16/1/2015: S&P Capital IQ Global Sovereign Debt Report: Q4 2014

S&P Capital IQ’s Global Sovereign Debt Report is out for Q4 2014, with some interesting, albeit already known trends. Still, a good summary.

Per S&P Capital IQ: "The dramatic fall in oil prices dominated the news in Q4 2014, affecting the credit default swaps (CDS) and bond spreads of major oil producing sovereigns which have a dependence on oil revenues. Venezuela, Russia, Ukraine, Kazakhstan and Nigeria all widened as the price of oil plummeted over 40%. Separately, Greece also saw a major deterioration in CDS levels as it faces a possible early election."

And "Globally, CDS spreads widened 16%."

No surprises, as I said, but the 16% rise globally is quite telling, especially given CDS and bond swaps for the advanced economies have been largely on a downward trend. The result is: commodities slump and dollar appreciation are hitting emerging markets hard. Not just Russia and Ukraine, but across the board.

Some big moves on the upside of risks:

• "Venezuela remains at the top of the table of the most risky sovereign credits following Argentina’s default in Q3 2014, resulting in its removal from the report, with spreads widening 169% and the 5Y CDS implied cumulative default probability (CPD) moving from 66% to 89%." 
• The only major risk source, unrelated to commodities prices is Greece where CDS spreads "widened to 1281bps - an election as early as January could see a change of government and fears over a possible exit from the Eurozone have affected CDS prices." 
• "Russia enters the top 10 most risky table as CDS spreads widened around 90% following the fall in oil price which is adding more pressure to an economy already subject to continued economic sanctions." 
• "Ukraine CDS spreads also widened by 90%." 
• "CDS quoting for Nigeria remained extremely low throughout the last quarter of 2014. Bond Z-Spreads widened 150bps for the Bonds maturing in January 2021 and July 2023 but remained very active." 

Venezuela and Ukraine are clear 'leaders' in terms of risks - two candidates for default next.

Other top-10 are charted over time below:

Again, per S&P Capital IQ:

• "The CDS market now implies an 11% probability (down from 34% in Q3 2014) that Venezuela will meet all its debt obligations over the next 5 years, as oil prices dropped 40% in Q4 2014." 
• "Russia and Ukraine CDS spreads widened 90% during Q4 2014. The Russia CDS curve also inverted this quarter with the 1Y CDS level higher than the 5Y. Curve inversion occurs when investors become concerned about a potential ‘jump to default’ and buy short dated as opposed to 5Y protection." This, of course, is tied to the risks relating to bonds redemptions due in H1 2015, which are peaking in the first 6 months of the year, followed by still substantial call on redemptions in H2 (some details here: http://trueeconomics.blogspot.ie/2014/11/24112014-external-debt-maturity-profile.html). As readers of the blog know, I have been tracking Russian and Ukrainian CDS for some time, especially during the peak of the Ruble crisis last month - you can see some comparatives in a more dynamic setting here: http://trueeconomics.blogspot.ie/2014/12/16122014-surreal-takes-hold-of-kiev-and.html and in precedent links, by searching the blog for "CDS".
• "Greece, which restructured debt in March 2012, returned to the debt markets this year. CDS spreads widened to 1281bps and the 4.75Y April 2019 Bonds, which were issued with a yield of 4.95%, now trade with a yield of over 10%, according to S&P Capital IQ Bond Quotes." 

By percentage widening, the picture is much the same:

So all together - a rather unhappy picture in the emerging markets - a knock on effect of oil prices collapse, decline across all major commodities prices, dollar appreciation and the risk of higher US interest rates (the last two factors weighing heavily on the risk of USD carry trades unwinding) - all are having significant adverse effect across all EMs. Russia is facing added pressures from the sanctions, but even absent these things would be pretty tough.


Note 1: latest pressure on Ukraine is from the risk of Russia potentially calling in USD3 billion loan extended in December 2013. Kiev has now breached loan covenants and as it expects to receive EUR1.8 billion worth of EU loans next, Moscow can call in the loans. The added driver here (in addition to Moscow actually needing all cash it can get) is the risk that George Soros is trying to get his own holdings of Ukrainian debt prioritised for repayment. These holdings have been a persistent rumour in the media as Soros engaged in a massive, active and quite open campaign to convince Western governments of the need to pump billions into the Ukrainian economy. Still, all major media outlets are providing Soros with a ready platform to advance his views, without questioning or reporting his potential conflicts of interest. 

Note 2: Not being George Soros, I should probably disclose that I hold zero exposures (short or long) to either Ukrainian or Russian debt. My currency exposure to Hrivna is nil, to Ruble is RUB3,550 (to cover taxi fare from airport to the city centre on my next trip). Despite all these differences with Mr Soros, I agree that Ukraine needs much more significant aid for rebuilding and investment. Only I would restrict its terms of use not to repay billionaires' and oligarchs' debts but to provide real investment in competitive and non-corrupt enterprises.

15/1/2015: Upbeat German Data Might Not Be a Boom Signal for Europe

So German economy expanded 1.5% in 2014 and managed a budget deficit of just 0.4% of GDP. That's the latests numbers and they are beating performance since 2011. Which is good news.

Except for the bad news. Take a look at CES-Ifo data on current economic conditions and forward 6 months expectations.

Chart 1:

Per chart above, euro area assessments of own performance over 2014 were upbeat compared to Germany. The outrun is euro area economy under-performed Germany in the end. And forward:

Chart 2:

Euro area forward expectations remain also upbeat through Q3 2014 on 6 months forward basis. Which turned into downbeat print in Q4. But they remain upbeat through Q1 2015. And taking in the economy print for Germany for 2014, this suggests that euro area will be disappointing on growth over the next 3 months. Thereafter, either Germany will reignite euro area growth (option 1) or continue expanding without much of a response from the euro area (option 2)

What's more likely? Since 2010 through present, 6mo forward expectations in the euro area have been posting much shallower correlation with 6mo forward expectations in Germany (+0.56) than over pre-crisis period (0.66 for 2000-2007 and 0.70 for 1991-2000).  And these are taking Germany into account in euro area data.

Which suggests option 2 is likelier.

So it's Germany 1: Rest of EMU 0.5. Things are more worrying than 1.5% growth 2014 for German economy might imply.

15/1/2015: 2015 Outlook for Ireland: Domestic Bliss & Foreign Squeeze

This is an unedited version of my article for the Village Magazine, January 2015 (link here)

December data on Irish economy is painting a picture of a major slowdown in growth momentum and once more highlights the troubling nature of our national accounts statistics. With that in mind, and given the spectacular tremors rocking the global economy outside the well-insulated doors of our Department of Finance, Irish economy is set for an eventful 2015.

Let’s take stock of the prospects awaiting our small haven for tax-optimising MNCs and regulations-minimising foreign investors in the New Year.

Domestic Bliss

On domestic front, three drivers of economic recovery are offering some fireworks over the next 12 months. Here they are, in order of their importance.

The ongoing shift in MNCs activities here from profit-booking to cost-based transfer pricing, colloquially known as ‘contract manufacturing’. In simple terms, this means unprofitable low margin activities are outsourced by MNCs to their subdivisions and other MNCs located abroad, and resulting revenues are booked into Ireland. Official GDP rises here, while our domestic economy stands still. In H1 2014 this game of accounting shells has accounted for 2.5 percent of the 5.8 percent recorded growth in Irish GDP. In other words, some 43 percent of the growth ‘miracle’ that is Ireland Inc. was bogus. We don’t have detailed analysis of Q3 2014 data to determine the broader impact of ‘contract manufacturing’ yet, but the National Accounts data is not encouraging. The gap between the National Accounts-reported exports of goods and the same exports reported in our Trade Statistics is growing once again. Over Q2 and Q3 2014, this stood at a whooping EUR7 billion more than what a historical average implies. That is, roughly, 7.65 percent of our entire GDP over the same period. If we correct National Accounts data for this discrepancy, cumulative Q2-Q3 2014 GDP in Ireland would have posted a 0.4 percent decline year-on-year, not a rise of 5.4 percent recorded in the official statistics.

As the trend accelerates in 2015, Irish economy is likely to post greater paper gains and lower real activity amidst continuously deteriorating quality of our economic data.

The second driver to the upside is also MNCs-focused. Budget 2015 introduced massive incentives for the MNCs to book into Ireland intellectual property. Instead of the notorious Double Irish we now have an even more generous Knowledge Development Box. This reinforces already absurd change to the National Accounts estimation practices that re-labels R&D spending into R&D investment. The combined effect of both factors is likely to be more R&D ‘imports’ into Ireland. Latest data shows that overseas-originating patents filled in Ireland rose 22.4 percent year on year in Q3 2014. And that is before the ‘Knowledge Development Box’ opened its welcoming lid. As 2015 rolls on, expect more GDP supports from the new ‘investment’ products to hit the market here. Just don’t count on new jobs and higher domestic incomes to materialise out of this ‘smart economy’ any time soon.

The third force likely to propel Irish growth to new highs is the ongoing squeeze on building and construction sector imposed by a combination of a credit crunch, Nama assets-disposal strategy and woefully poor regulatory reforms that de facto cut down supply of buildable land and redevelopment sites, funding for development and dried out planning applications pipeline. The result is rising rents (GDP-additive) and prices (so-called ‘investment’ side of the national accounts) amidst deepening misery of rising business costs and escalating cost of living. Added up, Irish property sector ‘revival’ is now yet another force that simultaneously transfers money from the households and firms into the pockets of rent-seekers and the Government, whilst gilding with fools gold national accounts.

Foreign Squeeze

The domestic bliss of GDP growth described above will be severely challenged in 2015 by the continued deterioration in the global economic conditions. Here we have some serious flash points of risks, trailing back from 2013-2014 and some new ones that are likely to emerge in 2015 on their own right.

Back at the beginning of 2014, expectations for global growth recovery in 2015 were driven by rosy forecasts for North America and the Emerging Markets.

Euro area was expected to post rather sluggish, but nonetheless above 1 percent recovery in 2014 and rise to close to 2 percent annual growth rate in 2015. Fast forward to today. Latest forecasts suggest near-zero growth in 2014 followed by ca 1 percent growth in 2015. So Europe’s prospects are bleak. That’s roughly 35 percent of our indigenous exports trade in the bin. But at least low growth is likely to delay the inevitable rise in interest rates, giving our heavily indebted households another stay on execution.

The U.S. miracle of economic recovery is heavily dependent on interest rates policy not reverting back to rising rates and in all likelihood, the U.S. Fed might just oblige. Should the Fed change its mind, all bets are off: we might see a slowdown in the U.S. recovery and with it – a fall-off in the U.S. demand for Irish exports, both indigenous ones and MNCs’.

The UK is a great example of the fragility also present in the U.S. economy. Like the U.S., the UK is heavily dependent on supportive monetary policy. And, ahead of the U.S., its economy is starting to hit serious bumps. Latest data shows continued declines in house prices, while demand is stagnating and inflation is slipping to long-term lows. Last time we saw UK inflation at current levels was in 2002 – amidst the dot.com bubble-induced recession.

Take U.S. and UK markets and we have over 50 percent of demand for Irish indigenous exports put under rising risk.

Which leaves us with the rest of the world. Here, the Emerging Markets are tanking, fast. Brazil is in an outright recession. Russia is slipping into one at a speed of a rock falling through the foggy ravine. China is on the brink of a major de-acceleration in growth, and that is under rather rosy predictions. India is enjoying some warm afterglow of expansionary monetary policies, but the question is – for how long. South Africa is moving sideways: a quarter of contraction is followed by a quarter of anemic growth.

Irish Government Budget 2015 projections were based on following assumptions:

-       Irish GDP growth of 3.9 percent or 0.85 percentage points above the IMF forecast from October and 0.6 percentage points below November forecasts by the OECD

-       Euro area growth of 1.1 percent or bang on with IMF and OECD forecasts, as well as the EU Commission, but the risks are still to the downside in all of these forecast.

-       U.S. growth of 3.1 percent, virtually identical to the IMF forecast and current consensus amongst the economists, but some business surveys suggest growth closer to 2.4-2.5 percent.

-       UK growth of 2.8 percent or 0.1 percentage points above the IMF forecast from October and OECD forecast from November. More recent forecasts published in early December suggest UK economy might expand by 2.4-2.6 percent in 2015.

Global headwinds are not favourable to Ireland, although we do have some aces in our sleeve. These aces are: aggressive tax optimisation and already suppressed domestic demand, the two drivers that might, just might return that 3.9 percent expansion in 2015.

Still, for now, the forecasts arithmetic suggests that the Government really did miss a major opportunity in Budget 2015. You see, the pesky problem is, as the Irish Fiscal Advisory Council estimates show, Irish growth at 3.5 percent in 2015 will mean the Government missing on the illusive 3 percent deficit target. As the above forecasts slip back over time, the 3.9 percent growth assumption is likely to be revised closer and closer to that critical point at which the Government risks losing face in front of the proverbial International Markets. And that won’t go too well in the Government buildings.

Add to the above some other silly assumptions made in the Budget, such as static current expenditure for 2015-2018 horizon and zero policy change, and you get the idea. Over recent months, the Government has revised its spending plans in relation to Irish Water by some EUR300 million. And over the next 12 months it will have to revise its agreements with the Trade Unions on public sector costs moderation. Then, there is the political cycle that simply commands that the Government unleash a torrent of budgetary giveaways onto electorate itching to send the FG/Labour coalition into the proverbial recycling bin of history.

All told, the real economy is likely to continue underperforming into 2015, just as it did in 2014. In the first 3 quarters of this year, total domestic demand (a sum of private and public consumption and investment, plus changes in the stocks of goods and services in the economy) was up just 2.18 percent year on year in real terms. Over the last three years, covered by the current Government policies, total domestic economic activity has expanded by a miserly 0.29 percent in real terms. That is less than half the rate of growth in GDP over the same period. And the latest quarter has been even less impressive, with domestic demand falling 0.3 percent year on year, same as in Q3 2013.

So tighten those belts for one more year of pain: the slimming down of Irish economy is not over yet.

14/1/2015: European Banks: Permanently in the International Isolation Ward

My blog post on the declining fortunes of European banking for Learn Signal blog is available here: http://blog.learnsignal.com/?p=143

14/1/2015: Gazprom to Europe: See You in Turkey

And we have it... from the mouthpiece of Moscow, the Rossiyskaya Gazeta (link to Russian version here).

Head of "Gazprom" Alexei Miller announced new strategy in response to the changes to the EU energy policy. This involves:
1) South Stream pipeline is dead. Permanently.
2) South Stream is to be replaced by Turkish Stream, crossing Black Sea and landing in Turkey, with no plans for connecting to Europe.
3) If Europe wants Russia gas, it will have to build its own connection from Turkey.
4) All gas supplied via Ukraine - currently 63 bcm of gas going to Europe via Ukraine transit - will be shipped via Turkish Stream.
5) Shipments of gas via non-Ukraine transit will continue (in 2013 total Russian gas supplies to Europe were 161.5 bcm and in 2014 these were down roughly 10 percent).

All of this is a response to the EU plans to monopolise purchasing of energy from outside the EU. The EU is aiming to increase its bargaining power both vis-a-vis prices of delivery and delivery channels (pipelines access). Understandably, Russian objective is to retain some pricing power and control over transit systems (remember, these systems are built either using Russian funds or a combination of funds involving Russian funds).

The implications of Miller's announcement are wide-ranging. In effect, Russia is calling Europe's bluff on both Ukraine and Energy Union.

If Ukraine is shut out of transit of Russian gas, Kiev will be forced to lock into European supply systems. The risk of non-payments - a very material risk given Kiev's track record over the 1990s and 2000s - will fall squarely onto European system. Alternatively, Ukraine will be exposed to the risk of Gazprom dictating its terms on gas supplies to Ukraine. Ukraine will also lose lucrative billions in transit fees (ca USD3bn in 2013 alone) and will face new costs for shipments of gas - cheaper via direct route from Russia, more expensive via European system link up.

Turkey is a big winner here as it gets to become the dominant key hub (ahead of Nord Stream) for transit of gas to Europe (including Central Asian gas).

EU is not necessarily a loser in this, however. Owning the pipe from Turkey to Europe, the EU will be able to negotiate transit of Central Asian gas as a substitute for Russian gas with minimal capital expenditure.

14/1/2015: ECJ Advocate on OMT: We Allow Fudge

Big news today is old news of yesterday:

We can now expect the European Court of Justice to give green light to the ECB's Outright Monetary Transactions (OMT) program as being 'compatible with EU law'. This is based on the interim ruling made today by the ECJ's Advocate General Pedro Cruz Villalon. In the tradition befitting European institution, Villalon said OMT is legal "in principle" under the EU treaty as long as it meets certain criteria.

The restriction is that the ECB refrains from "direct involvement" in fiscal/government financing (which can be satisfied by ECB buying sovereign debt via secondary markets alone). The problem here is that currently secondary markets are already pricing in huge premium on sovereign bonds, with many (including some 'peripheral' countries') bonds trading at negative rates. So ECB will be de facto buying an overpriced paper. The key question, therefore, is who carries two risks:
1) Market risk relating to market pricing (if bonds prices slip over time); and
2) Default risk relating to sovereign decisions (if bonds carry haircuts in the future).

More on these risks later today.

Key point missed by many commentators is that approving OMT does not equate to approving QE. Another key point is that ECB QE is restricted not only by the objections to any purchases of sovereign bonds, but also by the objections to the potential modalities of purchases, such as total quantum, the distribution of purchases across the member states and the nature of risk sharing. The latter problems were not addressed by the ECJ.

All in, there is little new in the ECJ ruling. ECJ traditionally rubber-stamps EU-centric measures. Hence, given the EU support for QE, the decision is hardly a watershed.


Background to ECJ decision:

The key issue to be decided by the ECJ is whether the ECB has, in principle, a right to purchase sovereign bonds outside the immediate monetary policy considerations (e.g. supply of liquidity to the banking sector).

Back in July 2014, Germany’s Constitutional Court criticised the OMT, saying it probably overstepped the boundaries of monetary policy allowed to ECB. However, the German Constitutional Court ruling effectively gave ECJ full consideration of the OMT legality. OMT traces back to July 2012, when ECB President, Mario Draghi, vowed to do “whatever it takes” within the ECB's mandate to save the euro.

The ECJ heard arguments from both sides of the OMT divide in October 2014.


What to expect next:

Technically, German court can revisit the issue after the ECJ ruling, but most likely, a favourable ruling from the ECJ will allow ECB to push forward with some direct QE measures, such as buying government bonds in the markets. The key question, therefore, is whether the quantity of purchases will be sufficient to stimulate the euro area economy or will it fall short of the required. Rumours have it, the ECB is likely to buy up to EUR500 billion worth of sovereign bonds on top of EUR1 trillion programmes to purchase private assets. One sure bet is that the move will be a huge support scheme for bondholders and banks, who will witness significant appreciation in the value of their bond holdings. ECB purchases will do nothing to ease the burden of already excessive government debt levels. And, depending on modalities, the ECB purchases of bonds can have little impact on aggregate demand in the euro area economy.

We can, nonetheless, expect some sort of a bold QE-related announcement at the next ECB meeting.

Key point is that even if ECJ approves OMT legality, we will need to see the details of the QE programme to make any judgement as to its potential effectiveness. The fudge of ECB policy 'innovations' lives on.

13/1/2015: Remittances from Russia: Big Business for Ukraine & Other ex-USSR States

An interesting chart in today's FT summing up the flow of remittances from Russia to other former USSR states:

The above highlights the tragic nature of the Ukrainian crisis. The economic and personal ties between Russia and Ukraine are not just deep - they are fundamental to the structures of both economies and societies.

As a note to the above: World Bank data is most likely underestimating the true extent of the remittances flows. Official figures understate true numbers of Ukrainian (and exclude dual) citizens working in Russia who have family connections back in Ukraine by a factor probably close to 30 percent. In 2013, Russian authorities estimated that of 11.3 million foreigners entering Russia, some 3 million did so to undertake illegal work.

The household remittances from Russia are vastly more significant to the Ukrainian economy than the entire trade with the EU and the US, combined. In effect, Russian labour markets sustain Kiev by simultaneously reducing demand for social funding of the unemployed, and increasing household consumption and investment, with zero input costs. Thus, remittances from Russia account for as much as 3.55% of the total value added in the Ukrainian economy in 2012.

Russia is home to 79.3 percent of the officially-registered migrants from all of the ECA countries, while Ukraine is net sender of some 5.1 million (based on 2013 figures) to other countries, including Russia.

You can read more here: http://siteresources.worldbank.org/INTPROSPECTS/Resources/334934-1288990760745/MigrationandDevelopmentBrief21.pdf

12/1/2015: Falling... falling... still... falling: Oil Prices in Time

With WTI just flying past USD45.99/bbl price marker and Brent fell through USD47.47, here's the best visualisation of the 'Plight of Oil' (courtesy of @EdConwaySky):

Note: Above is Brent, but, hey... anyone cares at that stage?..

And here's one in a more historical perspective (courtesy of @Convertbond):

Note: Above is through December 2014. Which means that by now, we are down at the levels of October1990-April 1991 crisis and heading further South.

And in case you are keen on celebrating the above as a definitive Western victory over the Bad Russkies, as Reuters is reporting - Standard Chartered might need to raise USD4.4 billion in capital to cover losses due to commodities-related loans exposures (link). 

12/1/2015: Euro Area vs US Banks and Monetary Policy: The Weakest Link

Cukierman, Alex, "Euro-Area and US Banks Behavior, and ECB-Fed Monetary Policies During the Global Financial Crisis: A Comparison" (December 2014, CEPR Discussion Paper No. DP10289: http://ssrn.com/abstract=2535426) compared "…the behavior of Euro-Area (EA) banks' credit and reserves with those of US banks following respective major crisis triggers (Lehman's collapse in the US and the 2009 [Greek crisis])".

The paper shows that, "although the behavior of banks' credit following those widely observed crisis triggers is similar in the EA and in the US, the behavior of their reserves is quite different":

• "US banks' reserves have been on an uninterrupted upward trend since Lehman's collapse"
• EA banks reserves "fluctuated markedly in both directions". 

Per authors, "the source, this is due to differences in the liquidity injections procedures between the Eurosystem and the Fed. Those different procedures are traced, in turn, to differences in the relative importance of banking credit within the total amount of credit intermediated through banks and bond issues in the EA and the US as well as to the higher institutional aversion of the ECB to inflation relatively to that of the Fed."

Couple of charts to illustrate.

As the charts above illustrate, US banking system much more robustly links deposits and credit issuance than the European system. In plain terms, traditional banking (despite all the securitisation innovations of the past) is much better represented in the US than in Europe.

So much for the European meme of the century:

1. The EA banking system was not a victim of the US-induced crisis, but rather an over-leveraged, less deposits-focused banking structure that operates in the economies much more reliant on bank debt than on other forms of corporate funding; and
2. The solution to the European growth problem is not to channel more debt into the corporate sector, thus only depressing further the reserves to credit ratio line (red line) in the second chart above, but to assist deleveraging of the intermediated debt pile in the short run, increasing bank system reserves to credit ratio in the medium term (by increasing households' capacity to fund deposits) and decreasing overall share of intermediated (banks-issued) debt in the system of corporate funding in the long run.

12/1/2015: Euro area and Russian Economic Outlooks: 2015

My comments to the Portuguese Expresso, covering forecasts for 2015 for Russia and the Euro area:

- Russia

Despite the end-of-2014 abatement of the currency crisis, Russian economy will continue to face severe headwinds in 2015. The core drivers for the crisis of 2014 are still present and will be hard to address in the short term.

Geopolitical crisis relating to Eastern Ukraine is now much broader, encompassing the direct juxtaposition of the Russian strategy aimed at securing its regional power base and the Western, especially Nato, interest in the region. This juxtaposition means that risks arising from escalated tensions over the Baltic sea and Eastern and Central Europe are likely to remain in place over the first half of 2015 and will not begin to ease until H2 2015 in the earliest. With them, the prospect of tougher sanctions on Russian economy is unlikely to go away.

While capital outflows are likely to diminish in 2015, Russia is still at a risk of increased pressures on the Ruble due to continued debt redemptions calls on Russian companies and banks. In H1 2015, Russian companies and banks will be required to repay ca USD46 billion in maturing debt, with roughly three quarters of this due to direct and intermediated lenders not affiliated with the borrowers. These redemptions will constitute a direct cash call of around USD25 billion, allowing for some debt raising in dim sum markets and across other markets not impacted by the Western sanctions. USD36.3 billion of debt will mature in H2 2015, which implies a direct demand for some USD17-20 billion in cash on top of H1 demand. The peak of 2015 debt maturity will take place in Q1 2015, which represents another potential flash point for the Ruble, especially as the Ruble supports from sales of corporate foreign exchange holdings requested by the Government taper off around February.

Inflation is currently already running above 10 percent and this is likely to be the lower-end support line for 2015 annual rate forecast. Again, I expect spiking up in inflation in H1 2015, reaching 13-14 percent, with some stabilisation in H2 2015 at around 11 percent.

Economic growth is likely to fall off significantly compared to the already testing 2014.

Assuming oil prices average at around USD80 per barrel (an assumption consistent with December 2014 market consensus forecast), we can expect GDP to contract by around 2.2-2.5 percent in 2015, depending on inflation trends and capital outflows dynamics.

Lower oil prices will lead to lower growth, so at USD60 per barrel, my expectation is for the economy to shrink by roughly 4-5 percent in 2015. Crucially, decline in economic activity will be broadly based. I expect dramatic contraction in domestic demand, driven by twin collapse in consumer spending and private investment. In line with these forces, demand for imports will decline by around 15 percent in 2015, possibly as much as 20 percent, with most of this impact being felt by European exporters. Public investment will lag and fiscal tightening on expenditure side will mean added negative drag on growth.

About the only positive side of the Russian economy will be imports substitution in food and drink sectors, and a knock on effect from this on food processing, transportation and distribution sectors.

To the adverse side of the above forecasts, if interest rates remain at current levels, we can see a broad and significant weakening in the banks balance sheets and cash flows arising from growth in non-performing loans, and corporate and household defaults, as well as huge pressure on banks margins and operating profits. This can trigger a banking crisis, and will certainly cut deeper into corporate and household credit supply.

On the downside of my forecast, a combination of lower oil prices (average annual price at around USD50-60 per barrel) and monetary tightening, together with fiscal consolidation can result in economic can result in a recession of around 7 percent in 2015, with inflation running at around 13 percent over the full year 2015.

Even under the most benign assumptions, Russian economy is facing a very tough 2015. Crucially, from the socio-economic point of view, 2015 will see two adverse shocks to the system: the requirement to rebalance public spending on social benefits in order to compensate for inflation and Ruble devaluation pressures, and the rising demand on social services from rising unemployment. Volatility will be high through H1 2015, with crisis re-igniting from time to time, causing big calls on CBR to use forex reserves and prompting escalating rhetoric about political instability. We can also expect Government reshuffle and rising pressure on fiscal policy side. The risk of capital controls will remain in place, but. most likely, we will have to wait until after the end of Q1 2015 to see this threat re-surfacing.


- Eurozone

2014 was characterised by continued decoupling of the euro area from other advanced economies in terms of growth. Stagnation of the euro area economy, arising primarily from the legacy of the balances sheet crisis that started in 2007-2008 will remain the main feature of the regional economy in 2015. Despite numerous monetary policy innovations and the never-ending talk from the ECB, the European Commission and Council on the need for action, euro area's core problems remain unaddressed. These are: public and private debt overhangs, excessive levels of taxation suppressing innovation and entrepreneurship, a set of substantial demographic challenges and the lack of structural drivers for productivity growth.

My expectation is for the euro area economy to expand by around 0.8-1 percent in 2015 in real terms, with inflation staying at very low levels, running at an annual rate of around 0.6-0.7 percent. Inflation forecast is sensitive to energy prices and is less sensitive to monetary policy, but it is relatively clear that consumer demand is unlikely to rebound sufficiently enough to lift inflation off its current near-zero plateau. Corporate investment will also remain stagnant, with exception of potential acceleration in M&A activities in Europe, driven primarily by the build up in retained corporate earnings on the balance sheets of the North American and Asian companies.

Barring adverse shocks, growth will remain more robust in some of the hardest-hit 'peripheral' economies, namely Ireland, Spain and Portugal. This dynamic is warranted by the magnitude of the crisis that impacted these economies prior to 2013. Thus, the three 'peripherals' will likely out-perform core European states in terms of growth. Italy, however, will remain the key economic pressure point for the euro area, and Greece will remain volatile in political terms. Within core economies, recovery in Germany will be subdued, but sufficient enough to put pressure on ECB and the European Commission to withdraw support for more aggressive monetary and fiscal measures. France will see little rebound from current stagnation, but this rebound will be relatively weak and primarily technical in nature.

Crucially, the ECB will be able to meet its balance sheet expansion targets only partially in 2015. Frankfurt's asset base expansion is likely to be closer to EUR300-400 billion instead of EUR500 billion-plus expected by the policymakers. The reason for this will be lack of demand for new funding by the banks which are still facing pressures of deleveraging and will continue experiencing elevated levels of non-performing loans. In return, weaker than expected monetary expansion will mean a shift in policymakers rhetoric toward the thesis that fiscal policies will have to take up the slack in supporting growth. We can expect, therefore, lack of progress in terms of fiscal consolidations, especially in France and Italy, but also Spain. All three countries will likely fail to meet their fiscal targets for 2015-2016. Thus, across the euro area, government debt levels will not post significant improvement in 2015, carrying over the pain of public sector deleveraging into 2016.

As the result of fiscal consolidation slack, growth will be more reliant on public spending. While notionally this will support GDP expansion, on the ground there will be little real change - European economies are already saturated with public spending and any further expansion is unlikely to drive up real, ROI-positive, activity.

Overall, euro area will, despite all the policy measures being put forward, remain a major drag on global growth in 2015, with the regional economy further decoupling from the North American and Asia-Pacific regions. The core causes of European growth slump are not cyclical and cannot be addressed by continuing to prime the tax-and-spend pump of traditional European politics. Further problem to European growth revival thesis is presented by the political cycle. In the presence of rising force of marginal and extremist populism, traditional parties and incumbent Governments will be unable to deploy any serious reforms. Neither austerity-centric deleveraging approach currently adopted by Europe, nor growth-focused reforms of taxation and subsidies mechanisms will be feasible. Which simply means that status quo of weak growth and severe debt overhangs will remain in place.

The above outlook is based on a number of assumptions that are contestable. One key assumption is that of no disruption in the current sovereign bonds markets. If the pick up in the global economy is more robust, however, we can see the beginning of deflation in the Government bonds markets, leading to sharper rise in 'peripheral' and other European yields, higher call on funding costs and lower ability to issue new debt. In this case, all bets on fiscal policy supporting modest growth will be off and we will see even greater reliance in the euro area on ECB stance.

11/1/2015: ECB's Favourite Inflation Expectations Indicator is Smokin...

And here's a nice reminder courtesy of @SoberLook.com of the markets' view of 5-year-to-10-year forward inflation expectations for the euro area:

Note: 5y/5y inflation swap basically measures expected inflation for the period of between 5 years from now and 10 years from now (5 years over 5 years from now). Here is a note on its importance to ECB policy http://www.itcmarkets.com/news-press/itc-egbs-questions-regarding-draghis-reference-to-5y5y-forward-rate-and-inflation.

Needless to say, at ECB inflation target of 2% over the next 1-2 years, we should be expecting 5y/5y to be above 2% mark, not below it. And if previous (2004-2007 period) should be our guide for growth, we should be looking at 5y/5y swap rate at around 2.4%.

Which means the 'flashing red' indicator for ECB is now smoking.

11/1/2015: Ending 2014 with a Bang: Russian Inflation & Ruble Crisis

Couple footnotes to 2014, covering Russian economic situation. Much is already known, but worth repeating and tallying up for the full year stats.

Ruble crisis with its most recent up and down swings took its toll on both currency valuations and inflation. Over 2014, based on the rate tracked by the Central Bank of Russia, the ruble was down 34% against the euro and 42% against the USD. The gap reflects depreciation of the euro against the USD.

Virtually all of this relates to one core driver: oil prices. In 2014, Brent prices lost 48% of their values and Urals grade lost 52% of its value. Urals is generally slightly cheaper than Brent, but current gap suggest relatively oversold Urals. It is a bit of a 'miracle' of sorts that Ruble failed to completely trace Urals down, but overall, you can see the effect oil price has - overriding all other considerations, including capital flight and sanctions.

Ruble valuations took their toll on Moscow Stock Exchange - RTS index, expressed in USD, lost 43% of its value, reaching levels comparable to Q1 2009 (791 at the end of 2014, from 1,388 at the start of January 2014).

And ruble crisis pushed inflation well ahead of 5% short term target from CBR set for 2014. Preliminary estimates for December put inflation at 11.4%, with food inflation at 15% (7.3% in 2013), goods (ex-food) at 8% (4.5% in 2013) and services at 10% (8% in 2013). M/m inflation hit 2.6% in December 2014 - the highest since January 2005). Overall inflation was 6.5% in 2013, 6.6% in 2012, 6.1% in 2011 and 2010 and 8.8% in 2009. Last time Russian inflation hit double digit figures was in 2008 - at 13.3%.

Comment via BOFIT: "The pick-up in inflation at the end of the year reflected the ruble’s sharp depreciation and the ensuing frenzy of household spending. Following the ban on certain categories of food imports last autumn, food prices have risen even if no food shortage has actually emerged." Most of this is pretty much as reported. One point worth highlighting - lack of shortages, which is contrary to some of the hype paraded in the media about Russians suffering greatly from diminished supplies and stores running out of goods.

Again per BOFIT: "Representatives of food producers and retail chains committed in September to a government initiative that their members would not raise prices without good reason or create artificial shortages in the market. There has been no move by the government as yet to impose price controls as in 2010. The agreement could have limited price increases somewhat."

And a chart from the same source illustrating pick up in inflation:

Update: Some more numbers on inflation: Meat prices were up 20.1% in 2014, having posted deflation of 3% in 2013; fish prices were up 19.1% in 2014, a big jump on 7.6% inflation in 2013. Cereals are up 34.6% against 3.2% in 2013.