Global economy: No surprises

The global economy faces deflationary pressures as the vast credit expansion of the last 4 decades comes to an end.

$60 Trillion Global Credit

Commodity prices test their 2009 lows. Breach of support at 100 on the Dow Jones UBS Commodity Index would warn of further price falls.

Dow Jones UBS Commodity Index

The dramatic fall in bulk commodity prices confirms the end of China’s massive infrastructure boom.

Bulk Commodity Prices

Crude oil, through a combination of increased production and slack demand has fallen to around $60/barrel.

Crude Oil

Falling prices have had a sharp impact on global Resources and Energy stocks….

DJ Global Energy

But in the longer term, will act as a stimulus to the global economy. Already we can see an up-turn in the Harpex index of container vessel shipping rates, signaling an increase in international trade in finished goods.

Harpex

The latest OECD export statistics show who the likely beneficiaries will be. Primary producers like Brazil and Russia have suffered the most, while finished goods manufacturers like China and the European Union display growth in exports. The US experienced a drop in the first quarter of 2015, but should rebound provided the Dollar does not strengthen further.

OECD Exports

Australia and Japan offer a similar contrast.

OECD Exports

Oil-rich Norway (-5.8%,-13.3%) has also been hard hit. Primary producers are only likely to recover much later in the economic cycle.

Liquidity Mismatch Helps Predict Bank Failure and Distress

Liquidity mismatch compares the saleability (liquidity) of a bank’s assets to the stability of its funding. Assets such as cash and Treasury bonds are highly saleable and one can expect a ready market even in times of crisis. Residential mortgages are less liquid, but still saleable at a discount, while development and construction loans may prove unsaleable at any price when the market is under stress.

In terms of funding, long-term deposits offer stability but are far more expensive than short-term wholesale sources and call deposits. The latter, however, are highly unstable and were instrumental in the collapse of Northern Rock (UK) and Washington Mutual (US) during the global financial crisis (GFC).

The challenge facing bank regulators is to monitor liquidity mismatch to ensure bank health. The more illiquid and speculative the assets are, the more stable (illiquid) the bank’s funding sources must be to avoid a liquidity crisis during a market down-turn.

Liquidity mismatch =
(Liquidity-weighted liabilities – Liquidity-weighted assets) / Total assets

This paper by J.B. Cooke, Christoffer Koch and Anthony Murphy at the Dallas Fed (Liquidity Mismatch Helps Predict Bank Failure and Distress) suggests that large banks suffer from higher levels of liquidity mismatch and that liquidity mismatch is as important as capital ratios in determining bank health:

Precrisis Rise in Mismatch
Liquidity mismatch rose significantly between 2002 and 2007. The median level of mismatch climbed about 6 percentage points. Most of this rise was driven by changes in liquidity-weighted assets rather than liquidity-weighted liabilities. Banks pursued higher returns on riskier, less-liquid assets. To a lesser extent, banks relied less on stable core deposits and more on “unstable” wholesale funding. The rise in liquidity mismatch before the financial crisis is noteworthy because equity capital (as a percentage of assets)—the ultimate buffer against losses—changed little. The rise in mismatch was faster and more persistent at the largest banks, representing the top 25 percent of institutions (Chart 2). Among those banks, the median mismatch rose about 8.5 percentage points between 2002 and 2007, while at the 25 percent representing the smallest banks, the increase was only 3 percentage points.

Early-Warning Sign?
Bank regulators look for early-warning signs of distress. Is liquidity mismatch one? Comparing the fourth quarter 2007 mismatch levels of commercial banks that failed or became distressed in 2008 or 2009 with those that did not may provide an indication. The average levels of liquidity mismatch for the two groups were significantly different. Failed or distressed banks generally had much higher levels of liquidity mismatch, as shown by the final entry in the liquidity mismatch row of Table 1.

Liquidity Mismatch

While the timing of the changes in liquidity mismatch (as seen in Chart 2) and the difference in levels of mismatch at any one time (as seen in Table 1) suggest that liquidity mismatch is important, they do not necessarily imply that a rise in liquidity mismatch helps predict future bank failure or distress. Higher levels of liquidity mismatch may be correlated with lower levels of equity capital and higher proportions of brokered deposits and construction and land development loans as well as with nonperforming assets or lower returns on assets—all well-known predictors of failure or distress.

Modeling Failure and Distress
Statistical models were used to disentangle the effects of changes in liquidity mismatch from the effects of changes in equity capital and the other predictors of bank failure and distress between 2006 and 2011.9 This period was chosen because it followed a time when there were very few failures or cases of distress, the early 2000s. Failure or distress up to two years ahead was considered. For example, fourth quarter 2007 data were used to predict failure or distress any time in 2008.10 The results suggest that recent failure and distress rates are explained or predicted by many of the same factors as in 1985–92, when large numbers of commercial banks and savings and loans failed. These factors include too little equity capital, a high ratio of nonperforming assets and a high share of construction and land development lending……

Liquidity Mismatch Matters
Liquidity mismatch rose significantly before the financial crisis, especially at large banks, our research shows. The rise in mismatch contributed to the rise in bank failures and cases of distress. Liquidity mismatch helps predict bank failure or distress one year ahead, even accounting for equity capital and the other indicators at which regulators look.

Cooke is an economic analyst, Koch is a research economist and Murphy is an economic policy advisor and senior economist in the Research Department of the Federal Reserve Bank of Dallas.

Hat tip to Barry Ritholz.

T-Bonds Burn, RBA Minutes Next

From Adam Button on AshrafLaidi.com:

…..The direction of the bond market in recent weeks has been a major driver but what was notable on Monday was the divergence. Bund yields were up 2.5 basis points while 10-year Treasury yields were up 9 bps.

This might be the start of a new stage for bonds. In the rout, everything was being thrown overboard but now market participants are looking through the wreckage to decide what’s worth keeping. Ultimately, the ECB is still buying 60 billlion euros of bonds per month and that may keep bund yields pinned, at least relatively.

Read more at T-Bonds Burn, RBA Minutes Next.

European stocks

Germany’s DAX encountered support above 11000. Penetration of the descending trendline would indicate the correction is over and follow-through above 12000 would suggest a primary advance. Declining 13-week Twiggs Money Flow warns of continued selling pressure and a further test of 11000, but respect of support remains likely and would provide a solid base for further advances.

DAX

The Footsie also displays long tails, suggesting medium-term buying support, but declining 13-week Twiggs Money Flow indicates continued selling pressure. Breach of 6900 would warn of a correction to 6700, but further losses are unlikely at present. Recovery above 7100 would confirm the long-term breakout, offering a target of 8000*.

FTSE 100

* Target calculation: 7000 + ( 7000 – 6000 ) = 8000

Upsurge in global trade?

While commodity prices are tanking, with iron ore now trading below $50 per tonne, there are signs that international shipping of manufactured goods is on the increase. Shipbrokers Harper Petersen publish the Harpex, a weekly index of charter rates for container vessels. The recent up-turn reflects increased demand for container shipping — an important barometer of international trade.

Harpex Index

Footsie breaks 15-year high

The FTSE 100 overcame resistance at its December 1999 high of 6950, closing the week above 7000 for the first time. Expect retracement to test the new support level, but breakout signals a primary advance with a long-term target of 8000*. A 21-day Twiggs Money Flow trough above zero confirms long-term buying pressure.

FTSE 100

* Target calculation: 7000 + ( 7000 – 6000 ) = 8000

Germany’s DAX recovered above 12000, suggesting continuation of the advance. Expect resistance at the Deutsche Bank target of 12500 (from late 2014). Rising 21-day Twiggs Money Flow indicates strong buying pressure. Reversal below 11800 is unlikely at this stage, but would warn of a correction.

DAX

* Target calculation: 12200 + ( 12200 – 11900 ) = 12500

Strong advances on these two indices suggest a broader European recovery.

Why our prep-school diplomats fail against Putin and ISIS | New York Post

Kerry and Putin

“Why do our “best and brightest” fail when faced with a man like Putin?” Ralph Peters asks. “Or with charismatic fanatics? Or Iranian negotiators? Why do they misread our enemies so consistently, from Hitler and Stalin to Abu Bakr al-Baghdadi, the Islamic State’s self-proclaimed caliph?”

The answer is straightforward:

Social insularity: Our leaders know fellow insiders around the world; our enemies know everyone else.

The mandarin’s distaste for physicality: We are led through blood-smeared times by those who’ve never suffered a bloody nose.

And last but not least, bad educations in our very best schools: Our leadership has been educated in chaste political theory, while our enemies know, firsthand, the stuff of life.

Above all, there is arrogance based upon privilege. For revolving-door leaders in the U.S. and Europe, if you didn’t go to the right prep school and elite university, you couldn’t possibly be capable of comprehending, let alone changing, the world…….

That educational insularity is corrosive and potentially catastrophic: Our “best” universities prepare students to sustain the current system, instilling vague hopes of managing petty reforms.

But dramatic, revolutionary change in geopolitics never comes from insiders. It’s the outsiders who change the world.

An Athenian general once wrote:

The state that separates its scholars from its warriors will have its laws made by cowards, and its fighting done by fools.

~ Thucydides (c. 460 BC – c. 400 BC)

Read more at Why our prep-school diplomats fail against Putin and ISIS | New York Post.

Deflation in Australia?

The Eurozone experienced negative CPI growth over December/January.

CPI EU

Australia shows consumer price growth declining at the end of 2014. The next CPI update (Q1 2015), at end of April, is likely to reflect further slowing.

CPI Australia

Declining inflation expectations reported by Westpac (in the 0 to 5% range) tend to support this.

CPI expectations Australia (0 - 5% range)

Putin Will Never Back Down | Institutional Investor’s Alpha

Excellent analysis of the situation in Eastern Europe by Bill Browder, founder of London-based Hermitage Capital Management:

I’m afraid that, based on the reasons behind Putin’s motivations for invading Ukraine in the first place, there is no chance that he will back down. To understand this, all it takes is a simple analysis of how this crisis unfolded.

First, Putin didn’t start this war because of NATO enlargement or historical ties to Crimea, as many analysts have stated. Putin started this war out of fear of being overthrown like Ukrainian president Yanukovych in February 2014. Yanukovych had been stealing billions from the state over many years, and the Ukrainian people finally snapped and overthrew him. Compared with Putin, Yanukovych was a junior varsity player in the field of kleptocracy. For every dollar Yanukovych stole, Putin and his cronies probably stole 50. Putin understands that if he loses power in Russia, he and his underlings will lose all the money they stole; he will lose his freedom and possibly even his life.

I believe that Bill is right. Putin was not reacting to EU or NATO encroachment (they were never a threat), but to Maidan. Especially when we read Michael McFaul’s (former ambassador to Russia) summation of Putin: “He is obsessed with the CIA…..With respect Ukraine he believes the US led the coup in the Ukraine. The Ukrainians had nothing to do with it. It was all the CIA.”

Former Ambassador to Russia Michael McFaul

….. Putin has never dealt with economic chaos before. Though some may argue that this will bring him to the table to negotiate with the West, in my opinion any negotiation would be seen as a sign of weakness and is therefore the last thing Putin would want to do.

Putin’s only likely response is to escalate in Ukraine and possibly open up new fronts in other countries where there are “Russians to protect.” But doing so will only harden the sanctions, leading to further economic pain in Russia — and further military adventures to distract Russia’s people from that pain.

I cannot imagine a scenario in which there is any compromise, because for Putin compromise means being overthrown. Judging from all of his actions to date, he is ready to destroy his country for his own self-preservation.

We should start preparing ourselves for a war in Europe that may spread well beyond the borders of Ukraine. The only Western response to this has to be containment. This all may sound alarmist, but I’ve spent the past eight years in my own war with Putin, and I have a few insights about him that are worth knowing.

In Putin’s mind, he is fighting for survival. The US/EU/Nato and Ukraine are just a convenient scapegoat. His real enemy is the Russian people. This 1945 image of Benito Mussolini, his mistress Clara Petacci, and three others hanging outside a petrol station in Milan must haunt his dreams.
Bodies of Benito Mussolini, his mistress Clara Petacci, and three others hanging outside a petrol station in Milan

When they realize they have been duped, the anger of the Russian people will be palpable.

Read the full article at Unhedged Commentary: Putin Will Never Back Down | Institutional Investor's Alpha.