6/2/21: Longer Trends in Economic Uncertainty

 

Quite dramatic trends in terms of rising economic uncertainty over the last 21 years:

And, not surprisingly, the rise of uncertainty in Europe, the U.S., and globally pre-dates the Covid19 pandemic. In fact, Europe has been experiencing dramatically elevated uncertainty levels since the start of the Euro area crisis, while the U.S. saw a virtually exponential rise in uncertainty from 2017 on. Global measures of uncertainty have been running high through 2016 and rose dramatically thereafter. 

While amelioration in the Covid19 pandemic dynamics is likely to lower the levels and the volatility of the uncertainty in global economic systems, it is highly unlikely to return us to the pre-Global Financial Crisis state of affairs.

20/8/20: All Markets are Now Monetized

 

While the economy burns, the stock markets are literally going bonkers. Here are the main implied volatility options:

Which are symmetric, in so far as they treat volatility as symmetrically-valued to the upside and downside. And here is another way of looking at the same concept via repricing speed, or the rate of change in actual P/E ratios of S&P500 over longer time horizons, in this case: 20 weeks running P/E ratios change:

Source of the chart is @longvieweconomics. What does the above show? We have S&P500 at an all-time high. S&P500's PE ratio (PER) is only slightly below the 2000 peak. And, we have the fastest rate of S&P over-valuation increase in history - full 85 percentage points trough to peak. Both, the fundamentals and the momentum of their deterioration are absolutely out of control. Of course, this is just the stocks. One must never mention the massive bubble blown up by the Fed in the bonds markets. 

The 20-weeks moving change in weekly yields for Aaa-rated bonds maxed out at historical high of -44.06% (remember, lower yields = higher prices) in the week of July 31st this year. Top three historically highest rates of change took place in the three weeks of July 24th-August 7 this year. Overall range of bonds repricing is in the range of 60 percentage points in the current cycle:

This is plain horrendous: there is nothing in the macro and micro fundamentals that can warrant these changes. Except for the expectation of continued monetary accommodation of the Wall Street into the infinitely long future. 

23/2/20: The 'Fundamentals' of the Financial Markets Are Hardly Changed by the COVID2019, So Far...

An informative chart via Holger Zschaepitz @Schuldensuehner on the Global equity markets impact of the continuously evolving threat of the nCov-2019 or #COVID2019 virus epidemic:

Looks not quite as dire as it might sound, folks.

• Global equities lost some $470 billion worth of market value this week. 
• Which is 0.537% of the market cap at the start of the week 
• The market is still up more than 3 percent year to date
• The market is massively up on 2020 to date lowest point (+3.7 percent)
• Most of the effect is in Asia Pacific - not to discount it, but it is material since AP region has much more capacity for a rebound (higher savings, investment and potential growth rates) from the crisis effects than slower moving advanced economies.

Looking at longer terms within the advanced economies, here is a summary of the major indices cumulative moves over the 1 week - 6 months time horizon in percent:

So far, no panic, but last week really does look ugly, unless one seriously thinks about the degree to which market pricing is divorced from economic fundamentals, as exemplified by the 6 months changes: 22.26 percent upside in Nasdaq? 15 percent in Germany? 13.43 percent in Japan?.. 

So let's ask two questions: Q1: Does anyone believe there are long term economic or socio-economic fundamentals behind the above numbers? and Q2: If the markets are pricing in monetary sugar buzz of Kiddies at Halloween  Bucket of Sweets proportion on the upside, how on earth can the same markets price some serious fundamentals on the downside? 

The markets gyrations are only tangentially - and only in the short run - relate to tangible news flows, like nCov-2019 statistics. And they sure a hell do not relate linearly to any data on GDP impacts of the epidemic. Because markets have not reacted to GDP figures since well-before the Global Financial Crisis hit. Worse, there is no logic that can explain why markets are reacting to nCov2019 promise of dropping interests rates and priming the global QE pump in an opposite direction to the markets reactions to all previous slowdowns in global growth. 

We are still dealing with the same 'clueless and buzzed' crowd of 'investors' who value Tesla at inverse of the company's manipulated core statistics, and Netflix at inverse of company's manipulated profitability metrics, and Apple at inverse of company's forward growth potential. We are still dealing with the same 'jittery herd' that slushes from one 'not QE' to another 'Abenomics breakthrough' to the fiscal policy moaning of the ECB, while stopping to slam some shots at the occasional 'take profit' Wild West saloon.  

Forget one week to next markets gyrations. The real impact of nCov epidemic won't be seen until we have the monetary policy reactions at an aggregate level. So watch this chart instead:

When this line heads North above 3-4 percent mark, the real markets data will come in. Indications are: https://www.marketwatch.com/story/all-star-economists-urge-fed-to-use-qe-and-new-tools-to-fight-next-recession-just-move-sooner-and-go-bigger-than-crisis-2020-02-21?mod=the-fed. 

23/4/19: Property, Property and More Property: U.S. Household Wealth Bubble

According to the St. Luis Fed, U.S. household wealth has reached a historical high of 535% of the U.S. GDP (see: https://www.zerohedge.com/news/2019-04-16/where-inflation-hiding-asset-prices).

There is a problem, however, with the above data: it reflects some dodgy ways of counting 'household wealth'. For two primary reasons: firstly, it ignores concentration risk arising from wealth inequality, and secondly, it ignores concentration risk arising from households' exposure to property markets. A good measure of liquidity risk controlled allocation of wealth is ownership of liquid equities (note: equities, of course, and are subject to Fed-funded bubble dynamics). The chart below - via https://www.topdowncharts.com/single-post/2019/04/22/Weekly-SP-500-ChartStorm---21-April-2019 shows a pretty dire state of equity markets (the source of returns on asset demand side being swamped over the last decade by shares buybacks and M&As), but it also shows that households did not benefit materially from the equities bubble.

In other words, controlling for liquidity risk, the Fed's meme of historically high household wealth is seriously challenged. And controlling for wealth inequality (distributional features of wealth), it is probably dubious overall.

So here's the chart showing just how absurdly property-dependent (households' home equity valuations in red line, index starting at 100 at the end of the Global Financial Crisis) the Fed 'wealth' figures (blue line, same starting index) are:

In fact, dynamically, rates of growth in household home equity have been far in excess of the rates of growth in other assets since 2012.  In that, the dynamics of the current 'sound economy' are identical (and actually more dramatic) to the 2000-2006 bubble: property, property and more property.

9/1/2019: Assets with Negative Returns: 1901-present [Updated]

Updating the chart for major assets performance 1901-present, based on data from http://trueeconomics.blogspot.com/2018/12/191218-assets-with-negative-returns.html:

This is epic.

19/12/18: Assets with Negative Returns: 1901-present

Highlighting the evidence presented in the earlier-linked article, here is the chart based on data from the Deutsche Bank Research team, showing historical evidence on the total percentage of all key asset classes with negative annual returns:

CHART

Source: Data from Deutsche Bank Research and author own calculations.

I have highlighted 7 occasions on which the percentage of negative returns assets exceeded 50%. Only three times since 1901 did this percentage exceed 60%, including in YTD returns for 3Q 2018.

8/12/18: Shares Buybacks Hit Diminishing Marginal Returns

The S&P 500 Buyback Index Total Return data tracks the performance of the top 100 stocks with the highest buyback ratios in the S&P 500 in terms of total return. As the chart below shows, the Buyback Index has generally and significantly outperformed S&P500 returns since 2008:

with three discernible periods of outperformance highlighted in the second chart:

In simple terms, since December 2015, the Buyback Index Total Return performance relative to S&P500 returns has stagnated, despite accelerating buybacks by the S&P500 corporates. In part, this is driven by the increased buybacks activity in the less active companies (not constituents of the Buyback Index), but in part the data suggests that the returns to buybacks are generally tapering out.

At the same time, correlation between S&P500 returns and Buyback Index returns has been weakening from around the same time:

All of the above indicates a breakdown in the traditional post-2008 pattern of returns, as buybacks role as the drivers for improved ROE performance for top S&P500 shares re-purchasers is starting to run into diminishing returns.

17/11/18: Nine in Ten in the Red: Asset Markets YTD Returns Signal Risk Repricing

According to a recent research note from the Deutsche Bank, 89% of global macro assets are posting losses on year-to-date basis. This is the highest level of losses in more than a century.

Given the scale of financial risk mis-pricing in equities and bonds markets in the post-QE period, we are likely to witness more downward movement in the assets valuations in months to come. A gradual deleveraging that the market trends have been supporting so far remains highly incomplete and requires more pronounced re-pricing of assets to the downside.

Read more on this here: http://trueeconomics.blogspot.com/2018/11/161118-horsemen-of-financial-markets.html. 

16/11/18: The Horsemen of the Financial Markets Apocalypse

My column for the Manning Financial  is now available here: http://issuu.com/publicationire/docs/manning_financial_november_2018?e=16572344/65613030.

9/9/18: Populism, Middle Class and Asset Bubbles

The range of total returns (unadjusted for differential FX rates) for some key assets categories since 2009 via Goldman Sachs Research:

The above highlights the pivot toward financial assets inflation under the tidal wave of Quantitative Easing programmes by the major Central Banks. The financial sector repression is taking the bite out of the consumer / household finances through widening profit margins, reflective of the economy's move toward higher financial intensity of output. Put differently, the CPI gap to corporate costs inflation is widening, and with it, the asset price inflation is drifting toward financial assets:

This is the 'beggar-thy-household' economy, folks. Not surprisingly, while the proportion of total population classifiable as middle-class might be stabilising (after a massive decline from the 1970s and 1980s levels):

 Incomes of the middle class are stagnant (and for lower earners, falling):

And post-QE squeeze (higher interest rates and higher cost of credit intermediation) is coming for the already stretched households. Any wonder that political populism/opportunism is also on the rise?

18/8/18: Kiplinger quotes on equity markets

Kiplinger quotes myself on Deutsche Bank, PG&E, and General Electric
https://www.kiplinger.com/slideshow/investing/T052-S001-10-roughed-up-stocks-to-buy-for-a-recovery-rally/index.html.

30/7/18: Impact of Terrorist Events on European Equity Markets

Our recent paper on the impact of terrorist events on equity markets valuations in Europe has been published in the Quarterly Review of Economics and Finance (November 2017): https://www.sciencedirect.com/science/journal/10629769

7/6/17: Equity Markets Continue to Mis-price Policy Risks

There has been some moderation in the overall levels of Economic Policy Uncertainty, globally, over the course of May. The decline was primarily driven by European Uncertainty index falling toward longer-term average (see later post) and brings overall Global EPU Index in line with longer term trend (upward sloping):

This meant that short-term correlation between VIX and Global EPUI remained in positive territory for the second month in a row, breaking negative correlations trend established from October 2015 on.

The trends in underlying volatility of both VIS and Global EPUI remained largely the same:

The key to the above data is that equity markets risk perceptions remain divorced from political risks and uncertainties reflected in the Global EPUI. This is even more apparent when we consider actual equity indices as done below:

Both, on longer-run trend comparative and on shorter term level analysis bases, both S&P 500 and NASDAQ Composite react in the exactly opposite direction to Global Economic Policy Uncertainty measure: rising uncertainty in the longer run is correlated with rising equities valuations.

18/7/16: Stock Markets Crashes: 1955-2015

A good summary of all stock markets crashes since 1955 through 2015 via Goldman Sachs:

The caption to the chart says it all.

12/5/16: Leaky Buckets of U.S. Data

Recently, ECB researchers published an interesting working paper (ECB Working Paper 1901, May 2016). Looking at the U.S. data that is released under the embargo, they found a disturbing regularity: across a range of data, there is a strong evidence of a statistical drift some 30 minutes prior to the official time of the release. In simple terms, someone is getting data ahead of the markets and is trading on it in sufficient volumes to move the market.

Let’s put this into a perspective: there is a scheduled release for private data that is material for pricing the market. The release time is t=0. Some 30 minutes before the official release, markets start pricing assets in line with information contained in the data yet to be released. This process continues for 30 minutes until the release becomes public. And it moves prices in the direction that correctly anticipates the data release. The effect is so large, by the time t=0 hits and data is made publicly available, some 50% of the total price adjustment consistent with the data is already priced into the market.

"Seven out of 21 market-moving announcements show evidence of substantial informed trading before the official release time. The pre-announcement price drift accounts on average for about half of the total price adjustment,” according to the research note.

Pricing occurs in S&P and U.S. Treasury-note futures and data sample used in the study covers January 2008 through March 2014.

Here is the data list which appears to be leaked in advance to some market participants:

1. ISM non-manufacturing
2. Pending home salses
3. ISM manufacturing
4. Existing home sales
5. Consumer confidence from the Conference Board (actually, CB has taken some actions recently to tighten their releases policy)
6. Industrial production (U.S. Fed report)
7. The second reading on GDP
8. There is also partial evidence of leaks in other data, such as retail sales, consumer price inflation, advance GDP estimates and initial jobless claims. 

Overall, plenty of the above data are being released by non-private (aka state) agencies.

The authors control for market expectation, including forecasts drift (as date of release grows nearer, forecasts should improve in their accuracy, and this can have an effect on market pricing). They found that “more up-to-date forecasts” are no “better predictors of the surprise” than older forecasts. In addition, as noted by the authors: “these results are robust to controlling for, among others, outliers, data snooping, nearby announcements and the choice of the event window length.”

The problem is big and has gotten worse since 2008. “Extending the sample period back to 2003 with minute-by-minute data reveals both a higher announcement impact and a stronger pre-announcement drift since 2008, especially in the S&P E-mini futures market. Based on a back-of-the-envelope calculation, we estimate that since 2008 in the S&P E-mini futures market alone the profits associated with trading prior to the o fficial announcement release time have amounted to about 20 million USD per year.”

Two tables summarising there results.

The paper is available here: http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1901.en.pdf?ca0947cb7c6358aed9180ca2976160bf



1/12/15: Markets at a Lower Edge of Growth

During a number of recent financial conferences that I had an honour of contributing to, the repeated leitmotif of Q&As with the audiences has been: "Where's the value in today's markets?" This is hardly surprising, given the state of prime sovereign fixed income and equities markets (both overbought), corporate fixed income markets (closer to fair valuation, but with elevated spreads and volatility), and commodities markets (depressed by long running fundamentals of demand and supply). Short of investing in 17th century furniture futures or philately options, any investor today will be hard pressed to find a broader theme for a buy-and-hold allocation.

Now, the same anecdotal evidence is confirmed by the Morgan Stanley analysts:

Source: Bloomberg

So equities/fixed income allocations for traditionally structured neutral portfolio have converged in returns for both the U.S. and European markets and at levels not worth taking a punt at. Meanwhile, risk-adjusted returns have all but evaporated:

 Source: Bloomberg

A handful of quotes (all via Bloomberg):

"What is notable for 2016 is that, unlike past years, both our long- and short-term forecasts point to muted equity upside.”

"Having been positive on developed market equities in recent years, it is notable that all of our regional index targets now imply little upside for stocks in 2016. Morgan Stanley’s economists forecast that global GDP growth will nudge slightly higher next year (to 3.3 percent from 3.1 percent in 2015), but our regional earnings forecasts suggest companies are having a tougher time turning modest economic growth into decent profit growth."

"The flatness of the [efficiency] frontier means that the optimal portfolio will lie near the left-hand extreme of the red line for a variety of investor utility functions. Relative to prior later-cycle periods, growth looks weaker, central bank policy looks looser, and credit risk premiums are more elevated."

In summary, then: there is no story of growth and with this, there is no story of financial returns uplift. 

9/6/2014: 2 charts, 2 markets, same nagging sensation...

Two charts worth paying close attention to:

The first one from Deutsche Bank:

The above is showing ratio of S&P500 Price/Earnings ratio to VIX (quarterly) volatility indicator. Recent uplift in the series is down to simultaneously:

• Rising equity price relative to earnings, and
• Falling markets volatility

The second one is via TestosteronePit, showing the first bit: rising equity prices relative to falling earnings, except not for S&P, but for European equities:

Care to draw any conclusions as to rational expectations vs short-term profit chasing?..

28/8/2012: Debt- v Equity-led Funding and Systemic Crises

Apparently, there's been some serious movements in today's banks CDS, signaling some pressure building up in the system and potentially a disconnect between equity markets and bond markets. This wouldn't be the first time the two are mis-firing in an almost random fashion. In the longer-term, however, such episodes are very troubling for a good reason - long term imbalances build up in the two sources of capital funding is hard to unwind. It turns out, however, the difficulty of unwinding these is non-symmetric.

Last week's NBER Working Paper number 18329 (link here), titled "Debt- and Equity-led Capital Flow Episodes" by Kristin J. Forbes and Francis E. Warnock looked at "the episodes of extreme capital flow movements—surges, stops, flight, and retrenchment... [leading to] the question of":

• Which types of capital flows are driving the episodes and 
• If debt- ( bonds and banking flows) and equity-led (portfolio equity and FDI) episodes differ in material ways. 

"After identifying debt- and equity-led episodes, we find that most episodes of extreme capital flow movements around the world are debt-led and the factors associated with debt-led episodes are similar to the factors behind episodes identified with aggregate capital flow data. In contrast, equity-led episodes are less frequent, more idiosyncratic, and differ in nature from other episodes."

The study uses data on 50 emerging and developed countries starting with 1980 (at the earliest) and running through 2009.

The study found that "the vast majority of extreme capital flow episodes across our sample—80% 

of inflow episodes (surges and stops) and 70% of outflow episodes (flight and retrenchments)—are 
fueled by debt, not equity, flows."

After that, the paper develops analysis of "the factors that are associated with debt- and equity-led episodes of extreme capital flows. We follow the Forbes and Warnock (2012) analysis here by describing capital flow episodes as being driven by specific global factors, contagion, 

and/or domestic factors." 

The study found that: "to a first approximation equity-led episodes appear to be idiosyncratic, bearing 
little systematic relation to our explanatory variables. Notably, even the risk measures that were 
highlighted in Forbes and Warnock (2012) as being significantly related to extreme movements in 
aggregate capital flows have little or no significant relationship with equity-led episodes. In contrast, 
risk measures are important in explaining debt-led episodes; when risk aversion is high, debt-led surges 
are less likely and debt-led stops are more likely. Contagion, especially regional, is also important for 
debt-led episodes. Country-level variables are largely insignificant, except for domestic growth shocks; 
debt-led stops are more likely in countries experiencing a negative growth shock and debt-led surges are more likely in countries with a positive growth shock."

Perhaps in a warning to the policymakers currently embarking on financial repression path for dealing with the ongoing crises, "capital controls have little or no significance in  both equity-led and debt-led episodes, as also found in Forbes and Warnock (2012)."

Of course, we have to keep in mind that the current crisis is really a debt-led capital markets crisis, both at the corporate and sovereigns levels. And it is symmetric both for the US and Europe, where the main difference is not as much in equity vs debt financing, but in intermediated vs direct debt issuance.

Economics 16/06/2009: Oil & Gas and NTMA's auction

For a longer post with my thoughts on oil and gas prices, scroll down.


NTMA's gamble... per NTMA release today:

On Tuesday 16 June, NTMA offered two bonds in the auction,

• the 3.9% Treasury Bond 2012 and
  
• the 4.6% Treasury Bond 2016.

Actual results are below:
"Total bids were received for €2.397 billion and it was decided to issue a total of €1 billion [as planned]. An amount of €500 million of the 4.6% Treasury Bond 2016 was issued where the total bids received were 2.5 times the amount allocated, while €500 million of the 3.9% Treasury Bond 2012 was also issued where the total bids received were 2.2 times the amount allocated. The 2016 bond was sold at an average yield of 4.755% while the 2012 bond was sold at an average yield of 3.056%."

If you look at the table above, NTMA always preferred issuing €300mln in shorter maturity bonds and €700mln in longer maturity bonds - a 30:70 split. This time around, it appears it had to borrow heavier in shorter maturity range, hence 50:50 split. And this is for 2016 bond as opposed to 2019 bond earlier. Ouch...

Price spreads min-max were also relatively heavy on shorter maturity. Compare the following two screen shots:
June 16th auction: spreads of 19bps on 2016 bond (2.375 pa ) and 16bps on 2012 bond (5.33 pa)
May 119th auction: spreads of 37bps on 2019 bond (3.7 pa) and 5bps on 2014 bond (1 pa).

Again, NTMA are doing excellent work here, but it is a tough job...



Natural Gas - upward?

Natural-gas prices have been lagging oil prices over the recent months despite the fact that gas drilling and production are on decline worldwide. This has been noted by some Irish analysts, most notably – Davy, whose June 15 quick daily note must be credited for spotting the trend first in the Irish market.

Per Davy note (Caren Crowley): “The ratio of the US oil price to gas price is reaching record highs. A reversion to more normal levels requires the oil price to pull back or the gas price to rally. With the oil price looking unstoppable, it is all up to the gas price, but it is an uphill battle.” There is not much of a real in-depth analysis in the Davy note, so here are some of my thoughts on the issue.

First some short-term facts:

US gas prices have fallen 34% in 6 months to June 2009 and 72% off 2008 peak. In part, this is driven by demand declines. But, as Davy note states, supply capacity has been catching up on downward trajectory: “the number of rigs exploring for, and producing, gas has fallen 56% since September 2008 when it peaked at 1,606, and is at its lowest level since 2002.” This is yet to translate into actual supply cuts as “US gas inventories are abnormally high and are 22% above their five-year average.”

In early April, US natural gas inventories stood at 1,650bn cubic feet in the week ended and steady, equivalent to 300 bn cf above 5 year average and 400bn above year before. Chart 1 below (courtesy of Energy Information Administration) shows that this abnormal situation has gone worse since then with gas inventories breaching the 5-year min-max range for the first time since May 2007.
Now, 25%-30% of US gas production comes from relatively young wells (drilled in the last 12 months). A significant cull of drilling rigs operating today will, therefore, translate into higher demand for imports in winter 2009-2010. The number of running (producing) rigs was down to 1,039 in the week of April 1, 2009, according to Baker Hughes (BHI) - down 49% from the 2,031 level seen in mid-September 2008 -- the highest since 1980.

Chart 2 shows the same over the longer period, with clear signs of seasonality and a rising trend in inventories over time.
One noticeable feature here is that volatility below the trend has been declining throughout the April 2003-April 2006. Afterward, the maximal depletions of gas reserves have steadily increased through April 2008, before once again starting to decline in late 2008 through April 2009. The rate of the later decline has been so far consistent with the rate of decline in 2003-2006 period. This is exactly identical to the 4 years falling, 3 years rising and 1 year falling cycle in 1996-2002.

Another feature is the lack of similar cyclicality at the maximum surplus inventories level, in other words – in peaks above the trend (dashed line). In fact, the trend here is identical (in slope) to the average trend line. Furthermore, when it comes to surplus inventories deviations, current historically high levels (for November 2008) are actually below the maximal inventories trend.

The two facts together suggest that high inventories are not being driven by excessively high supply of gas (which would be consistent with abnormally low minimal inventories in around April trough and abnormally high maximal inventories in and around late Autumn).

Yet another interesting feature of the data is captured in Chart 3, which clearly shows that in recent months, weekly growth rate in inventories has not fallen substantially for positive growth rates, while the rate of natural gas inventories depletion (the negative range) has declined.


Given that this already accounts for seasonality and the weather effects have not been dramatically out of line, what’s going on? The answer is: twin effects of demand changes and equity markets trends are driving prices of oil, while only demand changes have been instrumental in determining the price of natural gas to date. And this is about to change...

On the demand side, power gen accounts for 58% of all US gas demand and this has been falling – 6-8% down so far in 2009. It is also important to note that gas-based electricity generation in the US is concentrated in the Western Pacific states and Northern Atlantic Board states – all of which have seen serious economic pressures on demand side.

But these fundamentals do not really explain the historic trend in gas prices. Futures prices for natural gas have now hit their lowest levels since 2002. Recent pricing below $4 per million British-thermal-unit on the NYMEX, down from $9 mbtu in Q1 2008.

Again, supply-demand analysis does not explain this. Fundamentals analysis focuses on abnormally cold weather in early 2008, which pushed spot prices up and resulted in higher levels of exploration activity. Production capacity increased, but demand collapsed. Fine theory, except, recall prices are down more than 50%, although US Energy Department expects natural-gas consumption to decline by only 1.3% in 2009.

And US gas prices are linked to global gas prices – which are facing significant pressure on the Russian supply side. How? In two ways:

Short-term pressure is rising due to delays in pumping annual storage reserves in Ukraine – a technical issue that can derail gas supplies to Europe. Basically, the principle here is a simple one. To run gas pipe between Russia and Western Europe (the pipe transiting Ukraine), Soviets built a pressure maintenance system that requires intermediate storage facilities (positioned on Ukraine’s territory out of the Soviets’ consideration for ‘balanced regional development’ and owned by Ukraine) to be filled to capacity. This ensures that if Ukraine’s own gas purchases start depleting the pipe flow, the flow can be topped up with reserves of gas. Ukraine is broke and has no cash to pay for this gas – which it will own once it is pumped into storage. Russians are telling Ukrainians that they can’t give them a $2bn loan for gas and are offering to split the loan between Russia and the EU. EU is refusing. So we have stalemate. Now things are getting even more complicated because Ukraine also owes Russians further $3bn worth of cash for gas supplied to the Ukrainian consumers. In short – if gas is not pumped into storage tanks within the next 2 months, there will be serious risk of disruption of gas supplies to Europe in fall/winter 2009-2010. This in turn will lead to price increases for gas globally.

Long-term pressure is also rising due to Russian gas production now shifting to the Eastern Siberian plains. Completion of the new pipeline to service China and Japan is a sign of this. The problem here is that unlike Western Siberian plains, Eastern Siberian plains have smaller gas fields, fewer developed fields and geology that is much more challenging (shale, smaller reservoirs, more complex folds and more broken folds) that the near-perfect sands of Western Siberia. Again, this signals an upside to gas prices in the longer term (I will write about this in few days in more details).

So in the nutshell, future supply constraints are daunting. And these should be working in both short term and long term in the future... Again, supply is not the main driver for the abnormal situation of falling gas prices and rising inventories.


So what is? One word answer is ‘oil and gas price correlations with equity markets’. In my view, it is a speculative buying of oil as a hedge against inflation and the ‘blue chip’ low risk commodity that is driving a wedge between oil prices and gas prices and simultaneously driving closer oil prices and equity prices.

A series of charts below illustrate this point.



Chart above shows relatively coincident long-run trends in DJIA and Oil prices that are not replicated in gas prices. This is confirmed in the scatter plot below. Here, strong correlations in oil and gas prices against DJIA occur over significantly different slope relations. If 100 points increase in DJIA index leads to a $1.4 increase in the price of oil, the same change in DJIA index is associated with a $0.16 rise in the price of gas. While at parity this appears to be a movement in favour of oil, given current conditions in the market (the extremely high negative correlation between price of oil and price of gas and extremely low price of natural gas) any changes in the stock markets valuations should, based on fundamentals, drive prices of gas closer to the price of oil. Expressed in current price percentage terms, table 1 below the chart shows these historically-justified price responses.

Chart below illustrates what I mean by extreme correlations
Notice that current correlation is:
(a) within the range of -0.75-1;
(b) the change in correlation between peak of June 2008 (+99.3) to today (-88.1) is the highest on record for downward adjustment.
Chart above shows the replay of the oil and gas prices correlation in line with the broad equity markets. Here, while correlation between DJIA and oil prices stands at +0.78 and remains in the positive territory since September 2008, the correlation between DJIA and gas prices is at -0.57 and has moved into negative territory in May 2009.

This is interesting, because the structure of gas prices to date contrasts the findings of the recent research on links between oil and gas prices. Jose A. Villar (Energy Information Administration) and Frederick L. Joutz (Department of Economics, The George Washington University) paper The Relationship Between Crude Oil and Natural Gas Prices, prepared for Energy Information Administration, Office of Oil and Gas in October 2006, shows that there exist “a cointegrating relationship relating [natural gas] prices [and] the WTI and trend capturing the relative demand and supply effects over the 1989-through-2005 period. The dynamics of the relationship suggest a 1-month temporary shock to the WTI of 20 percent has a 5-percent contemporaneous impact on natural gas prices, but is dissipated to 2 percent in 2 months. A permanent shock of 20 percent in the WTI leads to a 16 percent increase in the [gas] price 1 year out all else equal.”

So the lags structure implies that a temporary shock to oil price should be followed by a delayed shock to gas prices 12 months after and that the magnitude of changes in gas prices is roughly 80% of the magnitude of shock to oil price.

Clearly, as table above and charts illustrate, this relationship is currently being reversed, suggesting two emerging short- and medium-term trends:

1. fundamentals (firming demand/falling supply) trends indicating significant room for gas prices increases in the range closely linked, but shallower (at 70-80%) than those in oil prices. This implies trend price for gas of ca $8-8.25 per thousand cubic feet of gas;
2. short-run dynamics trends, indicating a ca 6% upside to gas price relative to oil price in the next 3-6 months, implying a price range of $6.8-6.9 per thousand cubic feet.

Short of a W-shaped global recession risk, there is little downside pressure on gas prices in the medium term in my view.

Economics 05/05/2009: US' Green weeds

US data, some assert, points to a recovery around the corner. Well, it just might matter how far around the corner the recovery really is, doesn't it? A mile? Few hundred years? Or just at your feet - sitting cap-cap-in-hand and begging to be noticed.

Now, unlike many other economists, I can confess that I can't really tell. We, the economists, are, you see, rather far-sighted - neither good peripheral vision, nor short-sightedness afflict our ability to see into the future. We can tell you with some accuracy what the Euro/dollar exchange rate should be in 3-5 years ($1.10-1.05/Euro) but not what it might be tomorrow.

But there are facts that even we, the mighty economists cannot ignore. Here are some on those alleged 'green shoots'.

Fact 1: Home sales and prices: US new home sales were up in February +4.7% to a miserably low 337,000. At the peak in 2005 the number was 1.4mln. Do the maths.

March pending home sales index rose 3.2% compared with February and was up 1.1% y-o-y. The index covers sales contracts signed on existing homes. About time, given the historically low mortgage rates and an $8,000 tax credit for the first-time buyers. And it takes on average 6 weeks for this to feed through to the existent home sales figures. But housing starts are at 358,000 - 80.4% off their peak of 1,823,000 and the US still has some 12.2 months worth of housing stock on sale - more than 2.4 times the normal average.

Inventory-to-sales ratio for homes is now up at 1.43 (February figures) - relative to normal average of 1.25. In prices terms, median home is now selling for $200.9K - 20% below $251K.

Existing home sales have fallen 1/3 since the peak of September 2005 and the median price is down 28.7% since peak in July 2006. Again, February saw a rise ine xisting homes sales of 4.4% and the median price rose 2.4%, but inventories are still running at double the 5 month level of sales that is considered normal. Not surprisingly (see below under Fact 5), 45% of all home sales in February were foreclosed properties.

Since 2007, 0.9% of GDP was shaved off every quarter due to the 80% collapse in the new housing starts alone. Even if the US economy has hit the bottom in terms of new homes starts, this will only mean that housing starts from Q3 2009 (considering lags) will contribute 0% to GDP growth.


Fact 2: Consumption: In Q4 2008 personal consumption was down 3%. Then the Feds pumped $127bn into personal income via tax rebates (up 11% y-o-y), offsetting an $89bn cut in earnings in Q1 2009. This will slow down in Q2 2009 as the only personal income stimulus will be May Social Security 'bonus' of $250 per person. On the back of this, the engine of US economy, consumers is now showing signs of some revival - as the latest UofM index suggests. The process is aided by lower prices (deflation), lower gasoline costs and lower mortgage rates, although with most mortgages being fixed, the latter is of less help unless you are of the severely endangered species genus - the new buyer.

Demand for durable goods fell 0.8% in March in a seventh monthly decline since July 2008. New orders posted falls in virtually all sectors. Shipments were down 1.7%. On a positive note, inventories fell 1.1% and capital spending by businesses rose 1.5% posting a second consecutive increase, albeit on an abysmally depressing fall-off in January. Both, in my view, are not signs of strength, but of the moderation in the rate of industrial production slowdown – a ‘dead cat’ bounce. Since inventories are still running high, cutting these down to sales levels will mean erasing the loss in GDP growth of up to 2%. But the net contribution to GDP growth is going to be - you've guessed it - zero. And income is not necessarily going to translate into new spending - households first priority right now is deleveraging and the second priority is precautionary saving. What's left might be consumed, however little that might be...

But here is the bad news. All recessions in the modern history have on average saw personal income contracting 4-7%. So far, wages declined at 4% annual rate in Q1 2009, and payroll-tax receipts were down 8.2% in Q1 2009 y-o-y. So personal income growth will not be showing any 'green shoots' any time soon. Should we head for the upper range of the average 'normal' recession estimates, we are in for another acceleration in wages declines, to bring the total annual loss of income (and thus demand) to over $250bn in 2009. Good luck getting those Middle-Americans to consume much more than WalMart crisps and soda any time soon.


Fact 3: Growth in GDP won't yield growth in jobs: Unemployment is a lagging indicator in general, but consumers don't care that much what economists think - they need stability of income and security of job tenure before they start buying big ticket items again. Q2 2008 US had strong positive growth at +2.8% increase in GDP, while unemployment climbed up. In a traditional recession, this does not matter much as devaluation would normally drive investment cycle restart on the exports side, pulling in domestic consumers as well. Not this time around, folks. So we are down to looking at unemployment figures and unemployment sources.

Q1 2009 we saw US unemployment ranks swell by 2mln with unemployment rate moving to 8.5% (up from 7.6% in Q4 2008). US is now running on unemployment that is the highest (per unemployment rate) in over 25 years. And things are getting tougher by the day - March saw unemployment increases in 46 out of 50 states. California has 11.2% unemployment rate - record number for over 68 years. Even Jimmy 'Peanut' Carter wasn't able to wreck as much destruction during his disastrous Presidency.

Worse yet: underemployment (unemployed + part-time workers seeking full-time jobs + discouraged workers) is at 15.6%. Now, here is a tricky thing - underemployment is a leading indicator - temporary employment (a component of the part-time numbers) leads unemployment by 6-10 months. So if we are not seeing temporary jobs gains yet, we won't see ordinary unemployment falling for another 2-3 quarters. And then it will take some time for the labour market to work through the pool of surplus labour before we can expect a pick up in wages. The pesky issue is: in March there were further losses of 71,700 temp jobs - an acceleration on February and well above the monthly average of 47,900 temp jobs lost since December 2007 when the temporary jobs numbers fell for the first time.

Industrial production is down 1.5% in March m-o-m and 12.8% y-o-y, capacity utilization down to 69.3% - record low since 1967. Now, with this excess capacity in place, Goldman Sachs research estimated that even if output gap grows from 7% in 2009 to 10% in 2010, while GDP grws at 4.75% pa, it will take the economy some 5 years to work off excess capacity. This, of course is a powerful drag on business investment, which is good news for software companies and IT solutions speceialists and bad news for investment goods producers.


Fact 4: Financial Services are still in trouble. Banks, especially regional ones, are popping like soap bubbles - the grand total of failed US regional banks now stands at 32 since January 1 and 57 since the beginning of this recession. The rate of closures is accelerating. Two weeks ago - 5 banks were shut down, last week - 4. Not many green shoots (other than weeds) out there, amongst the smaller financials.

Per all the hype about the recent banks' results, here is a good analysis: "Citigroup said it made $1.6 billion [profit]. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi's own debt. ...Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn't actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of 'earnings'. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in 'profit' on impaired assets. Without theses one-time adjustments, Citi's $1.6 billion in first quarter profit becomes a $2.8 billion loss." Hmm... If I were a bank, I bet I could print profits out thin air and on the back of taxpayers cash injections too.

And the fundamentals are getting weaker too: some 3.22% of consumer loans were delinquent (30+ days overdue) at December 2008 mark - the highest rate of delinquencies in almost 35 years - since February 1974. The late payment rate on dealers-supplied auto loans were at a record 3.53% in Q4 2008, up from 3.25% in Q3 2008, direct auto loans: up from 1.71% to 2.03%. Late payments on home equity credit lines - a record 1.46% up from 1.15%, direct home equity loans delinquencies were up to 3.03% from 2.63%. Credit cards delinquencies rose to 4.52% from 4.20% but remained only slightly above the 4.47% average over the last four years. So with newly minted 2mln unemployed in Q1 2009 - expect these numbers to keep on rising.

There is no point to reiterate the estimates (the latest being from the IMF) that show the US banking sector standing to lose $1.5-2.5 trillion due to writedowns. So far, only $1 trillion of these were taken.


Fact 5: Personal and Business bankruptcies are up and rising. Average personal bankruptcy filings were at 5,945 daily in March - 9% increase in m-o-m terms and 28% up y-o-y. 5.06% of prime mortgage holders have already missed one or more payments, sub-prime mortgage holders (1/3 of the total market) delinquencies are at 22%. Foreclosures are up 46% y-o-y in March and 17% in m-o-m terms. Moody's estimate that number of repossessed homes will rise to 2.1mln in 2009 from 1.7mln in 2008. But business bankruptices are rising even faster than consumers' - last year, 136 US plcs filed for bankruptcy, up 74% on 2007, according to law firm Jones Day in April. IntraLinks, a bankruptcy data analysis group, said in April it had seen a 180% jump in bankruptcy and reorganization deals for the three-month period ended February 15, 2009, compared to the same period last year. US consumers bankruptcy filings jumped 29% in February y-o-y to 98,344, according to the American Bankruptcy Institute. ABI expect 1.4 million consumer bankruptcies in 2009, "at least".

On the net, do tell me if you see some 'green' shoots out there. I would love to seed them.