Economic and market themes: 2014-02-14

Themes for today:

• Commodities: soybean prices could fall due to increased supply. This would be troublesome for Argentina.
• Emerging markets: Of the fragile five, India is looking better, Brazil is still a big concern.
• Developed Markets: House price inflation makes France, the UK, Australia and Canada vulnerable to real economy shocks.
• US: Consumers are only supporting 1-2% growth. Q1 will be weak. Inventory builds are still the big story.

Okay. So here is my weekly roundhouse view of the economic and investment themes to compliment my single theme posts. I think I have posted on such a wide variety of subjects this week that the content of this post will come as less surprising than before. Here goes for a third time!!

Oh, and next week I will be taking time off for a winter break so my posting will be light. Posts on the blog portion of our site will be as normal.

Happy Valentine’s Day!

Commodities. I like the soybean stories in today’s links and the inter-relationship. In the US, where corn is king, farmers are getting killed by the bear market in corn prices. So farmers are thinking of rotating into soybeans, something that will increase supply and drive down price. In China, where the country net exported corn until 2010, people are vexed about its net importer status with 90% of crops coming from the US. China is the world’s largest importer of soybean, 63.4 million metric tons in 2013, much of that from the US and Argentina. The experience with corn has the Chinese thinking about how to reduce the country’s reliance on imports in soya. Meanwhile, Argentina is having a hard time with inflation, which was 4.61% month-on-month in January according to private sector estimates. So soya farmers are hoarding soya. Soya is a major export crop for Argentina and the dollars the crop can bring in are needed for foreign reserves as the Peso crumbles under the pressure of high inflation. The bottom line: supply in soya is going to increase and this will be a big problem for the Argentines and their need for fx reserves. I am bearish on Argentina. I believe devaluation awaits and this will unleash havoc because the government will have to either increase oil production or pass through the price increase from oil imports to the populace, such that the inflation bites even harder.

EM. Argentina is not big enough to make waves. India, China, Brazil and Russia are the big markets in EM. So, turmoil in Argentina will not make contagion waves except to the degree Argentina defaults and it causes a re-assessment elsewhere. Vulnerable to that kind of re-assessment are Venezuela and Ukraine in particular. In India, the higher rates have insulated the country somewhat from contagion as it has shored up the currency. Meanwhile, the telecoms auction will raise $10 billion and that will be a big deal in terms of the fiscal side of things. India looks less vulnerable in terms of the fragile five – a term introduced by Morgan Stanley to talk about current account ‘sinners’ Turkey, Brazil, India, South Africa and Indonesia. Brazil is probably the biggest concern of those five in my view.

DM contagion. I thought Matthew Lynn’s counterpoint on EM was interesting. He claims the next crisis won’t come from the emerging markets. Rather, he believes the ‘real’ fragile five are in developed markets and he singles out France, Britain, Germany, Australia, and Canada. I don’t agree with the country assessment, particularly Germany, which I think he included for shock value. But the points do deserve some consideration, particularly on housing prices in the France, the UK, Canada and Australia. There was a piece in today’s links on Toronto house prices, showing two areas were prices have skyrocketed just in the past two years. The average detached home in Toronto is now $888,210 (CAD). And “the median sale price for a detached house in Toronto-proper rose to $695,000 in January 2014, up 19.83 per cent from 2012” That’s really way too high. All of these countries – France, Australia, Canada, and the UK – are on any list of overvaluation on a price to rent or price to income basis. The question goes to real economy triggers for house price declines. In Australia, the trigger is China. So I would look there first for DM contagion regarding Lynn’s list. I would look second to France because the air is already coming out of French house prices, causing the real economy to underperform.

US consumers. For months now, I have been saying that the US consumer can only support about 1-2% GDP growth based on wage gains. Any other growth will have to come from inventory building, consumer credit accelerators, inventory building, or fiscal transfers to the private sector aka deficits. Last year’s two last quarters growth were really all about inventories. Moreover, if you look at jobless claims, the trough was really October. We should expect mean reversion of this time series. What I have been saying therefore, is that peak growth in the U.S. will be Q3 2013. But until the last few weeks, I felt that the increase in credit, the buoyancy of housing and the increase in interest rates could provide some credit acceleration to maintain growth above stall speed. The decline in interest rates, the decline in house price inflation, the trouble in autos, and the bad retail figures have really dented this thesis. All the major banks are reducing their Q1 GDP figures as a result. Some are saying this is just weather related and that the weather is ‘obscuring’ a good read on the path of GDP. A poll of economists expects the economy to accelerate in the second half – something we have heard time and again during this recovery. Every time we hear this, you should be sceptical. We are not at stall speed yet, but without wage growth (a good thing) or credit accelerators (a bad thing, by the way), we will be.

Inventories. A thoughtful reader passed along a chart of US inventories to me, saying he agreed the situation in auto inventories looked worrying. But he believes the chart on inventories shows that inventories elsewhere are not a major concern. His view is that autos are a “big sector with a lot of transmission to other parts of the economy — but, it seems that the rest of the economy is sporting low enough inventories to present a counterbalancing tailwind.” Here’s the chart:

I think the chart looks fairly good too. The problem here is two-fold. First, you can see this time series shows a secular decline in inventories to sales, which is an outgrowth of just-in-time manufacturing, something the US picked up from Japanese practices. The US has got smart about supply chain management and tried to keep inventories at low levels in order to increase inventory turns and reduce costs. This has been one reason to think some of the increase in profit margins, and therefore, P/E ratios is justified. But, I am more concerned with turning points i.e. the change in change. And this is what concerns me here. As Reuters put it, “the government in its advance estimate for fourth-quarter GDP said inventories increased $127.2 billion, the largest rise since the first quarter of 1998. At December’s sales pace, it would take 1.30 months for businesses to clear shelves, up from 1.29 months in November.” That’s worrying. That means sales to inventory ratios are increasing at a pretty sharp rate. And that’s definitely a second derivative – change in change – metric which bears watching. Again, we need to see wage growth for the end demand to be sustainable. And we are not seeing that. If we don’t get it, then at least job growth can compensate by increasing the number of people with income. We are not seeing that either. What’s more is a declining deficit says that government is a net drag on demand growth, This spells trouble in the face of the largest rise in inventories in 15 years. This is why I have flipped to seeing the US as now surprising to the downside. This is supportive of bonds.

That’s it for this week. Have a good weekend.