survey #78, 9 July). An increasing number of the respondents are citing weak demand.

If shipping and trucking are not doing well, rail is not doing much better. US rail traffic for intermodal units, which picked up in the spring after the end of the port strikes, is slowing again (Chart 10). 

Meanwhile, total carloads are contracting at an annualized rate of 10%. US rail stocks, already down 18% year-to-date, continue to underperform the broader index (Chart 11).

In sum, what the transportation market is telling us is that global trade growth is weak. This is consistent with the fact that in the June manufacturing PMI surveys released last week, new export orders were either declining or below 50 for most of the major economies (Chart 12). 

If global trade in manufactured goods is weak, it seems reasonable to think that global manufacturing is weak. Indeed, the new orders component of world manufacturing PMI has fallen in June to the lowest level in two years (Chart 13).

 - source Bank of America Merrill Lynch

To illustrate further the "illusory" recovery in 2015 we would like to add additional data, this time around coming from Deutsche Bank Freight Tracker note from the 21st of July. Truck Supply/Demand in 2015 is in fact weaker in 2015 than in 2014:

"Below we have illustrated the recent trends in TL dry van load-to-truck ratios (Figure 4 below) as well as dry van spot rates (Figure 5 below) in each of the past two years based on TransCore data.

 - source Deutsche Bank

If the economy is improving in 2015 compared to 2014, which would justify a "normalization" policy from the Fed, then we struggle in understanding the "dynamic" improvements so much vaunted by the "recovery" pundits...

This is leading us to our second point, namely that one should indeed focus less on Greece (a sideshow) but much more on the weaker global growth signs coming out of China.

• Forget Greece, China is sending a weak global growth message

Whereas the Greek soap opera has been gathering much of all the attention in recent weeks, the global growth seems to be heading like the proverbial bull in a China store. The preliminary PMI from Caixin Media and Markit Economics was at 48.2 for July from 49.4 the previous month, the lowest in 15 months, regardless of China's "engineered" 7% GDP growth.

Once again, shipping is leading us to some interesting indications when it comes to gauging the strength of the Chinese economy and the trajectory for world growth. If we look at the Shanghai-US Container Rates Overview from Deutsche Bank Freight Tracker note, one can clearly acknowledge the weaker tone in Chinese exports:

"SCFI spot rates declined 10.9% w/w as rates continued to fall across the board."

- source Deutsche Bank

Whereas we are talking West Coast Ports or East Coast Ports, the year on year change points to a clear weaker tone in exports towards the United States.

What we find of interest is the recent fall in consumer confidence which we think is indicative of the fragility of this much vaunted "recovery".  For instance, Consumer confidence in July dropped four points month-over-month to 45.2%, a low for 2015 but still higher than the 13 month low reported back in October (41.0%). But, "Confidence" among Small Business Owners is off as well at 53.8% (from 55.0% in June) which doesn't look great from an "employment" perspective.

As we pointed out in our 15th of August conversation "The link between consumer spending, housing , credit and shipping":

"Containerized traffic is dominated by the shipment of consumer products. A resurgence in international container volumes will be dependent on the housing markets improving. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia in containers. Furniture demand collapsed with the housing market." - source Bloomberg

The link between freight shipments and changes in housing start can be seen in the below graph coming from Deutsche Bank's most recent Freight Tracker report:

"Cass Freight Shipment Index Declines 3.4% Y/Y In June (+0.2% M/M). Last week, Cass Information Systems reported that the Cass Freight Shipment Index declined 3.4% y/y in June, which was an acceleration from down 1.3% y/y in May. Sequentially, the index was essentially flat (+0.2% m/m), which was worse than normal seasonality (June’s trailing five- and ten-year average m/m changes are up 1.8% and up 2.4%, respectively)."

 - source Deutsche Bank

Whereas housing starts have jumped in the U.S. in June to the second-highest level since November 2007 to  9.8 percent to a 1.17 million annualized rate from a revised 1.07 million in May, consumer confidence and shipping are yet to reflect this improvement so far. This is indeed depicting a conflicting picture when it comes to US growth particularly with the lack of acceleration in wages.

Moving back to China, not only does shipping and PMI points towards a slowdown but so does credit growth and passenger vehicle sales year on year as shown by Bank of America Merrill Lynch in their Cause and Effect note from the 13th of July entitled "Who do you believe?"

"The transfer of wealth from the people on the street to the wealthy who cashed out when the market was still going up is likely to hurt consumption. It is important to take note of the fact that in June, before the equity correction began, passenger vehicle sales fell for the first time since 2012 (Chart 16)."

It seems reasonable to think that a further moderation of Chinese growth will have global repercussions. On a Purchasing Power Parity basis, China is now the largest economy in the world, accounting for 16% of global GDP. More importantly, the IMF estimates that China accounted for one third of global GDP growth over the past three years (Chart 17).

A sharp Chinese slowdown in H2 (not the central scenario of our China economics team) would easily send world GDP growth to the lowest level since the recovery began.

That said, the impact of a Chinese slowdown on the rest of the world will be uneven. Countries like Korea and Australia whose exports to China account for a large share of their GDP will be especially vulnerable (Chart 18). 

Even Japan and Germany that have significant exposures to China will not be able to escape the implications of a sustained Chinese slowdown.

What about the US? US export exposure to China is modest, both in absolute and in relative terms. However, long-term Treasury yields have been more correlated with global growth outlook than US growth outlook over the past few years (Chart 19).

Moreover, further USD appreciation as other countries would be hurt more by the Chinese slowdown, by tightening US financial conditions, is likely to lead the Fed to go more slowly in the tightening cycle. The first batch of June data suggests that the momentum behind the US economy observed in late spring seems to be slowing. Aggregate payrolls in Q2 grew at the lowest rate in six quarters (Chart 20)."

- source Bank of America Merrill Lynch

 So if indeed China is slowing, then it makes sense to look at "shorting" the European Autos Sector (SXAP). This brings us to our third point namely never ending overoptimism from equity analysts...

• If China is stalling then it makes sense to short exposed European car makers 

If you buy into the story of an "Ominous Decade" and poor forward returns thanks to lofty valuations, Chinese slowdown and waning global demand (hence like us, sitting nicely in the "deflationary" camp), then we believe, it makes sense to look at over-exposed European car makers and to make a case for a "short" perspective we think.

On the subject of "deceleration" and cars in China, we read with interest Société Générale's note on Automobile and Components from the 15th of July:

"We see a margin issue in the Chinese premium car market: The market is crowded, not only on the roadway, where the number of premium cars has been growing fast, but also by the number of carmakers, who long for share in this formerly high-margin market. The “German big three” has 70-80% of the market, and the remainder is divided up among the Europeans, Japanese and Americans. Since H2 2014, these carmakers have started to see volume pressure owing to the economy’s slowdown, competition from local rivals, limits on car registrations in big cities, and pressure from a legitimized parallel premium car market. Official price cutting took place but turned out to be ineffective. Margin pressure was further aggravated by the rally in the A-share market in May that absorbed money from people who had delayed their car purchases. Despite these headwinds, we still see potential in the Chinese premium car market based on a growing middle class population because although the economy is slowing, the growth rate is still relatively high. Indeed, China’s economy historically has grown in the double-digits, but the market is now expected to experience a structural transition period where automobile financing (still low less than 20% in China vs. 50% in developed countries which reserves room for development) and electric cars (strong support from the government due to environmental concerns) could be a new growth impetus." - source Société Générale

While we agree from a long term perspective, there is further room for growth in the Chinese car market, the on-going pressure on the market is of particular interest as highlighted in Société Génerale's note:

"Premium carmakers have been forced to step into a tough price war since H2 2014, against the backdrop of China’s economic slowdown. Given the choice between market share and margins, carmakers chose to sacrifice margins temporarily in order to win and keep market share. Tier 1 premium brands have started to lower prices or decrease production in China. Audi is selling its two popular models, the A4L and A6L, at a 20-25% discount. BMW China’s CEO said that the group had already decreased its production in China as well as the supply to dealers (Source: Bloomberg 20 April). Going into the second quarter of 2015, new car sales have continued to shrink. The situation got even worse with the euphoria in the A-share market which absorbed the car budgets from a large number of people who were holding back on buying big-ticket items.
In our view, the other factors that are prompting a slowdown in premium car sales growth include but are not limited to: limits on new car registrations in big cities, pressure from a legitimized parallel car market, competition from local car brands, the government’s antiextravagance policies, consumption behaviour transformation (more mature customers) in the tier1 and tier 2 cities, an explosive second-hand car trade volume (9m units in 2014, over 10m expected in 2015), and a technology-driven growth model, which can be summarized as the Chinese automotive market’s “New Normal”.
In order to maintain margins and market share, we expect carmakers to cut costs, which
passes on pricing pressure to upstream auto parts makers and raw material providers. Thus, we believe the “German Big Three”, accounting for 70-80% of the premium car market, will leverage their negotiating power to lower production costs and save margins.

We expect a moderate premium car sales expansion in 2015, with a growth rate slightly higher than our forecasted 8% of passenger vehicle sales growth rate. The China Automobile Association forecasts that in 2015, the volume of sedans will increase slightly by 1% to 12.5m, SUVs will increase by 25% to 5.1m, MPVs will increase by 35% to 2.6m, and crossovers will decrease by 20% to 1.1m, which together represent passenger vehicle sales of 21.2m units and a 7.8% growth rate.
We expect three trends in the Chinese premium car market in 2015
1) The import growth rate to slow to the single-digits when premium carmakers focus on localisation: the high tax rate imposed on imported cars is one reason for customers’ move to localised cars, especially against the backdrop of the economic slowdown and customers’ high cost/performance preference. We expect more import models to be localised in the coming year.
2) SUVs to continue to be popular: the Chinese prefer large-sized cars and have a tendency to favour popular models, thus we expect premium carmakers to take action and make profits in this segment with new localised models." - source Société Générale

So the only way for the German Big Three to maintain further their margin will be to either force more deflationary pressure on their suppliers impacting furthermore the "commodity" sector in the process or to localize even more the production of cars in China to lessen the high tax rate imposed in imported cars which have been impacted by the bloodbath in the A-share market as of late.

What goes up must come down:

As per the conclusion of our "Ephedrine" conversation focusing on China in May this year, where we pointed out correctly that Dr Copper, the metal with the economics Ph.D was still in a bear market, we believe that European car makers in particular the German Big Three will soon have to adapt to the "new normal". This is clearly illustrated in Société Générale's note:

"The market for premium cars in China has expanded at an impressive rate of 36% per year over the past decade. Multinationals dominate China’s premium car market, with German carmakers accounting for 70-80% of market share.
Premium segment development is part of the change in passenger vehicle sales. From 2000 to 2010, the average passenger vehicle sales growth rate was 24%, and from 2010 to 2014, the growth rate slowed to 7%, which indicates that China’s automotive industry has stepped into a new growth period." - source Société Générale

The "goldilocks" period for the German Big Three, from a "short" perspective, seems to us an attractive proposal given their significant exposure to China. On that "short" interest, we agree with Louis Capital Markets recent take on this "trade idea" in their recent Cross Asset Strategy note from the 15th of July:

"The European Autos sector (SXAP) is fully driven by the German carmakers as Daimler, Volkswagen and BMW make more than 50% of the sector index. These global companies have a significant exposure to non-European markets and particularly, to China. The chart below shows the amazing increase of the profitability of the European Autos sector since the great crisis.

Despite a sluggish European economic environment, these European companies have benefited from their global exposure to record all-time high profits. In relative terms (below chart) the diagnosis is even more impressive and this explains why this sector has been a strong market leader since 2009.

The sector has been weak recently (2nd worst performer behind basic resources over the past 3 months). This is an interesting message as the profit dynamic seems intact. The direct consequence is that analysts have seen the recent correction as a buying opportunity given their unchanged earnings forecasts over the period. According to them, nothing has changed except the upside potential that is restored thanks to the decline of share prices. This differs from banks on which analysts remain cautious and do not expect a significant share price recovery.

We do not wish to treat analysts with disdain but there is clearly a risk that, once again, their expectations fall short of the reality. We do not see the latest correction as another opportunity but rather we see this correction as a warning for the sector similar to what banks experienced in the summer 2007.
The story of the Autos sector during the past decade looks like a “super cycle” and because we believe in cycles (i.e. ups and downs) we suspect that the nicest part of the story is far behind us and that difficulties can arise faster than expected.

We are beginning to see less positive stories coming from China regarding the Autos sector (price discount to revive sales, subsidies to affiliates) but these less positive aspects seem to have gone largely unnoticed by market commentators. It is typical to see some denial at the early stage of a new trend. The charts below shows the strong fundamentals of the “big three” – the 3 biggest components of the SXAP Autos sector – that have enjoyed a super-cycle over the past 5 years (average sales growth of 11.7% against average of 2.6% during the 2002-2007 cycle).

Also, perhaps the most impressive achievement is to see the structural improvement of margins since 2009. On the below chart we plot on the Y-axis the quarterly EBIT margin and on the X-axis the quarterly sales growth for the Big3. The blue dots represent the 2002-2008 cycle whilst the grey dots represent the 2010-21015 cycle. The message is crystal-clear here: despite some volatility of the business activity, the EBIT margin has remained resilient around 7%. This is a real performance that was flagged by analysts and this could explain why some investors play the “change of status of the sector” due to its new “growth status” (luxury goods + pricing power).

Its a nice story but too good to be true in our opinion and reminds us of our discussion with Banks’ analysts back in 2007 (see our European Equity Note No241 – 25 June 2007 – “The Valuation Principle”, CA Cheuvreux) when we told them that the specific risk premium that was emerging on financial stocks was worrying and that these stocks were expensive. We want to say the same thing today: despite apparent low valuation ratios, European carmakers are expensive because profits should revert soon and will reveal therefore that the profit trend growth of these companies is lower than expected.
We show on the following chart Global car sales growth and that of the Big 3. Obviously the correlation is strong between the two series but we see the significant outperformance of these winners in the aftermath of the Great crisis thanks to their Chinese exposure and their above-average pricing power.

However, talking about the past will not help us in forecasting the market behaviour of these names in the coming weeks so the latest data are more interesting and they show a very significant slowdown of the sales dynamic. In China, June was a negative month, for the first time since 2013. The 3-month moving average is at 0.5%, the lowest level since Q1 2012 which was at that moment only temporary.

We think that the current weakness will not be transitory and reflects the start of the down cycle for the European car makers exposed to China. The rationale is simple: generating growth is a tough task as for a carmaker it implies selling more cars each year. The strong growth rate achieved by the European carmakers in China was the result of the concurrency of several factors: low base effect (low starting equipment rate), strong growth of income and strong growth of the potential client base (emergence of the middle class). Today these factors have not disappeared but have strongly diminished. The number of cars in use compared to the size of the urban middle/upper class in China is no longer extreme. The catch-up process from this point of view is over and now, the demand for cars should be driven by more classic factors like the vehicle age (implicitly the average life expectancy of cars) and the size of the middle class.
In the short term, the excesses have to be clear and this implies a decline in units sold in China by the European leaders of the car industry. Thus, the investment risk is very high for the Big 3 as investors are not ready for this outcome. They will be reluctant to sell them because of some sentiment towards stocks that have done so well in their portfolios in this cycle. We understand that but investors have to set aside “affect” and be pragmatic as downs follow ups and China will not be an exception." - source Louis Capital Markets

Of course from a long term perspective China and Asia will continue to be important drivers for European car makers but, we do have to agree with LCM's tactical view on this interesting "short" contrarian proposal, which we think is enticing.

China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing, therefore we think shorting the German Big Three from a valuation perspective could be an interesting proposal should China worries persist.

German exports and Chinese PMI are still showing a disconnect which we think is not justified. Car sales in Europe during the first six months of 2015 are down 14% compared with the same period in 2007. In Germany, car sales are up by only 3% in the same period whereas Italy is down by a cool 38% and Spain is down 35% back to 90s levels (for more on cars sales and trends see our 21st of April conversation "The European Clunker - European car sales, a clear indicator of deflation").

So even the mighty German can't really look West to find some Chinese solace...

Does a Chinese slowdown spell an "Ominous Decade" for German car makers? We wonder...

• Final chart: Credit and Equities parting ways

Whereas in 2014 the much vaunted story of  the "Great Rotation" from "Bonds3 to "Equities" failed to materialize, in 2015 it seems indeed there has been some rotation at least in European towards equities as depicted by Bank of America Merrill Lynch in their Follow The Flow note from the 17th of July entitled "June'15 Flows: biggest outflow for fixed income funds since the tape tantrum":

"Credit and equities: parting ways
Flows remain on the negative side for both high-grade and high-yield funds, despite strong risk-on sentiment. Outflows from high-grade credit funds were the third largest this year, at $2.1bn, and ~$10bn has departed from the asset class in the past six weeks. Outflows from high-yield credit funds were marginal, however, marking the sixth consecutive week of withdrawals from the asset class.
On the other side of the fixed income world, government bond funds followed an opposite course from credit: the asset class recorded an inflow of +$1.4bn during the last week, the first in seven weeks and the highest in 18 weeks, dating back to the pre-bundshock period. Money market fund flows went back to negative territory.
But the picture is different in the equity land. European equity funds have seen inflows doubling that of the previous week, getting very close to $3bn. Equities have now had a nine week streak of positive inflows, against six weeks of consecutive outflows from high-grade and high-yield credit funds combined.

 - source Bank of America Merrill Lynch

"Where wealth accumulates, men decay." - Oliver Goldsmith, Irish poet

Stay tuned!

Chart of the Day - European Car Sales and Consumer Confidence

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

As we posited in our conversation "The Regret Theory" back in December 2012, in relation to European Consumption, Consumer Confidence is key (in continuation to our extensive look at car sales in Europe from our conversation of April 2012 - "The European Clunker - European car sales, a clear indicator of deflation"):

"One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost"

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well as per the below Chart of the Day - graph source Bloomberg:

New car registrations in Western Europe have continued their positive trend in conjunction with European Consumer Confidence:
-UK +8.2%
-France +5.8%
-Spain +28.7%
-Italy +1.9%
-Germany -3.4% (slightly off this month)

European's five largest markets for passenger car sales have generated 817,158 units sale, up 4.1% from a year ago. The big winner has been Renault group reporting double-digit growth in sale in Spain (+43.3%) driven by the domestic market France with 18.4% growth according to CreditSights from their European Morning comment of the 8th of May.

"If you have no confidence in self, you are twice defeated in the race of life. With confidence, you have won even before you have started." - Marcus Tullius Cicero

Stay tuned!

Credit - The Awful Truth

Lucy: It's enough to destroy one's faith, isn't it?
Jerry: Oh, I haven't any faith left in anyone.
The Awful Truth (1937)

Following up on last week conversation in relation to the deflationary forces at play and in continuation to last week's analogy to one of our favorite movies of all time, we thought this week we would as well use one in our title, this time 1937 classic starring Cary Grant, namely "The Awful Truth", which catapulted is career. 

In the movie, Lucy and Jerry Warriner having filed for divorce have to settle in court for the custody of their dog Mr Smith. Abandoning the law books, the judge leaves the "final decision" of custody up to the dog:  "The custody of the dog will depend upon his own desire". 

In similar fashion, to last week's argument about inflation and deflation and the gold sell-off, in the movie, the dog, Mr Smith, swiveled his head back and forth between his two owners (inflation or deflation) unable to choose until Lucy lured him by cheating, surreptitiously with a glimpse of its favorite squeeze toy. 

All that glitters is not gold, and while some central bankers managed to trigger inflationary expectations with various QE programs, the recent sell-off in gold might indeed be the boogeyman in this deflationary environment. In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg:

The Fed’s five-year, five-year forward break-even rate, fell to 2.69% last week, the lowest since before the central bank said in December it would buy $45 billion of Treasuries a month on top of the $40 billion of mortgages it was already purchasing.

Yes, QE is supposed to create inflation and should be supportive of gold, but looking at this chart from a recent Bank of America Merrill Lynch report from the 16th of April entitled "The Curious Case of Stocks and Credit", as indicated above the recent fall in break-even inflation rates is a not a good sign:

In this week's conversation we will therefore look at various deflationary signs that signal caution in this very complacent environment, as displayed by the on-going disconnect between equities and bond yields.

As indicated by Bank of America Merrill Lynch's recent note, stocks should normally be reacting to an ease in inflation expectations:

"Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time. We continue to side with the weakening macro backdrop and retain our tactical (short-term) short positioning in investment grade credit. Perhaps stocks and credit are holding up on the perception that US and Japanese QE will push investors into US risk assets regardless of fundamental weakness – in other words, that strong technicals will overcome weak fundamentals. That appears uncharted territory, as what we have seen in the past is that QE can work to push investors into risk assets when perceived to boost economic activity and thus create inflation (Figure 3). We have little evidence that QE alone can do the job, without being perceived to improve fundamentals. Thus, again, we expect the weakening macro backdrop to prevail. However, in the meantime the technicals are undeniably strong despite the lack of retail inflows to long and intermediate high grade bond funds. Clearly we are seeing foreign institutional investors – especially from Asia – moving into US corporate bonds. However, this process has been ongoing for at least a year and is unrelated to the expansion of Japanese QE." - source Bank of America Merrill Lynch

For us the 5 most dangerous words have always been:
"It is different this time"

As we clearly indicated last week, in the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:

While Bank of America Merrill Lynch's short term positioning in investment grade seemed obvious early April,  the recent weakness in both the S and P500 and High Yield, in conjunction to weaker macro data warrants caution we think. 

Maybe we ought to be worried that something not great is unfolding in Asia, probably the reason why the US is so nervous about Abenomics. Is China at risk of social unrest due to labor conditions and weaker inventories signaling a much weaker economic outlook than expected?

With Japan playing "beggar thy neighbor", it is risks stirring trouble in the entire Asian region which is already hurting badly South-Korea with companies like Bridgestone and Sumitomo Rubber being the biggest winner so far of the weaker yen - source Bloomberg:

"The CHART OF THE DAY shows the best and worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, with Japan’s Sumitomo and Bridgestone, the world’s largest tire maker, surpassed by only Mazda Motor Corp. Their rivals Milan-based Pirelli & C SpA and Michelin & Cie., which is headquartered in France and is Europe’s biggest tire producer, are among the worst performers. The euro-zone economy has contracted for five straight quarters and the jobless rate rose to a record in early 2013, crimping vehicle sales. Bridgestone, which had 77 percent of its sales from abroad last year, said in February profit would climb to a record high in 2013, even under the assumption the yen would average 89 per dollar. Japan’s currency slumped to 99.66 per dollar on April 9, the weakest level since April 2009, after the Bank of Japan took unprecedented stimulus last week to end 15 years of deflation." - source Bloomberg.

On top of that, the European automative market's weakness continued in March and new car registrations were down 10.3% YoY following a 10.2% decline in February and 8.5% decline in January. It marks the 18th consecutive months of YoY decline. European car sales are sliding to a 20 year low. Not even Germany is immune to the deflationary trend given its auto market plunged by 17%. European car sales are a clear indicator of deflation as we indicated in April 2012. Our concerns have unfortunately been confirmed by these latest figures and as indicated by Tommaso Ebhardt in Bloomberg on the 17th of April in his article - "Europe Car Sales Heading for 20-Year Low as Germany Plummets", not even mighty Germany is immune:

"The German car-sales drop was the steepest among Europe’s five biggest auto markets, and compared with an 11 percent fall in February. The U.K., where sales increased 5.9 percent, overtook Germany in deliveries in March, according to the ACEA. Spain, Italy and France all posted declines.

“The western European passenger-car market is on track this year to hit levels last seen in 1993, and Germany seems to be in a free-fall,” Max Warburton, an analyst at Sanford C. Bernstein Ltd. in Singapore, wrote in a report to clients yesterday. “While unit profitability in Germany is not nearly as high as China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing.” Deliveries at Wolfsburg-based VW, the regional market leader, dropped 9.3 percent, with the namesake brand posting a 15 percent decline. BMW, the world’s biggest luxury-car producer, sold 4.7 percent fewer vehicles in Europe last month." - source Bloomberg.

And if France is in trouble as we currently think it is, Germany will be too, very soon, given motor vehicles are Germany's biggest export to France as indicated by the below graph from Exane BNP Paribas:

As far as motor vehicles and China, should the Chinese economy weakens further, Germany will no doubt have issues:

- source Exane BNP Paribas - 28th of March 2013 report.

German exports and Chinese PMI showing a disconnect - source Exane BNP Paribas:

China accounts by the way 34% of global demand for rubber and inventories have climbed to 117,696 tons according to the Shanghai Futures Exchange, the highest in more than three years. 

Evolution of rubber in the largest exchanges in China and Japan since March 2010 - source Bloomberg:

"The CHART OF THE DAY tracks rubber on the largest exchanges in China and Japan since March 2010, with the gap reaching a 27-month high on Feb. 20 amid a weakening yen and strengthening yuan. The material used in tires and medical gloves traded at an  equivalent of about 404 yen in Shanghai on Feb. 11, the most  since September 2011. The Tokyo price had an 11-month peak of  334 yen per kilogram on Feb. 6, data compiled by Bloomberg show.  The Tokyo price last exceeded the Shanghai price in May 2011, the data show. Japanese Prime Minister Shinzo Abe’s monetary easing, dubbed “Abenomics,” has contributed to the yen’s more than 15 percent decline since mid-November. The yen fetched 93.50 per dollar as of 7 p.m. in Tokyo yesterday. By contrast, the yuan rose to a 19-year high of 6.2073 per dollar. Even as rubber futures in Tokyo fell 2.6 percent yesterday into a bear market, the most active contract in Shanghai lost 3.2 percent. Along with the currency market, China’s efforts to boost stockpiles in the world’s largest rubber market had contributed to the premium. With the inventory program set to decelerate, prices in Shanghai could fall, particularly as Southeast Asian producers have stepped up shipments to China to take advantage of the price differential, Tang said. Inventories in the Shanghai Futures Exchange were the most in about three years as of March 29, at 117,696 tons, according to the bourse. “Buying in Tokyo and selling in Shanghai may be the most profitable trade to get exposure.” Tang said." - source Bloomberg.

As we indicated in our conversation Pareto Efficiency:

"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement." - source Bloomberg.

In true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars and "Abenomics", a subject we approached in last month conversation "Have Emerging Equities been the victims of currency wars?" - MSCI EM versus Nikkei - source Bloomberg:

If you look again at the Bloomberg table displaying the worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, the most affected, in true Pareto efficient allocation process are the Europeans, sinking deeper in a secondary depression.

While the strength of the Euro has been supported by the FOMC's January 2012's decision to maintain US rates low until late 2014, has in effect prolonged the European recession, delaying in effect a painful adjustment in Europe and to make matters worse, Europe is facing prolonged agony, with now Japanese joining the party with "Abenomics".

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, and using another analogy, Europe is now facing pressure from two tectonics plates, initially pressure from the US and now Japan.

We always thought that the on-going crisis had a path similar to a particular type of "rogue waves" called "three sisters" ("three sisters" rogue waves sank SS Edmund Fitzgerald - Big Fitz) which were used as a comparable analogy by Grant Williams in November 2011.

We are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis

Another sign of the deflationary forces at play is the Euro-zone Corporate Credit Supply which continues to be elusive - source Bloomberg:

"A lack of corporate loan supply continues to hamper economic recovery across the euro zone. Lending to non-financial corporates (NFCs) fell in 11 of the 17 euro area countries in early 2013, with the Netherlands the sole large economy to show an increase in loans outstanding. Unless there is a pick-up in supply, growth forecasts will likely remain anemic and recovery slow." - source Bloomberg.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

We believe that the current disconnect between oil prices, the Standard and Poor's index and the US 10 year Treasury yield warrants caution, as it seems to us that the divergence is very significant as displayed in this graph from Bloomberg from the 12th of April:

In a recent note entitled "The asymmetric beta of credit spreads" , Bank of America Merrill Lynch points as well to a weakness of oil prices which might be indicative of weaker growth expectations:

"Is oil re-pricing growth expectations?
A slowing economy could push Brent down below $95/bbl Brent prices have declined by almost $20/bbl on a combination of seasonal and cyclical headwinds. Some of these cyclical pressures are too large to ignore, such as China’s drop in energy demand growth or Europe’s sharp contraction in credit supply. In addition, emerging and developed markets face mounting structural challenges. To name a few, energy importing countries like China, Japan or India are seeing $15/MMBtu nat gas prices at the margin, while others like Brazil are struggling with high labor costs and rising inflation. In Italy or Spain, a high cost of capital poses a major challenge to a recovery. Should the global economic recovery stall further, Brent oil prices could fall below $95/bbl in the near-term.  
Our economists see few downside risks to EM growth…
At any rate, our economists still expect China to post GDP growth of 8.0% in 2013 and 7.7% in 2014. These numbers are consistent with our expectations of 360 and 485 thousand b/d in oil demand growth, respectively. A robust China outlook should translate into strong EM growth and hence oil demand. Having said that, Chinese oil demand in March grew by just 255 thousand b/d, consistent with average GDP growth of around 5 to 6%. Surely, solid EM demand has been a constant in the oil market for decades, so a structural slowdown in economic activity would not bode well for global crude oil prices."
 …so we keep our $112/bbl Brent forecast in 2014 for now

For now, we stick to our 2014 Brent forecast of $112/bbl despite the weaker data, as OECD ex-US inventories remain low. But we are concerned about the structural headwinds facing many economies. Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

The issue of course is that we believe that "Abenomics" is a game changer from a pareto efficient allocation approach and that Emerging Markets in the vicinity of Japan which are already suffering, will be facing even more suffering in the second quarter hence our negative stance on emerging market equities, and on commodities as well.

On a final note, the latest hedge fund monitor from Bank of America Merrill Lynch from the 19th of April shows that they are positioning for a market correction:
"Based on our exposure analysis, macro hedge funds sold the S&P 500, NASDAQ 100, and commodities to a net short while increasing long exposure to the US Dollar Index. This suggests that macro funds are positioning for a market correction. Macros also sold 10-year T-notes to a net short. Within equities they switched to favor small caps from size neutral but are not at an extreme reading." - source Bank of America Merrill Lynch.

And as we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us given that as per a graph from Barclays, CFTC Comex positioning is the shortest on record:

"Copper plunged through $7,000 a metric ton in London for the first time in almost 18 months and

headed for a bear market on concern that demand from China to the U.S. and Europe may falter. Tin was also poised to enter a bear market. Copper for delivery in three months on the London Metal Exchange slumped as much as 4 percent to $6,800 a ton, the lowest level since October 2011, and was at $6,850.50 at 2:56 p.m. Seoul time. A close at the current level would be more than 20 percent below the metal’s last bull market peak in February 2012." - source Bloomberg, 18th of April 2013, Copper Poised to Enter Bear Market as Industrial Metals Slide.

Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...

And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well...

"Wonder rather than doubt is the root of all knowledge." - Abraham Joshua Heschel, Polish educator.

Stay tuned!

Credit - The Regret Theory

"In history as in human life, regret does not bring back a lost moment and a thousand years will not recover something lost in a single hour."  - Stefan Zweig

This year, we have on numerous occasions touched on game theory in our posts (The European iterated prisoner's dilemma, Agree to Disagree) and we also used an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept (Schedule Chicken). We even ventured towards computational analogies in our title selection process (Bankers' algorithm). Given the latest raft of European PMIs, pointing to a continued (albeit much smaller) divergence between the United-States Growth and Europe (Growth divergence between the USA and Europe), reason being the lack of credit provided to the real economy due to:
-inappropriate European Banking Association decision of imposing banks to reach a 9% Core Tier 1 ratio by June 2012 
-unrealistic budget deficit targets (A Deficit Target Too Far), 

We came to the conclusion that we ought to use in our title a reference to the Regret decision theory.

The divergence between US and European PMI indexes - source Bloomberg:

The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play). 

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario. One approach is to treat this as a game against nature (deflation in our case) and using a similar mindset as "Murphy's law" ("Anything that can possibly go wrong, does"), taking an approach which minimizes the maximum expected loss, but we ramble again...

And what could possibly go wrong in relation to European growth in 2013? After all, one might posit it is only a game of confidence. Well, looking at consumer confidence in Europe, "Murphy junior" would certainly comment that his father is probably too optimistic when looking at European Consumer Confidence.

European consumer confidence indicators for some European countries - source Bloomberg:

We already looked at the link between consumer confidence and consumption back in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we undertook at an interesting exercise following Yogurt giant Danone profitability warning announcement (affected by Spanish woes), namely plotting Danone share price against consumer confidence - source Bloomberg:

We wrote at the time:
"Yogurts matter as an indicator? One has to wonder...

As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

In relation to European Consumption, Consumer Confidence is key. The latest data relating to car sales in Europe, confirms the deflationary forces at play in Europe with car registrations falling plunging 19.2% in November in France on a monthly basis and 13.8% in the first 11 months of the year and Italian care sales by 20.1% in November (for a lengthy analysis on the subject of the car market in Europe please check - "The European Clunker - European car sales, a clear indicator of deflation").
As far as 2013 is concerned, European car sales are at risk on weaker consumer consumption as indicated by Bloomberg:

"Bears suggest discounting by automakers may not be enough to boost unit sales in Europe. Austerity in Europe is straining disposable incomes, with consumer household expenditure falling for three consecutive quarters. Car sales in Europe fell 4.2% yoy in the first three quarters of 2012 and any sustained recovery will be challenging as economic pressures mount." - source Bloomberg

One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost" - source Bloomberg:

Weak economy, low consumer confidence and high unemployment are indeed the deflationary forces at play plaguing European consumption and impacting car sales in the process. 2012 will be the fifth consecutive year of declines in the European car market below 12.8 million units, 20% below pre-crisis levels.

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well.

France Consumer Confidence and Household Consumption YoY since 2001 - source Bloomberg:

For instance, another indicator of the divergence between Europe and the United States, comes from the auto sector where demand for US light vehicle sales were up 7% year over year in October and 14% year to date, whereas Europe was the only region to decline in 2012, down 4.6% in October and down 6.9% in 10 months. Even China, passenger car sales were up 6.4% in October and nearly 7% year to date. In Europe the European Automobile Manufacturers Association, or ACEA, indicated in November car sales decreased 6.9 percent to 10.7 million cars. The ACEA indicated Europe’s car sales would reach a 17-year low in 2012. It also estimates that as much as 30 percent of production capacity is not used.

We think our European politicians would be wise to look at the minimax regret approach given Intrade is now putting a 30.6% chance of breakup of the Euro by December 31st 2013 as reported by Stephen Rose from Bloomberg on the 3rd of December: 
"Following is a table listing the odds that one country currently using the Euro will change its official currency by the expiration date, based on bets made at Intrade.com."

Europe is still a story of deleveraging and as pointed out by a recent note from Credit Agricole Cheuvreux from the 29th of November entitled "EU, The Road through purgatory", should our European politicians decide to tackle the minimax regret approach, there are indeed four possible recipes: "There are four basic recipes for deleveraging: austerity, inflation, growth, and default. The optimal is growth but Europe as whole cannot export its way out of its challenges and nor does it need to. Europe overall runs a current account surplus; the challenge lies in the balance within the Union. Europe needs further debt restructuring, inflation and a rebound in consumption (domestic growth). Deflation is the key risk here, but Draghi appears to understand this danger and has proved a better lateral thinker than his predecessor." - source Credit Agricole Cheuvreux.

Yes, our "Generous Gambler" aka Mario Draghi has been clearly a better lateral thinker in preventing a financial meltdown following the acute liquidity crisis of the financial sector in 2011. But as far as our Regret Theory is concerned, we previously indicated that in the case of Europe, causation implied correlation:
"Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth."


Looking at the prospect for the younger generation of Europeans and high level of youth unemployment, maybe Murphy junior is correct in assessing his father's law after all:

-source CA-Cheuvreux / Eurostat.
"These unemployment trends are very worrisome and if they are not reversed in the short term they may lead to increased social tensions and structurally higher long-term unemployment, which has negative effects on a country's growth prospects as part of the workforce becomes impaired. Also, youth unemployment leads to emigration, which will have a negative impact on demographics, as will be seen in most European countries in the medium term." - source Credit Agricole Cheuvreux.

Deleveraging leads to lower domestic consumption while tax rates are increasing with a shift from income taxes to consumption taxes:
"As taxes increase, and penalise an already fragile economy, consumption decreases exponentially and corporate investment is postponed, which leads to lower tax intakes. This means that more taxes are levied on the economy to try to cover the shortfall and a vicious circle is perpetuated." - source Credit Agricole Cheuvreux.

Maybe the minimax regret approach is the right approach after all. Oh well...

On a final note and in relation to struggling peripheral countries, Spain has indeed very apt in avoiding "tapping out" for help in this European fight of the Century, given it has so far managed to retain market access with timely sales as indicated by Bloomberg Chart of the Day:

"The CHART OF THE DAY shows Spain, which has auctioned about 82 billion euros ($106.7 billion) of bonds this year, sold the most debt when borrowing costs were at their lowest. That’s allowed it to retain market access and so far avoid a sovereign bailout even as 10-year rates surged to a euro-era record. “Spain has been smart in timing the issuance in the market,” said Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam. “A loss of market access in July this year could have easily driven Spanish yields to the 8 to 9 percent area.” The nation’s 10-year bond yielded about 5.32 percent on Nov. 30, down from 7.75 percent on July 25. The yield touched 5.20 percent last week, the lowest since March 20. Spain sold the biggest proportion of its debt in January, when the 10-year yield averaged 5.30 percent, and auctioned the lowest amount of bonds in August, when yields ranged from 6.15 percent to 7.44 percent. The Treasury completed its program of medium- and long-term debt sales earlier this month, and has used subsequent auctions to raise funds for 2013." - source Bloomberg

"Uncertainty is the worst of all evils until the moment when reality makes us regret uncertainty."

- Alphonse Karr, French critic

Stay Tuned!