WORLD ECONOMY AND EMERGING COUNTRIES: THE END OF THE FINANCIAL TANGO

WORLD ECONOMY AND EMERGING COUNTRIES: THE END OF THE FINANCIAL TANGO

As of the end of April, the world economy is going to have great difficulty to reach 3.5% yearly growth as forecasted by the IMF in its latest report. Despite all these favorable conditions, why doesn't the economy recover?

The indicator most closely followed by the world economy on a monthly basis is the JP Morgan global composite PMI index: it has declined by 0.6 on year-to-year basis and reached a point near the six month zenith with 54.2 but 54.2 seems to be inadequate. Oil prices have declined by 30% since the beginning of the year, the Fed no longer prints more money. But more than 30 central banks have filled his gap. The tightening period of budgetary policies has taken an end.

Everyone can sense a number of reasons. For example, the US economy has left behind a terrible 1^st Quarter due to the temporary shocks, and could not contribute enough to the global demand. China has no longer the same power. Japan is still trying to recover from the impact of the increase in VAT introduced last year which had a negative effect upon the demand, developing countries are delaying the supply-side reforms, etc.

But these are very superficial explanations; a more structured and somewhat alarming causes lie beneath. First, the global production chains are no longer prolonged. That is, the production does not diversify from one country to another, in a sense the globalization has slowed down and the world trade has started to grow slower than the world output. The export-based economies such as South Korea, Taiwan and China are the ones that suffer the most from this. Even worse, the US began to import manufacturing to his country thanks to cheaper oil and natural gas and the multiplier effect has been reduced.

The second reason for the sluggishness of the world economy was due to the slowing down in the global trade and liberalization of the investment and capital flows. With the countries returning to the protectionism, the world economy is growing slower.

The third reason is the cheapening of oil that has not yet been fully reflected in consumer prices. In some countries, the state confiscated the cheap oil bonus through the budget savings, consequently the oil prices did not drop enough due the appreciation of the Dollar Index, so the consumer who has not prospered ultimately does not spend. In parallel with this, the global liquidity did not expand enough. Because the rich OPEC and Russia have seen their petrol-dollars evaporate and this has sucked some of the additional liquidity that ECB’s monetary expansion had provided.

But the biggest reason is the evolution of the global trade credit system. After the Lehman crisis, the banking supervisors of major countries have been very successful in their duties. The banks were denied giving risky loans. As a result, the commercial loans are no longer supporting enough the world economic growth. This weakness has been partially offset by the inflating dollar and euro-denominated private sector bond market but for many SME, nothing can take the place of the commercial loans. Rather, a series of giant banks are now narrowing their operations in the emerging countries and are turning to more profitable areas and the weakness in the growth of this region seems to be as permanent.

What will happen in the future? The cyclical recovery of US, Japan and China's spring-summer is inevitable (if of course China does not participate into this). To these, the secular recovery of the euro-zone and developing countries benefiting from the partial rally in commodity prices will participate and in the coming months a more optimistic global landscape will be shaped. However, the world economy will continue to produce light output in the 2015-2016 period.

What will be the repercussions upon the developing countries? This output deficit will delay the Fed’s decision to increase the interest rate by keeping the inflationary pressures weak or the expectation that it will keep the interest rates of US-German government bonds low is a clear illusion. The second noticeable feature of the world economy is the shifting of the recovery’s main axis from the emerging countries to developed countries. That is, the inflationary pressures will this time begin to appear first in the US and the EU. If the rise in oil prices continue, the emerging countries may join this towards the end of the year. This scenario poses a series of adversities for the emerging markets. As the growth does not occur to its full consistency, the rise in the yields of US-German government bonds which set the precedent for the entire world, is negative for the emerging countries’ fixed income securities. Second; with the closing of the growth gap between emerging countries and developed countries in favor of the second, the speculative capital will move to the second and has started already. Third; in the period when the Fed will raise the interest rate, the shocks in the emerging countries that did not reinforce sufficiently their real and financial structures may take place much harder than expected.

Then the following questions should be asked: is the 10-year reign of emerging countries over? Despite all the generosity of the ECB-BOJ and now PBOC together with the historically lowest inflation rates and bond yields, are we entering into a 5-year period where the speculative capital is not entering into the emerging markets and the financial crisis as well as recessions will start to show up again?

OIL AND GOLD: A SHORT TRIP INTO THE STORM

Some of the Canadian energy stocks may see a price appreciation in a merger & acquisition activity if OPEC’s meeting on June 5 results in the continuing of keeping oil production stable. But if a decision is reached as to reduce the production ceilings and the non-members follow suite, one can then see a recovery of crude oil price up to 60 USD to 70 USD per barrel. This will give some room to the companies whose finances are not in good position with oil prices trading below 45 USD.

If this price appreciation does not materialize during the current year, the said companies will have to revise downwards the value of their assets thus narrowing the margin between the offer and the demand in the merger & acquisition activity. Of course, this very expectation is the fuel for the mergers & acquisitions activity.

Under these conditions, it would be logical to look for companies whose costs and debt levels are low but which have seen their share prices unreasonably depreciate to bargain levels.

As far as the mining industry is concerned, the drop in the metals prices prompted industry leaders to look for a rapid rebound by relying on China’s possible massive demand thus considering it as the ultimate solution to the industry’s current problems. But several monetary stimulus undertaken by major economic regions did not affect gold prices despite some expectation regarding a rise in the inflation.

The energy investors had parallel thoughts on the matter; the recent crash in oil prices had burst a bubble and investors expected that Saudi Arabia would solve the problem through production cuts but that was not the case. The Canadian and U.S. companies have expended vastly their production. And the energy prices had appreciated substantially by insufficient resources; now the process has reversed.

This was followed by the deterioration of the assets of the energy companies. In turn, they issued new shares and convinced the investors that the proceeds would be used to liquidate debt. On the other hand, the mining companies opted to wait for a recovery in the metals market for some time. But the current situation forces them to write down their overvalued assets thus incurring massive losses.  The prolonged downturn in the mining industry will also affect the low-cost producers, despite blue chip names and dragging their share prices to bargain levels. Then one will have to wait for substantially higher prices in order to see some improvement in the cash flow and debt levels of the said companies. But when?

The successful recovery of the oil industry depends on the extent of supply cuts which should be triggered by bankruptcies or shutdowns. This in turn may cause a temporary drop in the energy indexes but once the balance is restored, the current trend should reverse itself favorably. The long-term trend is favoring increases in the curve steepness in the price of oil thus a strong rally in the near-term commodity prices, say, this summer…

The next question would be the following:

Will oil price reach 80-90 USD level? Will gold reach 1550 USD level?

BOND MARKET CRASH AND THE CONTAGION EFFECT

BOND MARKET CRASH AND THE CONTAGION EFFECT

The prices of long-term government bonds have been trading at high levels during the last years (implying that their yields have been very low). In the United States, the 30-year Treasury bond yield has reached a record low of 2.25% on January 30.

Despite the fact that this yield has recently moved slightly higher, it remains exceptionally low. It is almost impossible to provide an explanation as to why investors carry on placing their savings in these 20 or 30 years bonds in order to earn a mediocre return which is close the Fed’s 2% target rate for annual inflation. But the bond market is fragile at the wake of an interest hike and could undergo a major correction. Consequently, the investors are worried as to whether this correction could turn into a crash which in turn would bring down the housing and the equities altogether.

Market participants in the housing and equity markets tend to set prices with a view to prices in the bond market. Thus, a contagion from one long-term market to another seems to be likely...

In theory, long-term rates in the US bond market should be even lower because of the very low levels reached by the inflation and the short-term real interest rates (close to zero or negative). In today's environment, the impact of the quantitative easing which has been incepted in 2008 should have translated into lower long-term rates but it is the opposite now.

A crash in the bond market can only be possible under two conditions: a sharp tightening of Fed's monetary policy through a hike in the short-term interest rates or a dreadful rise in the inflation.

Bond-market crashes are rare but not dramatic. Consequently, one has to look for a possible event that may ignite a crash in the long-term bond market. But the threat lies somewhere else: private bonds.

During the low interest rate environment, companies have built a substantial long-term debt in the liabilities by issuing bonds massively in order to finance their investment projects. As long as their IRR stays above the interest rate, they load their long-term liabilities with bonds. On the eve of a Fed's interest rate hike, the whole picture will start to reverse and those companies will have to roll-over their bonds with higher interest rates which may cause a wave of default. This, in turn, will spread over the equities and we may actually see the dreaded erosion of the assets.

After all, the investors who lose in one of the assets will try to limit their loss by moving in than out of the stock market. We have seen this before in 1929 where the real-estate bulbs burst in 1928 and the investors rushed to the stock market with the related consequences. Same held true in the 1973-1974 crash and 2006 house bubble which triggered the 2008-2009 crash. Anyhow, such a crash should start towards the end of this year or early in 2016 and may last well into the first half of 2018. In such an environment, the initial correction may be 20% - 30% range but the rest will follow up thus turning it into a crash with a total correction of more than 50% at its depth.

SLUMP IN THE COMMODITY PRICES: WHAT'S NEXT?

The economies across the world do not show any sign of strong economic growth. The world economic stagnation has reached levels that push down the demand for raw materials which in turn is reflected by the severe drop in the commodity prices to the levels that are lower than the 2008-2009 recession. As everyone is focused upon the crude oil's price that went down by more than 50% since the summer of 2014, a large section of the basic commodities have been under the same price pressure.

This severe drop in the price of the commodities is due to the insufficient demand for raw materials coupled with the excess in the production capacity which was created by investments in the anticipation of strong economic recovery and followed by a steady economic growth across the world.

But the turbulence witnessed in the world such as the slowing of the economic growth in China or the weakness of the Russian economy and Greece's economic crisis has resulted in the decline of the commodity markets. The sharp drop in oil which started last summer has affected adversely many energy-producing countries such as OPEC members and Canada and saw their economic growth reduced as a whole.

This combination of slow growth in demand and excessive capacity expansion resulted in the sharp drop of commodity prices. China's gradual slowing of its economy represents only one part of the problem. The weak conditions of the world economy has also affected the global shipping of the goods. The amount of raw materials being shipped has dropped significantly thus signalling a negative outlook as a key indicator for consumption and manufacturing trends.

The combined effect of slow global demand and expanding supplies resulted in a terrible period for the commodities. The sudden shrinking of oil prices has changed severely the economic outlook in energy-producing countries as well as around the world. But the rise of the U.S. dollar against most currencies should have some deflationary effect. The devaluation of some national currencies could boast their exports thus reviving their ailing economy but in turn could affect adversely the U.S. prices.

The slump in the oil price will force the non-Arab OPEC members who feel uncomfortable with the present situation whereas the Arab bloc still enjoys good profit margins due to their low cost production, to call for extraordinary meetings . But these meetings will be the signs of deepening unrest about this oil crisis as some OPEC members requested and will request again the cut in the oil production output on a bid to reverse the current trend in the oil price.

One should expect to see a balance to be reached by the summer where the price of oil should reach the 80-90 levels at best and it should remain there for while, say until the spring of 2016 before picking up steam. This will occur following the interest rate decision of the Federal Reserve, expected on June 2015; currently, its postponing constitutes a psychological barrier. The same holds for the other commodities as the economies will start to liquidate their excess capacities with the restoration of the economic growth across the world by the same time next year. The cyclical nature of the commodities will reverse its bearish course after a long consolidation period and should start an bullish course with the next favourable economic circumstances. Also, it should be added that the rise in the value of the U.S. dollar has exerted a downward pressure upon the commodities and as the EUR/USD parity has bounced back slightly from 1.11, it should be expected to go to 1.25 figure and this will have a beneficial effect upon the commodities in the short run.

DEFLATION AND INTEREST RATES

The large funds have finished determining the investment strategy for the first half of 2015 towards the middle of this month. We can more or less solve these strategies by looking at the global fund flows. Two main investment themes are forming currently. First, the euro will become the main carry trade currency debt instead of the dollar and the yen. The second and more comprehensive betting strategy is to bet on the global deflation. With this bet, the US long-term bond yields will remain low despite the Fed's inclination towards the monetary tightening. Emerging countries will still receive support more from the global deflation thesis than from cheap oil or ECB QE preparation.

Investors see that there's an excess capacity in the world; the global recovery is not strong enough to employ this idle capacity. The oil shock that erupted over this, will reduce the price pressure to a minimum level. Brent oil forecast made by Goldman Sachs for the end of 2015 for $ 50.5 / barrel, was revised for a temporary drop to $ 40 / barrel. In case that the very low cost based inflation remains permanent, by affecting the pricing behaviour, it can cause the individuals to predict low inflation in the long term. The inflation expectations which are calculated from the difference between the 5-year and 10-year and inflation-indexed Fixed-Income government securities in the USA dropped to 1.5%.

Even if the Fed raises the interest rate, the investors have started to bet on the fact that the interest rates of 10 and 30 years will remain low due to the declining inflation expectations. Moreover, the money printing type QE that the People's Bank of China, ECB and Bank of Japan have or are expected to perform are exciting the demand towards the US government bonds that provide relatively high yield and thus putting a downward pressure upon the returns. The size of US government securities creates a benchmark for the yields of the $ 100 trillion in the world bond markets, which means that all the interest rates are determined by adding a spread upon this yield.

According to Bloomberg, the yield on the US government securities will be 3.01% by the end of this year; but HSBC FIS research director Steven Major who has done the most accurate prediction in 2014, says "no; the yield first will drop to 1.5% and will close the year by only 2.5%."

The expectation that the global long-term interest rates will remain low favours mostly Turkey. The interest rates are also high in Russia and in Brazil, but the instability of the rouble in Russia and the low level of commodity prices in Brazil mean that these countries are currently not an attractive destination for the speculative capital.

THE NEXT CRISIS: A WAVE OF DEFAULTS IN THE PRIVATE SECTOR BONDS

The end of the year has arrived but the storm in the risky assets did not get any relief. The panics that started with the end of the QE asset buying took an end in the stock market with the statement of being patient with the rate hikes but the interest rates of the junk bond with under investment grade credit rating are soaring.

The panic regarding the Fed's interest rate hikes and the very serious decline in energy prices in the market where the US has a size in excess of 2 trillion USD and the size of the Emerging countries' stock estimated as being between 600 billion USD and 1.1 trillion USD, causes the threat of a serious bankruptcy and default. Even if there isn't any threat of default in some cases, it will become very expensive to issue new bonds in the coming months.

Following Yellen's warning in August regarding the over-valuation, the weather suddenly changed in the junk bonds that were the brightest asset class in 2014. The investors realized that the returns had dropped significantly and thus started to shun the new issues. At the end of November, the annual return on these assets had already become nil.

The drop in energy prices, a couple of minor default cases in the Chinese bond market and the rise in bond yields in the 2-year bonds in the US were also one of the straws that broke the backbone of the market. Currently, while the return in the energy companies' bonds have risen to double digits, the spreads in the others, that is the interest rate difference with the US government securities in peer-term, began to expand as the market indicated that the default risk was on the rise.

Widening of the spreads does not indicate the deterioration of the financial condition of the company; on the contrary, as the energy constitutes an input for all the companies, their costs are going to drop significantly. However, the liquidity is tight in the markets and the existing funds have started to move to the private sector bonds with high credit rating and to the US government securities.

Many companies had issued new securities under the assumption that the maturing bonds would be rolled-over. If they are forced to redeem them due to the rise of the interest rates, they may default. And the defaults could put into trouble the leveraged funds that hold them in their portfolio. This wave of defaults could well spread to the stock market.

The risks regarding the raising of the interest rates by the Fed by mid-2015 and the harsh decrease in the available foreign currency reserves in Russia's central bank could reach proportions that could ignite a panic in the financial markets. And the spark that could set the fire on may come from China. China is the number one issuer through Hong Kong in the Emerging Economies section of this asset group and is also the most risky country. In particular, the situation of companies operating in the housing sector is faltering. Currently, China's private bonds are standing tight based on the assumption that the Chinese government will not allow the bankruptcy of the debtor companies. In the event that Beijing changes its attitude, a real panic could start in the junk bond market and could spread to all risky assets...

BOOM BUST SEQUENCE IN OIL

During a market turmoil, any asset can drop severely and investors who are trying to catch the bottom of this free fall end up losing their money and sometimes their fortunes in the process. During such an environment, it is rather difficult to tell whether the drop in the price is heading for a crash or is only a correction, often a short-term one.

The recent drop in the oil prices reminds us about the dilemma faced by every investor or trader: is it a crash or a short-term correction? Oil prices dropped by more than 35% since early summer and more than 50% from its top of 147 USD a barrel which was reached in 2008. When you have such a severe drop, you start to ask to yourself whether it is time to buy it? A correction of 50% is enough for many investors and traders to start buying but what if it were to drop further to 60 USD a barrel? One should look for the possible catalysts that would permit a comeback of the oil...

A low price in oil stimulates the demand in many related sectors but diminishes the exploration and development thus reducing the oil supply with time. At one point, the demand starts to push the price of oil until a point is reached where the imbalance between supply and demand reverses the process and we have a severe drop if not a crash in the price of oil.

Currently, many oil producers (many of them being high-cost producers) have a break even price in the range of 60-70 USD and if the prices were to continue to drop, they will get into trouble: their budgets for capital expenditure will record a loss and a drop in the supply will follow; currently, there are deferrals and delays and their cost structure don't make that profitable at 70 USD a barrel. And the long-term outlook for the industry is moderate; in fact, the price of the barrel may remain flat around 70 USD for some time to come.

But there is also the production level of the conventional oil approaching the peak level. Despite the development of the unconventional oil production (oil sands, U.S. oil shale, biofuels and natural gas liquids), the drop in the price of oil will hurt their production as they are costly. Their production determines the growth in the production of oil in general and they depend too much on higher price levels. Further, the current levels of the oil prices will hamper the development of electric and /or hybrid cars as their operating costs are higher.

The oil producing countries in the Middle-East and Africa, as well as Russia need prices that are higher than 70 USD a barrel in order the break-even with their budgets (Russia has a break-even level of 85 USD a barrel) . Saudi Arabia has a strong financial position which will permit her to withstand for long years of low prices (thus allowing her to drive out competitors such as U.S. oil shale producers) but the other oil producing states do not have that luxury; if the low prices persist for some time, they will reach a limit and production cut will follow thus driving up the price of oil.

The energy stocks got hurt from this process and we can find many beaten stocks in the industry. This also leads us to believe that one should feel bullish as far as the pessimism is concerned. The depressed energy sector forces us to think that there are some value stocks present there but currently the investors look to the short-term. With no replacement of the fossil fuel in the near future, the long term outlook of the sector is still bright. The most important factor which affects the oil price is the growth in the world's economy and the current slow growth is affecting adversely the price of the oil. But a surge in the demand for oil from countries such as China and India will create a shortage in the supply of oil and the price will go up. And the current selloff witnessed in the energy sector is currently telling us that the worst being left behind; soon, a rebound will start but it will be a slow one. Nevertheless, the price of oil should fluctuate in an upward trend, reaching the target price of 180 USD a barrel in the long run.