Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author

Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

Synopsis:

• Macro and Credit - Attempts in exploiting the Phillips curve have failed
• Final chart - Trumpflated

• Macro and Credit - Attempts in exploiting the Phillips curve have failed

Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas

We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:

"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:

"Wage wars

The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.

There is the theory

The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.

The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.

And then the data

We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.

We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch

Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:

"In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017

Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:

"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).

- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":

"Current state of Japan’s labour market

Japan’s labour market is at its tightest level since the early 1990s 

Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."

- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:

"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages

The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.

Progress until now and further progress on labour reforms should help Japan’s economic recovery continue

The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.

 Back in our January conversation "The Ultimatum game", we indicated the following:

"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.

The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

• Final chart - Trumpflated

For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:

"The deflating of the reflation trade

As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.

US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse

As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley

Stay tuned!

Macro and Credit - Cinderella's golden carriage

"The very concept of objective truth is fading out of the world. Lies will pass into history." - George Orwell

Listening with amusement to "Le Chiffre" aka Mario Draghi, losing some of his "Sprezzatura" ("studied carelessness") following the ECB meeting last week, leading to some significant "sucker punches" being delivered for the "Balanced funds crowd" (long German government bonds and European equities) and Euro short punters alike, given that all market pundits have been used to the "fairy tales" from the "Generous Gambler" and "happy endings" for risky assets, we decided this week to steer towards a European folk tale as an analogy for our chosen title. The story of Rhodopis, about a Greek slave girl who marries the king of Egypt, is considered the earliest known variant of the "Cinderella" story (published 7 BCE), and many variants are known throughout the world. One of the most popular versions of the story was written in French by Charles Perrault in 1697 under the name "Cendrillon" and in his version he introduced the "pumpkin". While the fairy godmother turned a pumpkin into a golden carriage in the story depicted by Walt Disney, she did warn Cinderella to return before midnight. Central bankers with their various iterations of QE have provided "balanced fund managers" a tremendous goldilocks period for investing. While we have warned of the rising instability risk caused by positive correlations in August this year , which is leading more and more to "large standard deviation moves" (sucker punches) in various asset classes, it seems to us that investors are not taking seriously fairy godmother Janet Yellen as we are indeed approaching midnight (watch what our US CCC credit canary is doing as of late...). One of the moral of Charles Perrault's version is as follows:

"That "without doubt it is a great advantage to have intelligence, courage, good breeding, and common sense. These, and similar talents come only from heaven, and it is good to have them. However, even these may fail to bring you success, without the blessing of a godfather or a godmother"

No doubt to us that without the blessing of the "fairy godmother from the Fed" aka Janet Yellen, we think, it is going to be incredibly difficult to achieve significant "positive returns" in 2016 for the "long only" crowd, as in similar fashion to the fairy tale, Cinderella's golden carriage spell is about to be broken and return to being a simple pumpkin (hence our call for heightened volatility in 2016 and the need to put on some still "cheap hedges").

In this week's conversation, we will continue to look at 2016 prospects. We will also touch on some "macro convex trade" of interests (by the way we submitted our HKD idea from September to Saxo's 2016 "Outrageous predictions", so let's see if we make the cut...).

Synopsis:

• One "macro convex trade" to think about for 2016
• Container shipping and large surge in US inventories, a great cause for concern
• Final chart - Global equities: more de-equitisation to come in 2016

• One "macro convex trade" to think about for 2016

Our own "outrageous 2016" prediction - A HKD devaluation.

Back in September this year in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

At the time we argued the following:

"A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China." - source Macronomics

Given that the latest data from Hong Kong’s Land Registry shows sales of registered residential units in November slumped to their lowest in nearly two decades with Residential mortgage approvals falling 40 percent in October as reported by Reuters in their 3rd of December article entitled "We need to talk about Hong Kong’s property market. Again.":

"The second major factor, and arguably the more important one in the short term, is what is happening on the mainland. China’s marked slowdown has taken a toll on everything from property transactions to tourist arrivals and retail sales in Hong Kong.

Chinese tourists buying up everything from Louis Vuitton bags to milk powder in Hong Kong’s shops accounted for nearly half of the city’s retail sales last year. This is slowing sharply as the economy slows and as Chinese tourists prefer to take their shopping to Korea and Japan instead. The knock-on impact is putting rents in shopping malls at risk.

The backdrop appears anything but sanguine.

But Macquarie takes a calmer view. It estimates that there is a decade worth of pent up demand (roughly amounting to 262K households) in Hong Kong that has built up as buyers got increasingly priced out of the property market. Unless there are widespread job losses it is unlikely that this demand will disappear.

If they’re right, that suggests every dip is likely to find buyers come back in even if interest rate slowly nudge higher.

Dents in the armour are showing. But 2016 may still be too early for the start of the collapse." - source Reuters

And this is indeed is a big if à la Cinderella's golden carriage being able to return before midnight no offense to Macquarie. If we want to add more "ammunitions" to our "simple" macro convex trade we can simply point out to a few factors, one being the approximate direct contribution of China tourist revenues as a percentage of GDP in 2014 and 2015, as indicated by CITI in their very interesting Emerging Markets Macro and Strategy Outlook - Prospects for 2016" recent note. Spot the "outlier":

"Direct contribution to GDP on recipients of China outflows are very small for most except in “special” territories (Macau, HK), which are suffering from a Chinese tourist slump. While tourist arrivals are booming in Japan, the biggest beneficiary of strong mainland arrivals relative to the size of their economy appears to be Thailand.

A second important constraint is the overhang from the build-up of nonfinancial private sector leverage, in the backdrop of a maturing credit cycle.

While we don’t expect any disorderly deleveraging/credit crunch given stronger balance of payment/less FX mismatch risks for most (though Indonesia corporates have some issues), with room for some to pursue counter-cyclical monetary easing in contrast to the Fed rate hiking cycle, there are a few FX-managed regimes with very open capital accounts– HK and Singapore – that inevitably will see rates rise alongside the US and will need some monitoring, especially given its knock-on impact on property markets and household balance sheets. Moreover, persistent capital outflows could tighten domestic financial conditions, especially for those without offsetting current account buffers and/or had been significant recipient of those volatile types of capital flows– e.g. Indonesia and Malaysia look vulnerable here. Even if central banks keep monetary conditions accommodative through interest rate and liquidity tools, we note that many countries in Asia -- notably China, HK and ASEAN countries – have seen a notable rise in “credit intensity” of output in the post-GFC years. We think this is a sign of credit being increasingly allocated to less productive sectors that, over time, manifests itself in weakening cash flows relative to debt service payments. This dynamic will lead to two things: first, greater demand for balance sheet repair among indebted entities, which will drag aggregate demand, or second, if balance sheet is irreparable, rising default rates and loan losses in the banking system, which will then feed into tightening of credit standards and higher costs to credit. Our bank analysts see the biggest NPL risks arising in China, Indonesia, Thailand and eventually Malaysia. Thus, a more mature phase of the credit cycle will mean that even the effectiveness of monetary policy as a counter-cyclical policy easing will weaken." - source CITI

Very open capital accounts means that as CNY/Yuan downward pressure continues to intensify, the pressure upwards on HKD will intensify leading to more and more intervention from the HKMA to defend the peg. Defending a peg, as clearly shown by the Swiss National Bank (SNB) in 2015 works, until it doesn't.

If indeed Hong-Kong is highly dependent on Chinese tourism, then particularly the study of the "Luxury" sector and the CNY/Yuan impact is paramount. When it comes to the "Luxury" sector and Hong-Kong, we read with interest Bank of America Merrill Lynch's Luxury Goods note from the 7th of December entitled "2016 years ahead: Luxury sector embedded with earnings & valuation risk":

"2016 likely to be another weak year for Hong Kong, don't count on the weak base to support growth 

The weakness in Hong Kong is driven by lower traffic. Total visitation is flat in 2015 ytd, but down about 7% in the last 3 months. The quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Most European luxury companies have reported Hong Kong revenues down 15-25% in the most recent quarter. Based on conversation with Hong Kong based luxury companies weak trends have continued into October despite an easy comparison base, which included the impact of Occupy Central last year. The outlook for 2016 remains subdued.

We track Watches & Jewellery retail sales to gauge luxury market demand in Hong Kong. In 2015 ytd HK Watches & Jewellery retail sales are down -13.1%, with September down 23% despite an easier comparison base. September volumes decreased 16.7% and average selling price was down by 6.2% in the month. This is shown in the charts below.

We believe monthly retail turnover for Harbour City & Times Square luxury malls in Hong Kong also provide a guide to market growth. Revenue is down around 9-10% in 2015 ytd, with the biggest declines since in the most recent quarters. This is shown in the charts below.

- source Bank of America Merrill Lynch

Now if tourism growth is close to zero and direct contributions from Mainland China tourists amounts to more than 12% of  Hong-Kong to GDP, we hope "Cinderella" investors have not forgotten that indeed the "golden carriage" can turn into a "pumpkin".

Indeed has shown in Bank of America Merrill Lynch's note, it seems the Hong Kong "golden carriage" is losing some of its appeal. We do like to track "traffic" as great macro "growth" indicators, such as Air Cargo, Container traffic and many more. What is indeed of great interest is that no new seats are being added to China-Hong-Kong flight routes for 2016 YTD:

"Hong Kong continues to lose its appealChinese consumers no longer see Hong Kong as an attractive luxury shopping destination. We think this stems from a lack of newness, increased social tension, occupy central and a strong HKD.

Total visitation is flat in 2015 ytd, but down 7% in the last 3 months, which reflects the decline in Chinese inbound tourism. However this still under-states the decline being felt by luxury companies in HK given the quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Chart 76 shows no new seats are being added to China-Hong Kong flight route for 2016 YTD, suggesting the underlying weakness in traffic is expected to continue.

- source Bank of America Merrill Lynch

And of course the winner of the "currency war" when it comes to the "Shrinking pie mentality" we discussed in April 2014:

"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in." - source Macronomics, April 2014.

No wonder Japan is "winning it all" when it comes to tourists and "competitive devaluation" as indicated by Bank of America Merrill Lynch:

"Japan has grown 100% in 2015, strong growth likely to continue as appeal picks up
The number of China outbound tourist to Japan has increased by more than 100% in 9m 2015. This has led to 35% growth in luxury consumption in Japan. We expect Japan to continue to take share from Hong Kong, which is still 7x the size in terms of inbound tourist from China. As a result we expect ongoing solid luxury goods revenues in Japan (+25% cFX), despite a very tough comparison base. 

Chart 78 15-20% more seats are being added to China-Japan route for 2016 YTD, suggesting the increased in traffic is expected to materialise.

- source Bank of America Merrill Lynch

So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again.

Also with continuous pressure on China's FX reserves  which have fallen by $87.2 billion to $3.44 trillion at the end of November, from $3.53 trillion a month earlier, and in conjunction with China 's bad exports/imports data (-6%/-8%) this will further accentuate the pressure on the HKD in the coming year. The latest CNY/Yuan picture, graph source Bloomberg:

- source Bloomberg.

On that matter we read with interest Société Générale's take on the subject:

"China's FX reserve data, released yesterday morning European time, had an impact on Asian markets today. The USD 87.2bn fall was a good bit bigger than expected, even if about half off the fall is due to FX valuations. Throw is some more weak trade data this morning (surplus USD 54.1bn as exports fall 6.8% y/y, imports fall 8.7%) and the stage is set for more CNH weakness. As USD/CNY edges higher again, to 6.42, the currency's stealth-like depreciation since the start of November is looking less stealthy. Once USD/CNY breaks 6.45 or USD/CNH breaks 6.50, this is likely to be a major source of concern to markets globally, let alone in Asia." - source Société Générale

If Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think.

Furthermore, as we mused in our November 2014 conversation "Chekhov's gun":

"Interesting thing happens during currency wars, currency pegs like cartels do not last eternally." - source Macronomics - November 2014.

 We would also like to point out that, in similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale

More closely to "home", in Europe that is, of course we continue to believe that Denmark will as well eventually be forced to "ditch" its peg to the Euro. On that take we read with interest Bloomberg's article from the 7th of  December entitled "Currency Battle-Front Reset as Danes Seek Euro Peg Normalization":

"While Denmark won its battle against currency speculators earlier this year, there’s still far to go before the central bank can consider a “normalization” of its monetary policy.
Governor Lars Rohde says Denmark’s benchmark interest rate will over time be closer to the European Central Bank’s. The Danish deposit rate is now minus 0.75 percent, and the ECB’s is minus 0.3 percent. Denmark pegs its krone to the euro in a tight band, forcing the central bank to track ECB policy closely.
“One might ask if minus 0.75 percent as a marginal rate is normal, and the answer is that it’s probably not and neither is minus 0.3 percent at the ECB,” Rohde said on Monday in an interview in Copenhagen.
How soon Denmark acts to reduce that spread “will largely depend” on the actions of the ECB. President Mario Draghi’s decision last week to deliver a smaller-than-expected stimulus package certainly provided relief to the Danish central bank. “It turned out to be very easy not to do anything,” Rohde said.
The ECB on Dec. 3 cut its deposit rate less than some traders and investors expected. It also extended, but didn’t raise, its bond-purchase program. The news sent the euro more than 3 percent higher against the dollar and took pressure off a number of central banks across Europe that had previously struggled to prevent their currencies from strengthening against the euro.
“The projected krone appreciation pressure is unlikely to intensify materially after the ECB left the big easing bazooka at home,” Danske Bank analysts said in a note on Tuesday. The Danish central bank “effectively delivered a small rate hike by not shadowing the ECB last week.”
Nykredit, Denmark’s biggest mortgage bank, says Denmark is now set to raise rates twice next year, following the “soft” package unveiled by Draghi last week."  - source Bloomberg

While indeed the Danish central bank has won a battle, it hasn't won the war and at some point we think, that in similar fashion to the SNB, it will lose the war but that's another story.

When it comes to Denmark, and in particular the "game of survival of the fittest" being played in this "shrinking pie mentality" world, we previously pointed out Danish A.P. Moller Maersk as a "survivor" in the container shipping industry in our August 2012 conversation "The link between consumer spending, housing, credit and shipping":

"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - source Macronomics - August 2012

What is getting us more and more worried for the  probability of the "golden carriage" to turn into a "pumpkin" is that even our identified "champion" has not been immuned to the very strong deflationary forces at play and is in fact moving towards "loss-making". This brings us to our second point of our conversation.

• Container shipping and large surge in US inventories, a great cause for concern

Containerized traffic is dominated by the shipment of consumer products. Weaker traffic means very simply weaker demand (and no we don't care about what European PMIs are supposedly saying).

Back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry, and guess what, it did! Not to mention the fact that we indicated some forced exposed players such as Commerzbank with their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses as pointed out in our June 2013 conversation "Lucas critique":

"In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":

"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing." - source Bloomberg" - Macronomics - June 2013

If indeed our favorite "survivor of the fittest" Danish giant A.P. Moller Maersk is turning into "loss-making", then indeed, we would caution investors to start in earnest to think about "battening down the hatches" to use a shipping analogy.

On the subject of shipping we read with great interest Nomura's Special Report on Container Shipping entitled "Counting Containers - Unprecedented action required" published on the 26th of November:

"Container shipping lines have a choice: return chartered vessels, or face the consequences

Supply-demand balance to deteriorate significantly in 2016-17E
Supply outstripping demand is nothing new in the container shipping industry, as evidenced by nominal capacity +53% during 2008-14, vs volumes +22%. What is new, however, is that slow steaming – which absorbed 26% of capacity during this period – is now reversing, adding new capacity on top of that provided by the orderbook. With nominal capacity expected to increase by 5-6% CAGR during 2016-17E, and volumes unlikely to exceed 3%, the supply-demand balance is set to deteriorate even without increased vessel speeds. If this trend continues, the industry will face an even more severe imbalance.

Freight rates can – and most likely will – decline further
With headline freight rate indices currently at historical lows, further reductions may appear unlikely. However, on a cost-adjusted basis, freight rates remain well above the trough levels seen in 2009 and 2011, periods during which the industry suffered heavy losses. With supply-demand set to deteriorate, and contract rates to be revised downwards, we believe freight rates can – and most likely will – decline further, driving the industry back into financial losses. 

Maersk Line case study provides some grounds for hope… 
With supply-demand fundamentals overwhelmingly bearish, container shipping investors could be forgiven for giving up hope. However, our analysis shows that, if other shipping lines follow Maersk Line's successful recent strategy – of maximising utilisation rates by returning chartered capacity to owners – the supply-demand imbalance can be rectified, with persistent losses averted.

…but only if the industry can act with unprecedented discipline
Our analysis shows that competitor shipping lines should narrow Maersk Line's cost advantage during 2016-17, but only if utilisation rates can be maintained. Returning chartered capacity to owners, culminating in a significant increase in idled capacity, provides the best means to facilitate this. Yet we estimate idled capacity would need to reach 14% for this to be achieved – materially ahead of the previous peak of 11-12% seen in 2010. Whether the container shipping industry has the discipline required to achieve this, only time will tell.

- source Nomura

When it comes to "hope" being a bad "strategy" such as expecting a "golden carriage" not to return to its initial "pumpkin" state, we reminded our thoughts from January 2013 from our conversation "The Fabian Strategy":

"People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!""So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

Looking at the growing divergence between "hope" (equities) and reality (US High Yield), we wonder when "reality" will settle in. Could it be that in 2016 we will see the return of the "pumpkin"?

When it comes to the "reality" that can be assessed from Shipping, demand outlook is not favorable as pointed out by Nomura in their special report:

"Demand outlook remains tepid, at best

The world has changed. Let’s accept it and get on with it

The days of 3-4x GDP multipliers are gone – possibly forever
The 3-4x multiplier of GDP at which global container volumes used to grow is well known – for instance, with the volume CAGR of +12.5% seen during the period between China joining the WTO in December 2001 and the start of the global financial crisis (GFC) in 2008 equating to an average GDP multiplier of 3.8x.

Since this time, the high growth rates of 14.9% seen in 2010 and 7.4% in 2011 were driven by the end of destocking, which occurred towards the end of 2009, rather than underlying strength. When global inventory levels had returned to more normalised levels, the volume CAGR of 3.5% seen during 2012-14 equated to an average GDP multiplier of 1.4x.

2015 will likely be the first ‘normal’ calendar year to see a multiplier <1 b="" x="">
We often find that investors and industry commentators alike take a global container GDP multiplier in excess of unity for granted. Yet a multiplier of 1.0x was recorded for 2013, and for 2015 we expect volume growth of c+0.8%, equal to just 0.3x of the 2.9% increase in global GDP that is forecast by the OECD.

This would be the first time, on our records, that the global container volume multiplier has fallen below unity during what we consider to be a relatively ‘normal’ calendar year of economic activity.

…but this is not unprecedented on a rolling 12-month basis
On a rolling 12-month basis, the global GDP multiplier has already fallen below unity during what we classify as a ‘normal’ period without any major macroeconomic fluctuations or inventory swings – specifically, the 12-month period to 4Q13.

Although this weakness was only temporary, we do consider it to be important, given that it demonstrates that, even during a period of steady-state economic conditions, a global container GDP multiplier of less than 1.0 x is not unprecedented.

Looking ahead, ‘GDP plus a bit’ feels about rightAlthough forecasting global container volume growth will never be a precise science, we continue to believe that a growth rate of ‘GDP plus a bit’ remains an appropriate rule of thumb. We assume a multiplier of 1.1x for 2016-17, consistent with the 1.0-1.3x range that we consider to be reasonable during steady-state economic conditions. 

In reality, fluctuations during this period are inevitable, but for reasons that are difficult or impossible to forecast (eg, inventory movements, currency swings, technological changes, among others). As such, we do not attempt to incorporate such factors into our mid-term forecasts." - source Nomura

Conclusion: secular stagnation is here to stay and one can expect "rates" to stay lower for longer and demand to be weaker as well. "Mind the gap" between effective capacity and total demand as it is widening...because "demand" is not outstripping "supply". Another illustration of the "shipping glut", is that for the first 10 months of 2015, Chinese ship builders saw orders for new vessels plunge 62% from to same period last year, for a total of 20.3 million tons, according to data from the China Association of the National Shipbuilding Industry (CANS)

Apart from "weaker demand" another concern which has been highlighted justifiably so is the current US level of inventories. This worrying trend has been as well clearly highlighted in Nomura's recent Shipping special report:

"US inventories peaked in February 2015, at a level that warrants major concern

Although our analysis suggests the destocking that has prevailed in Europe during 2015 will soon moderate, the situation in the US suggests concern for import volumes in 2016. As shown in Fig. 43, the total business inventories-to-sales ratio spiked up sharply during the several months to February 2015, and showed smaller increases during the months leading into September 2015.

This upward movement bucks the downward movement in US inventories-to-sales that has prevailed over the past 20+ years, and after controlling for this trend by considering inventory-to-sales in terms of the number of standard deviations from the trend line, the recent upward spike in inventories is even more apparent. Specifically, inventories-to-sales are more than 1.5 StDev from the trend, not far off the peak of 2.0 StDev seen in January 2009, around which time US imports fell precipitously.

Irrespective of the sector, US inventories appear ominously highFigs. 45 and 46 summarise the split of US Business inventories (measured in US dollars) between the retail, manufacturing and wholesale sectors. The current share is remarkably uniform, with manufacturing the largest sector with a share of 36%, but retail and wholesale not far behind on 32%.

- source Nomura

You can expect this level of inventories to be a drag on fourth quarter GDP when the Fed is about to "hike" in a weak demand environment. It looks like the "fairy godmother from the Fed" aka Janet Yellen is about to pull the spell which has so far being "levitating" the "golden carriage".

When it comes to continuing with the "golden carriage", one thing we are certain in 2016 is that the global "de-equitisation" process will continue to run its course and generates further instability into the financial system as per our final point.

• Final chart - Global equities: more de-equitisation to come in 2016

In June 2015 in our conversation "Eternal Return" we made the following point:

"The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think." - Macronomics, June 2015.

The above debilitating effect on corporate balance sheets was already highlighted in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:

"The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.
What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.
We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole" - Macronomics, October 2013.

What is concerning is that ZIRP has accentuated the "de-equitisation process fueled by "cheap credit". This has also been again indicated by CITI in their Globaliser Chartpack from the 30th of November 2015 and is our chosen final chart:

"Global equities: more de-equitisation?De-equitisation should remain a key global investment theme for the next 12-18 months; the most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9)‘More de-equitisation’, declares Global Strategist Robert Buckland, ‘for deequitisation should remain a key global investment theme for the next 12-18 months.The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares (equivalent to 9% of average market cap over the period). The most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9). Share buybacks is currently a very US-heavy theme; we also note positive momentum in Japan. Names like Ahold, Boeing, Xerox, Allstate, Adecco and Yahoo! feature’." - source CITI

In 2013 we concluded our 2013 conversation as follows:

"We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom"

Although the "fairy godmothers from the Fed" did put a spell on for many years, we think we are indeed coming closer to midnight and the "Cinderella" investors of the world would be well advised to "hedge accordingly" before they are left holding the "pumpkin", as it looks increasingly clear to us that 2016 will be indeed a very challenging year.

"A powerful idea communicates some of its strength to him who challenges it." - Marcel Proust, French writer

Stay tuned!

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

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