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.

10/1/2015: Where did Europe's EUR3 trillion worth of debt go?

You know the Krugmanite meme… Euro area is doing everything wrong by not running larger deficits. But here is an uncomfortable reality: since 2007, Euro area countries have managed to increase their debt in excess of 60% of GDP by a staggering EUR3 trillion.

So here's the crux of the problem: where did all this money go?

We know in terms of geographic distribution:

EUR1.6 trillion of this debt increase went to the 'peripheral' countries, and EUR39.2 billion went to the Easter European members of the Euro area. EUR517 billion went to the 'core' economies. And a whooping EUR759.9 billion to France. Now, across the 'periphery' some 20-25% of the debt increase is attributable to the banks measures directly, but the rest is a mix of automatic stabilisers (e.g. increases in unemployment benefits due to higher unemployment) and old-fashioned Keynesian policies.

It might be that Euro area is not spending enough in the right areas of fiscal policy. But to make an argument that it is not spending enough across the board is bonkers. We have allocated some EUR3 trillion in borrowed spending and we will continue to run the debt up in 2015. And still there is no sign of growth on the horizon.

So, again, where is all this money going?

10/1/2015: Irish Retail Sales: November

Irish retail sales figures for November, published by the CSO earlier this week came in at the weaker end of the trend. Here is detailed analysis.

On seasonally-adjusted basis:

• Value of retail sales ex-motors fell 0.31% m/m in November having posted a 1.04% gain in October. 3mo MA through November was down 0.11% on 3mo MA through October, which itself was down 0.07% on 3mo MA through September.
• Volume of retail sales ex-motors was up 0.19% m/m in November, having posted a rise of 0.96% in October. 3mo MA through November was up 0.26% m/m  for the 3 months through November compared to 3mo MA through October, having previous posted identical increase in October, compared to 3mo MA through September.
• Meanwhile, Consumer Confidence was, for a change, more closely aligned with value of sales indicator. Consumer Confidence indicator was down0.23% m/m in November, having posted 0.68% decline in October.

Two charts to illustrate:

The first chart above plots longer-range series, showing two main insights:

1. Consumer confidence continues to vastly outpace actual retail sales performance in terms of both value and volume of sales, although we are starting to see de-acceleration in consumer confidence growth in terms of trend. Nonetheless, consumer confidence bottomed-out around July 2008. Actual retail sales did not bottom out until June 2012 (in Volume and Value of sales terms).
2. Since bottoming out, retail sales have been performing with virtually divergent dynamics. Trend in Volume of sales is relatively strong, upward. Meanwhile, trend in Value of sales is relatively flat, upward. In more recent months, this divergence is increasing once again.

The above is again confirmed in November data and in year-on-year comparatives too, as shown in the next chart.

Year on year (based on seasonally unadjusted data):

• Value of retail sales ex-motors rose 1.33% y/y in November having posted a 1.91% gain y/y in October. 3mo MA through November 2014 was up only 1.4% on 3mo MA through November 2013.
• Volume of retail sales ex-motors was up robust 3.92% y/y in November, having posted a rise of 4.40% in October. 3mo MA through November was up 3.7% y/y.

The above data clearly supports trends identified in previous months: Irish consumers are not striking, nor are they holding back consumption. Instead, they are willing to buy when they see value. Unfortunately for our retailers, that means more sales with lower profit margins. As the chart below shows, we now have 13 consecutive months of growth in volume of sales outstripping value of sales and out of the last 21 months, only one posted growth rate in value of sales in excess of volume of sales.

Using my Retail Sector Activity Index to plot underlying activity across the sector (note: the RSAI has much higher correlations with both indices of retail sales than consumer confidence), chart below shows that in 2014, growth rate in overall sector activity slowed down significantly compared to 2013.

The above, of course, is rather natural for the recovery that first produces a faster bounce up and then settles into more 'sustainable' over time rate of growth. The problem, however, is that current activity by value of retail sales is still 39.1% below the pre-crisis peak levels and for volume of sales it is 34% below peak. Even compared to the pre-crisis average (2005-2007), activity is down 11.2% in value terms and 3.2% lower in volume terms.

9/1/2015: Advisor-Driven Investment Management: Partial, Biased and Risky?

My post for Learn Signal blog on the issue of sell-side advice and inherent conflicts of interest and biases that are material to advice-driven investments: http://blog.learnsignal.com/?p=142