Don’t Fight The Dow

Those who forget History are fated to relive it, goes the saying.

Financial markets, prone as they are to swings between boom and bust, are a particularly good case.  Reasons for this reach at least as far back as Adam Smith’s “animal spirits”, and probably even further to ancient Mesopotamia and Man’s first go at organized agriculture.  I bet the connection between water flow in the Tigris - Euphrates  rivers and grain productivity soon became obvious to a few smart farmers. Ditto cornering the market.  A few thousand years later, Egyptian bureaucrats kept accurate records of the Nile’s seasonal ups and downs.

                                      The Palermo Stone, Egypt circa 25th Century BCE

Fast forward to the Fed as keeper of the floodgates.  The chart below shows Fed Funds rates and recessions (shaded grey).

Every time the Fed starts tightening from a seminal low stocks drop and a recession follows.  It’s not rocket science: interest rates are simply the price of money and as it goes up the marginal demand for investment goes down. Hence, Don’t Fight The Fed.

Presidents absolutely hate to be caught in the middle of a tightening cycle because they, at least, never forget that people vote with their wallets and Mr. Trump is no exception (except that his mouth and Twitter run faster than his common sense).

Ok, nothing new in all of the above, of course.  Or.... is there?

In my opinion, there is. Rates bottomed out at 0%, an unprecedented low in history, and the Fed has ALREADY raised rates 9 times, succeeding - as it always ultimately does - in abating the market’s animal spirits.  After the worst December since the Great Depression, IN JUST ONE MONTH!, stock indexes are now officially in bear market territory.  Never mind Mr. Trump’s rantings, the Fed cannot but take heed of the direct connection between markets and the “real” economy, a connection that has only become stronger and more direct in the last 30-40 years.

In other words, yes, don’t fight the Fed - but the Fed increasingly understands (I hope) that it cannot and should not fight the Dow.  As I have put it in several older posts, the tail (markets) wag the dog (the economy).

The Grinch That Stole Christmas

Merry Christmas everyone... except if you are long stocks in which case Santa most certainly put a lump of coal in your stocking making it the worst December in a very long time.

So, who is to blame? According to Mr. Trump, the Fed Chairman is guilty of “not understanding markets” and would love to boot him out as he did with more than a dozen other top officials in his administration. Needless to say, I strongly disagree; the Fed’s independence is crucial if the dollar is to remain the global reserve currency. Nevertheless, yes, the Fed is probably raising rates a bit too fast given the health of the global economy, which is not quite robust (Europe is struggling and China is ramping down its growth).

Then again, with US equity markets previously showing every sign of “irrational exuberance”, it was the Fed’s duty to take away the punch bowl before the prom turned ugly. Let’s not kid ourselves: rates were raised mainly to bring down stocks and cool rampant speculation, not because of higher inflation concerns. Given that Mr. Trump’s sole presidential claim to fame was measured by the Dow, his anger is understandable.

So, yes, Mr. Powell is the Grinch. Then again, this is precisely what he should be doing.

                                                 The Donald And The Grinch

It’s Just Too Perfect...

Technical chart analysis can often produce useful insights.  Patterns such as Head and Shoulders are considered powerful predictive tools by technical gurus.

The following chart of S&P 500 exhibits a picture-perfect top Head and Shoulders pattern, confirmed by the lower readings of the Relative Strength index and the sharp breakdown below the “neckline”.

*****Updated Chart*****


A technical analyst would have little to argue with such a pattern and would very likely recommend getting out of stocks and/or shorting.

However... it just looks “too perfect” to me. Obviously, I’m not the only one looking at this picture and I bet a lot of the recent extreme bearishness emanating from market analysts is already incorporated in this chart.

So, here’s a lesson I’ve learned in my 35 years in the business: if something looks obvious AND everyone agrees.... it is highly likely to not happen.

******UPDATED DEC. 22.... the breakdown continues below the neckline.  The speed of the decline is the fastest since the 2008 plunge.*****

Stocks vs. Bonds

The chart below from Yardeni Research is one of the most interesting I’ve seen in a long time.

The gap between stock earnings yield (=the inverse of the P/E ratio) and Treasury bond yields is quite wide, meaning that stocks are still significantly more attractive than bonds.BUT.... it also shows how low bond yields are, historically.

That’s why stocks are swooning every time bonds twitch...

Populism, Explained

Yellow Vests are storming the Bastille, Trump is playing to the discontent of the working poor, ditto the Brexiteers, Germans are voting down mainstream parties in record numbers, stocks around the globe are tumbling, ditto commodities.

IMHO they are all connected and explained by the chart below from a World Economic Forum publication.   (https://www.weforum.org/agenda/2016/01/3-charts-that-explain-global-inequality/)

The chart is from an Oxfam report on global inequality:  According to the report, 62 billionaires own the same amount of wealth as 3.5 billion people who make up the poorest half of the world’s population. In a dramatic widening of inequality, this number has fallen from 388 in 2010, and is set to become just a handful of super rich by 2020.

Apart from ethical, societal, etc concerns there is a “technical” story here, one that concerns stocks: the market has become very narrow, fewer people own a larger proportion of shares.  This means that volatility goes up and, inevitably, downturns can become crashes as the number of potential buyers is now smaller. Looking at it another way, the ultra wealthy have painted themselves into a corner.

Backpedaling At Tour de France

Faced with massive violent protests in Paris and across France President Macron has been forced to backpedal on his previously announced economic policies. Unfortunately, it’s too little, too late.  Leaders of the popular Yellow Vest uprising (revolt?) have already decided they are not satisfied;  it seems that only Macron’s resignation will do.

But France is only one hotspot of many.

There is a deep malaise in many EU countries: France, Great Britain, Italy, Belgium, Austria, Hungary, Greece, Poland, Slovakia are gripped in some form or another of reactionary populist politics.  The proximate issues may be varied but the root cause is the same: economic underperformance and slipping of living standards for the shrinking middle class.  Macron is the poster boy of a privileged urban yuppie who ignores the plight of the poor citoyens trying to make do in La France Profonde.

It is becoming increasingly clear that the response to the Debt Crisis of 2007-2010 may have saved the financial “system” but it did so at a severe societal price. State bailout costs were passed to the taxpayers, particularly those who were used to a kind, gentle and generous Nanny State. But Nanny’s economy could no longer create the necessary wealth to support them so it started cutting corners.

To use a TdF analogy, cycling downhill makes everyone look like a champ. But once you hit the infamously steep and long cols (climbs) of the French Alps it is only those who train hard that make it. Oh, sure, doping may carry you through for a while but eventually you are either caught or it kills you.  Just like too much debt....

Margin Debt As Percentage Of Wiltshire 5000

From Yardeni Research comes the following chart: margin debt as a percentage of total market value of Wiltshire 5000, the broadest equity  index in the US (data go up to October)

At 2.1% it is (surprisingly) at the lowest level since late 2006, just before the Debt Bubble blew out to great proportions. However, they are at the top end of the Dotcom Bubble.

Despite my blog’s title, these days I don’t see debt as a serious threat to markets.  Instead, I’m really worried about ugly populist politics around the world.

More on another post.

May You Live In Interesting Times

The post’s title is a well known Chinese curse.  For financial markets, the equivalent (and ambivalent) saying is “May you trade in volatile markets”. Remember, it’s a curse not a blessing.

Long term equity investors hate excitement and love to be bored. They buy, they hold, they prosper. For them "interesting" is synonymous with fundamentals and value;  their heroes are Graham, Dodd and - above all - Buffett.

Traders, on the other hand, love excitement - known as volatility in markets. They buy, they sell, they short, they cover, they scalp. For them "interesting" is the equivalent of precipitous declines followed by massive rallies, preferably within the same day.  Their heroes are the anonymous designers of black boxes and whoever can get their network nodes as close as possible to the exchanges' transaction mainframes.

Up until the start of 2018 US markets were "boring" in the sense that buy and hold, the trend is your friend type of strategies worked best.  Score one for Buffett and cohorts.

The rest of the year, however, has been heaven for the practitioners of the Dark Arts.  So much so that it was actually trades on first and second derivative volatility indices (VIX and VVIX) that drove markets into several tailspins (see VIX chart below). Game and set, so far, to the Bad Boys.  The match is still undecided, but it increasingly looks like they will win this one.

VIX - S&P 500 Volatility Index 

Back in 2006 I started this blog because I saw the threats posed by the Debt Bubble and its derivatives which had expanded and permeated the “real” economy to an unprecedented extend, particularly in the real estate sector.  What followed nearly threw the global economy into a new Great Depression, averted only because central banks and governments were willing to employ unconventional weapons in the battle against asset deflation.: Quantitative easing, zero or even negative interest rates, massive bailouts for the financial sector. In some ways we are still relying on them, albeit to a significantly lesser extent than previously.  If nothing else, it is now a commonly held belief that the powers that be will always be there to rescue the system.

I beg to differ.

Oh, bankers and most politicians may wish to repeat the process when the need arises again - and it always does - but I'm not at all sure that they will be allowed to do so.  I interpret the rise of populism and right wing political activism to a strong undercurrent of anger amongst the former middle class, now relegated to "working poor" status.  Basically, they now see financiers and bankers making billions after they were bailed out with public money, while they themselves struggle to make ends meet.

So, another volatility index which is today even more significant than VIX is PAX, i.e. Political Anger index, shown graphically below.... it's from the Yellow Vest turmoil in France, but we are also seeing similar anger simmering just under the surface in Great Britain (Brexit), Italy (Five Stars), Germany (AfD), and of course the USA (Trump).

Interesting times, indeed...

Travails Of A Bond Blogger

What am I supposed to do, huh?

I mean, I am a blogger who specializes in writing about debt. You know, A Merchand Of Venice kind of deal... does “a pound of flesh” ring a bell? As in if you don’t repay your debts WITH INTEREST the lender will have your arm. Maybe your leg, too.

But, in the decade-long aftermath of the Big Dip the world of finance has gone topsy-turvy. You now have to PAY borrowers to lend them money. As in, here, please borrow my money and when you return it I’ll give you MY arm. Crazy stuff.

For example, Germany charges investors -0.589% annually for the (extremely dubious) privilege of holding their money for 2 years. Yup, you give the Germans 100 euro and two years later they give you 98 point something back, all is square. Sort of..

Germany 2-Year Government Bond Yield

Going on a bit longer with the Shakespearean analogy, Bassanio keeps the loot, snags Portia, buys a luxury caravel and they sail off to party in the Bahamas, while poor Shylock goes bankrupt. Moral suasion goes waaaaaay out the window.

Willy would be floundering today, probably penning something like The Playboy Of Venice.

What am I trying to say? That I am confounded, dear reader. I was raised in a world where one pays for the privilege of using something - even fiat money.

Ahhhh... but... when things don’t make any sense it is time to sense that a change is coming.  Just as a change was coming back in 2006-07.

The EU: Beggining Of The End Or End Of The Beginning?

Where to EU?  What started as a lofty and noble idea to establish an enduring  peace in the continent most guilty of global blood letting is turning into a low, cheap and acrimonious scuffle about Polish plumbers and Italian bravado.

Cheap it may be, but the current fight amongst member states is, nevertheless, dangerous.  And the reason is not what the fight is about, but because of what is missing at the very foundation of the EU. To wit, a common fiscal policy mechanism and a common defense structure.

What are the two most important elements of an empire?  A strong global currency and a strong military with global reach.  The EU seemingly has the first, but in the absence of a common fiscal policy structure it actually doesn't, and has zero common military.

Therefore, if the EU is to survive and even thrive it urgently needs:

1. A European Department of Treasury / Ministry of Finance AND
2. A European Army

Just think of Rome without its legions and aurii or the British Empire without a pound sterling and the Royal Navy.

Barrels, Boats, Bitcoins, Brexit, and Other Bubbles

This blog is founded on the premise that ALL bubbles burst, sooner or later.  The rule of thumb is pretty simple: to paraphrase the old Crazy Eddie TV ad, if prices are INSAAAAAANE then the bubble is to pop sooner rather than later.

And there is always some form of loony "fundamental" hype which pops up as "analysis" to goose things along and provide that last HURRAH that produces forced short position liquidation.

Cases in point:

•  Peak Oil!,  the theory that global oil production was about to peak and head inexorably down.  A large number of innocents were caught up in this, even publishing thousands of articles in The Oil Drum, a site which propagated the scientific version of the hype.  Oil zoomed to $145 per barrel and then melted down to $35.

 

• No Boats!, the notion that the world didn't have enough boats to carry the increasing cargo needs of China and other developing nations.  Spot charter rates for large Capesize ships went as high as $150.000/day, and prices for new vessels skyrocketed to almost $200.000.000.  There was a flood of newbuildings just as the economy went south and charter rates sank to$7.000/day. 

• Bitcoins Are Best!, the belief that "regular" money was somehow unsafe and would eventually become worthless as a storehouse of value and wealth, whereas computer-generated cryptobits had rarity going for them.  Duh... anyone with a computer could come up with a catchy name, generate a new crypto and go to town mining away - and did.  
• Rule Brittania!, the idea that, somehow, in this globalized world a (now rather smallish) former empire can become Great again all by itself.  This is different from the aforementioned cases, obviously ongoing - and Britons are ultimately sensible people. So, who knows.. they may yet come to their collective senses.
• Make XXX Great Again!, the wave of global populism is still in its early stages, I'm afraid, and has a lot of room  to grow and become a poisonous bubble before it too - hopefully - bursts.

Remember Chavez?

Way back in 2002 a most unusual man was elected President of Venezuela: Hugo Chavez. Remember him?  People may forget now, but he was the first 21st Century example of a Reactionary Populist to gain power in a major (almost) Western nation.  You may argue that Venezuela was not a truly Western nation and you aren't far wrong - but you aren't too right, either. It was then one of the wealthiest countries in South America and had (still has) vast reserves of crude oil.  Why did Chavez gain power? Massive income and wealth inequality. The masses were poor and the rich were massively wealthy.

 Hugo Chavez, First Of Many...

Fast forward to today.  Populism is increasingly prevalent across the West: USA, Brazil, Germany, Great Britain, France, Italy, Poland, Hungary, Turkey, all now have populist leaders or strong populist parties rising fast (eg AfD in Germany). The same cause applies as in Venezuela: income and wealth inequality - real, perceived or threatened.  The latter applies to Germany and Great Britain in particular, where the economy is doing well but your Average Johann and Joe feels threatened by the "unwashed masses" of illegal economic migrants (Germany) and poorer EU citizens "stealing their jobs" (Great Britain).

Should we be concerned? Is another Mussolini or Hitler on the rise?

I believe the political ideology clash is no longer between Left and Right.  Rather, it is Rationalism versus Populism, or to put it in personal terms Merkel vs. Trump.  Unfortunately, Ms. Merkel - who is certainly to blame for lots of issues but is certainly no Populist -  effectively just resigned. And that's really bad news for us Rationalists...

Merkel To Retire

Following yesterday's abysmal results for Merkel's CDU in the regional Hesse elections (down 11% from previous polls) she is said to have declared her decision not to seek re-election as her party's leader in its upcoming congress.

Austerity and fiscal propriety are eroding fast, the Greens and AfD are big winners.

Europe is changing fast.

and PS Bolsonaro won in Brazil.  Reactionary Populism is gaining all over the world... (sigh).

Italy - The Rise Of (Fiscal) Populism

Bond and equity markets do not react well to overt signs of fiscal populism.  Case in point: Italy.

Italian 10 Year Government Bonds

The Italian government submitted its 2019 budget plan to the EU calling for a large deficit, unacceptable to the Commission.  A spat has ensued, causing bond yields to rise sharply.

Unlike the Greek "tragedy" of the last 10 (!) years, Italy is a very, very large economy and cannot the pushed aside and/or be blackmailed into submission.  A dogfight will eventually lead to tearing apart the entire EU structure, so an easing of the "German" fiscal probity model is likely in the cards, also given that Mrs. Merkel is now weaker than ever politically.

China Has To Grow Up

China has become the world’s second largest economy based largely on the ability to churn out cheap consumer goods in vast numbers. It could do so because of a) very low wages, b) cheap land and c) nearly zero regulatory costs (i.e. pollution and labor safety regs).  Couple that with an artificially low foreign exchange peg, and it’s no wonder that  low and medium value-added industries moved there en masse.

However, China is now very keen to move up towards more sophisticated, tech heavy industries like autos, aerospace and high end electronics, heretofore the domain of Western companies and institutions that have created a huge pool of proprietary R&D and the mechanisms to transform it into high-end products.

The problem of safeguarding such Intellectual Property has been around since at least the early 1990s and has never been addressed properly.  As the US economy moves more and more towards a Fourth Stage (ie knowledge-based) leaving behind its manufacturing roots, IP is today’s fortune and must be protected.

China needs to realize that the US will no longer turn a blind eye to IP exploitation.  Furthermore, it needs to “grow up” and institute developed country norms:

• Its currency must float
• Its markets must open up
• Its government must impose western-level regulations on pollution and worker safety
• It needs to institute a comprehensive pension/social security system.

Trump’s opening salvo on possible import sanctions is a warning: join the globalization party as an equal on ALL terms, or suffer the consequences.

Trade War Over Steel? Gimme A Break...

So Trump throws up this firecracker about import duties on steel (25%) and aluminum (10%).  It’s a non-issue folks, despite hot air from Brussels about retaliation via Levi’s, Harleys and Jack Daniels. (Notice that the Chinese haven’t said a word - and rightly so).

Fact is, the US hardly imports any steel from the EU or China, as you can see from the graphic below.

Now, if Mr. Trump starts talking about consumer electronics, that would be an issue.  But in an economy completely dominated by the likes of Apple, Google, Microsoft and Amazon imposing duties on their products would be plain suicide and it won’t happen.

Greek GDP And PMI

Greek 4Q GDP rose 1.9% YOY, the fastest in 10 years. Similarly, manufacturing PMI rose to the highest level on record in February.

Steel Duties, Seriously?

Imposing import duties on steel and aluminum is akin to protecting the horse buggy business when Ford set up his car production line... completely useless and meaningless.

The US economy is long past it’s heavy, metal-basing industrial era.  Trump is just playing up to his lowest common denominator electoral base, that’s all.

For proof, just look at the makeup of the DowJones Industrial Average in 1980 (even 2000) and today.  Unlike the past, the US economy today is all about Google, Amazon, Apple, Microsoft and a couple pharma companies.

Move on...

Interest Rates And Savings

One single chart: Ten year Treasury yields and the personal saving rate (ie the percentage of income saved).

The correlation is interesting.

Yes, Virginia, There IS Volatility

What happened with US stocks?  Why did they tank so suddenly after months of steady gains?

No, there was no irrational exuberance, no massive leveraging, no pernicious balance sheet shenanigans at banks, no NINJA loans, no CDS/CMO/CDO (plain, squared or cubed) baloney. Valuations weren’t even that high, given forward P/Es around 18-16x.

There was, however, a sort of  “complacency bubble”, aka very, very low volatility. This in turn spawned a variety of listed and OTC trades that shorted volatility for profit.  It worked like a charm - until it didn’t.

The following chart makes things quite clear.  It’s the price of an ETF (exchange traded fund) that shorts VIX futures.  Yes, Virginia, there IS volatility!

In my opinion that’s all there was to it - the snap unwinding of short vol trades.

USA Margin Debt

Given the stock market plunge of the last few days, the following chart is interesting.  It is current to year-end 2017 (latest available), the data comes from FINRA.

Given that total market cap at the time was approx. $32 trillion, margin debt of $650 billion doesn't seem all that excessive.  In other words, selling due to system wide over-leveraging isn't the likely culprit of the sell-off.

Greek PMI Near Record

Manufacturing in Greece is staging a strong and rapid comeback.  The Purchasing Manager's Index for manufacturing is now at the highest level since 2007.  Increasing new orders is the biggest contributor to the rise, with new employee hiring also boosting the index.

The PMI is a diffusion index, with levels over 50 indicating expansion and under 50 indicating contraction. The light blue area is annual GDP change, left scale.

Manufacturing accounts for only 12-15% of Greek GDP, but the correlation between PMI and GDP is pretty solid.  Interestingly, the last time PMI was at current levels the Greek economy was growing over 5% per year.

USA Debt: Is It A Threat?

US federal government debt is now at 106% of GDP, the highest in decades.  It got there because it was forced to bail out the financial sector during the 2007-10 Great Meltdown, essentially having the Federal Reserve "print" money with its Quantitative Easing (a.k.a. Ben's helicopter).

 This debt load certainly looks formidable and perhaps threatening to the economy's health.  Is it so?  Well, yes.  And, no...

Yes, because a highly leveraged economy has, by definition, a lower capacity to overcome recessionary downturns without painful asset liquidations and capital losses, perhaps even social unrest.  Just ask the Germans and how scared they (still) are of the Weimar hyperinflation period which paved the way for Hitler.

And no, because it matters very much to WHOM the debt is owed.  Just ask the Japanese today, who owe their huge debt (250% of GDP) mostly to themselves (i.e. they are self-financed through a high saving rate).

 In the case of the US national debt, 25% is inter-government (mostly held by the Social Security Trust Fund), another 25% is held by American investors (e.g. pension funds, banks, individuals) and 12% by the Federal Reserve.  Thus, a total of 62% of the debt is owned directly by American holders. This leaves 32% owned by foreigners, but even there I expect that a chunk is owned by Americans through entities in tax havens such as the Virgin Islands, Channel Islands, Switzerland, etc.
 

 More important still, is how the government is managing its finances. It is doing quite well, as the following chart shows: government spending is back to 34% of GDP, very near a 50 year low.
 

 Bottom line - even though it may seem high, US debt is not a threat to the economy.

Disruption

Buffett, Bezos and Dimon announced they are going to massively disrupt US healthcare by designing and implementing an in-house system for their combined 1+ million employees on a not-for-profit basis, and potentially rolling it out to the rest of the country.

This is simply huge.

The US has arguably the world's most inefficient healthcare system, entangled in a mess of legal, insurance, pharmaceutical (need I mention Valeant?) and hospital concerns, all jockeying for legitimate and illegitimate profits.

The following chart says it all:  The US spends 17% of GDP on healthcare, far more than other countries. Even a 2% reduction means savings of almost $400 billion per year.

 If the trio manages to streamline the healthcare industry it will create a paradigm shift akin to Henry Ford's automobile assembly line.

There is another American "industry" that has also become very expensive when compared to the rest of the world: College education.  I don't think it will be long before some other leaders get involved there.

A Funny Thing Happened On The Way To The Forum

The World Economic Forum at Davos is in the news these days, as it is every year at this time. The world’s leaders - political, business and financial - gather to rub shoulders and, very occasionally, achieve something more than self-congratulation.  Going back a quarter century, however, the WEF wasn't nearly as famous as it is today.  

And that's when yours truly comes into the story..

It was around 1992 when I saw an ad in The Economist for a position at the WEF.  They were looking for someone that combined knowledge in engineering/energy with finance. It fit my profile pretty nicely so I sent off a resume, mostly on a lark since I wasn't quite ready to move from the Big Apple to Geneva or some remote village in the Swiss Alps, no matter how glamorous. 

About a month later, however, I was surprised to get a call inviting me for an interview to be held in Manhattan.  More surprising still was that the lady on the phone spoke Greek and introduced herself with a last name that was instantly recognizable: a very, very large Greek tycoon shipping family.  

She explained that Professor Klaus Schwab - the founder of WEF himself - was in NYC for a few days and would I mind if I met him on short notice?  The meeting would take place at her apartment in Midtown, just a few blocks from my office.  I agreed.

On the appointed hour the door was opened by an attractive middle-aged lady who showed me to the living room and explained that the Professor was running a bit late, would I care for some refreshment in the meantime? A crudites, cheese and cracker platter was set on the coffee table.

We sat down and engaged in some idle remarks which quickly petered out.. that's when I noticed a portrait hanging prominently over the fireplace.

 This wasn't the painting, but close enough..

"That's a very nice painting, almost like an El Greco" I said, eager to re-start the conversation.

I will never forget the icy hauter in her voice as she responded:

"It IS an El Greco".

Professor Schwab came in a few minutes later and we proceeded with the interview, but it might as well have not happened.  My faux-pas with the painting had sealed my fate, since the WEF was - and still is - much more of a diplomatic institution than anything else...

I chuckle every January as news and images from snowy Davos hits my TV...

Greece: Various Data

The situation in Greece continues to improve.  Latest data:
  

• The 5-year CDS (credit default swap) dropped to 292.9, the lowest point since the crisis began.

• 
  
  
  • S&P upgraded Greece one notch to B, with positive outlook.
  • The 2-year  government note now yields 1.25%, a multi-year low.
  • Building permits for  October 2017 were up 16.4% vs. Oct. 2016.  More importantly, the surface area represented in these permits was up 67% and the buildings' volume up 109%.  This means that large structures are involved, exactly in line with my predictions for major hotel building/renovation activity, right after the conclusion of the tourism season.
  • Electricity consumption for the whole year 2017 was up 3%, with the middle-power segment showing the largest increase at 5.84%.  That's demand coming from hotels, restaurants and other medium size businesses.

Greece, The IMF's Sugar Daddy

Today, a look at the Greece-IMF relationship from the only perspective that really matters: money.

When Greece imploded back in 2010 it turned to the IMF for help.  The IMF agreed and as of Oct. 2017 Greece owes it 9.5 billion SDR (Special Drawing Rights, the IMF's in-house currency), equivalent to 11.3 billion euro.  The loan carries an interest rate around 3.5% per annum. 

So, Greece pays the IMF roughly 340 million SDR per year in interest (=396 million euro). 

So what, you ask?  Greece is the IMF's largest borrower by far and without the income generated from these loans the IMF would be hard pressed to make any profit at all.  

An excerpt from the IMF's quarterly statement ending Oct. 31, 2017 (I have annualized all amounts, in million SDR).

Operational Income:         1,658
Operational Expenses:    -1,344  (mostly salaries and admin.) 
Operating Net:                      314
Other Income:                         94
 Total Net:                         408 million SDR

As you can see, the Greek loan interest is 20.5% of operating income and a whopping 83.3% of total net.  Given that IMF's expenses are basically inelastic - salaries and administrative expenses -  total net without the Greek interest income would drop to a mere 68 million SDR.

And here's the rub: Greek bond yields have now dropped so low that early repayment of IMF loans is very possible. They are due in several installments with average maturity around 2.5-3 years and cost 3.5%.  Compare that, for example, with the 2-year Greek government bond at 1.40% and the 5-year at 2.80%.  

Therefore, issuing new 2 and 5 year GGB's to pay off the IMF early is a very attractive possibility, one that would save Greek taxpayers some 200-250 million euro per year.  It would also mean lean times for the Washington boffins, but I'm sure no one will shed tears for them.

And what are them boffins doing about it? The relationship between Greece and the IMF has been testy for the last 3-4 years;  so much so that the IMF is no longer a "full" member of the bailout program (i.e. it provides no more financing), instead participating on an advisory role only.  It has frequently intimated that it would rather withdraw altogether.

So, here's the good part: in the last few days the IMF has done a complete about face and is now eager to participate in the Greek program, including fresh financing!

I think the IMF's income statement (here) explains a lot..

Yadda, Yadda, Yadda And A Bottle Of Ouzo

Greece is highly indebted, bad loans swamp banks, the economy is in tatters... yadda, yadda, yadda.  Highly conventional wisdom, the one you get from the popular (and even specialist) media, is always last year's news and not only useless but potentially dangerous. 

Following up on my last post on the fast rise of Greek private sector debt during 1998-2008  (i.e. very much yesterday's news) and the resulting collapse, where does it stand now in comparison to other countries?

You may be surprised to know that the country's households and businesses are still very under-leveraged when compared to the rest of the world and the eurozone/EU in particular - just look at the chart below (Data: World Bank, 2016).

Furthermore, the same chart indicates that Greek banks' credit exposure to the private sector is likewise very modest.

 I'll let readers figure out what this means for the future of the Greek economy and its banks - but, yeah, I think its becoming more and more realistic to break out the ouzo bottle.

Leverage In Haste, Collapse At Leisure

"Sin in haste, repent at leisure" goes the well known sobriquet.  In the case of Greek businesses and households, they leveraged themselves so fast that the implosion was all but inevitable, particularly since state debt was also rising fast at the same time.  But, unlike other bubbles, the aftermath was not only painful but unnecessarily drawn out, too.

Going back to the beginning, we can see that private debt rose much faster than GDP between 1998-2008, going from 34% to 103% of GDP in just ten years. It was not so much a case of "too much" as "too fast", which created the real problem in Greek private sector debt and which left banks with a mass of non-performing loans. Unlike other western economies, Greeks were previously very under-leveraged and had no credit culture.  When the bubble economy collapsed many Greeks simply refused to pay their debts; their populist politicians played along, essentially prohibiting real estate and other property to be auctioned to satisfy debts.

Hobbled from enforcing loan agreements, banks were swamped with bad loans and had to be recapitalized several times. Naturally, they quit making new loans.

So, after the initial shock that saw GDP collapse 25% in just 3-4 years, the economy sat at the bottom for five long years, unable to capitalize on lower asset and labor costs. And how could it, since there was no fresh capital, no fuel to energize the positive part of the creative destruction process?

The Greek economy has been repenting its debt bubble sins for too long now and it is high time to start growing rapidly again.  Healthy, well capitalized banks are crucial in this process.

I strongly believe that Greece is now very close to achieving this necessary condition: its banks have consolidated massively, slashed operating costs and driven core profitability (pre-provisions) to near record levels.

What is the next step? The complete abolition of capital controls is an absolute must, if deposits are to come back in size.

Greece: Creditless Expansion

The Greek economy is growing once again, and this time it is doing so without the benefit of credit expansion to drive consumption and investment.  For us schooled in chemical engineering, it is like running a reaction without the benefit of the necessary catalyst: if it proceeds at all, it does so at very low speeds and product yields.

For the first three quarters of 2017 (latest data available) nominal GDP has been rising, despite the credit contraction. Banks are scaling down their balance sheets, and the government is running very large primary budget balances, i.e. not borrowing at all.

In other words, monetary and fiscal policies are very restrictive in Greece.

 Nevertheless, the economy is growing - and what does this tell us?  Firstly, it says the economy is largely "importing" its growth via increased tourism and exports, instead of rising domestic consumer spending. Secondly, and far more importantly, it says that growth will accelerate once credit conditions improve.  Will they?

Yes, they will.  

1. Banks are finally on track to deal decisively with their NPLs via a combination of sales, write-offs, reserves and workouts (collateral auctions are crucial, here).
2. Confidence in Greek credit is improving, as seen in plunging interest rates on bonds and bills.  The last 3 month bill auction came in at 0.99%, and CDS's are at multi-year lows at 332 bp.
3. Bank funding is also improving with customer deposits rising (too slowly, as yet) and more interbank transactions (bank-to-bank repos).
4. Banks' reliance on the ECB's expensive Emergency Liquidity Assistance is constantly shrinking and will likely terminate within 2018.
5. Once Greece is finished with its bailout program in August 2018, with or without a standby loan facility, the road will be clear to abolish capital controls imposed in 2015.  This should rapidly bring deposits back into the system, allowing banks to start expanding credit once again.
6. Fiscal policy is set to remain restrictive for several years, since future large primary surpluses are a bailout condition. Therefore, once deposits start flowing back in, banks will have to expand credit as one of only two ways to increase earnings (buying new government bonds is the other).
   

It looks like 2018 is going to be a crucial year for the Greek economy.  So far, all the "reactants" are coming together in the chemical reactor vessel - the only ingredient still missing  is the credit "catalyst".  But I think I can see the truck bringing it in, out in the distance. 

Driving Ms. Hellas

Another alternative data set which better follows Greek economic conditions than headline GDP figures.

First-time vehicle registrations are up in 2017 for the fourth year in a row, now higher than 2011 levels.  More significantly, the rise comes from pricier automobiles (+22.1%) and trucks (+14.6%) rather than cheaper motorcycles, which were down 28.2%.

 While still very far from the unsustainable debt bubble days of 2000-08, the rise is indicative of core economic growth precisely because of the absence of auto loans.

Greek GDP And Credit Expansion - No Money, No Honey

Credit expansion, i.e. easy and cheap access to bank loans, is an essential ingredient of economic growth.  But as with all good things, too much of it can lead to trouble.

This was certainly the case with the economy of Greece during its debt bubble years.  The chart below shows how credit expansion grew much faster than GDP-  sometimes as much as 10 times faster. And this chart shows only bank credit, i.e. it does not include government borrowing which was also rising very fast.

The bubble burst in 2009 and the economy went south, staying in recession for eight straight years.

Can the economy now recover and grow without credit expansion? It is already doing so in 2017, even as banks shrink their balance sheets by selling or writing off bad loans (thus the large credit contraction in 2016-17).  Moreover, the government is not adding any new debt, instead producing oversize primary budget surpluses.

Therefore, credit conditions are currently very, very tight in Greece - one would characterize its economy as the diametrical opposite of a debt bubble;  let's coin a phrase and call it the "no money, no honey" economy..

The economy can continue growing for a while by focusing almost entirely on expanding its external markets such as tourism and exports - and that's exactly what is happening right now.  But this creditless expansion will not, and cannot, create the vigorous growth necessary to bring Greece back to financial health and raise living standards back towards those of a decade ago.

Greece needs healthy, well capitalized and deposit-rich banks that can once again provide sound businesses with plentiful credit to stimulate economic growth well above the 2-3% range.

Is this a realistic possibility? After all, everyone in Greek banking is focused on dealing with bad loans, meeting new regulatory criteria and cutting operating costs.

I believe it is more than possible, and there are early signs that astute, experienced bankers and investors are catching on to this idea.  There are - apparently - several entities preparing to submit applications for new banking licenses to establish credit institutions unencumbered by old bad loans, ready and willing to provide fresh credit.

This will play out over the next few months - so how are the four large systemic banks going to respond?  Certainly, they won't roll over and die... they have several factors in their favor, and I am willing to bet they will use them this year.

Stay tuned, because we may soon see fresh money coming into the Greek banking sector... otherwise, no honey!

Greek GDP - A Better Estimate

I have in previous posts expressed my doubts about official Greek GDP numbers as reported by the statistical authority (ELSTAT).  The major reason is the large "shadow" economy which operates under the table to avoid high value-added, income and social security taxes.   

A recent study by the Institute for Applied Economic Research at the University of Tübingen says Greece has the largest shadow economy in the world at 21.5% of GDP. 
 

It follows that calculating growth/recession rates becomes quite problematic since variations in the shadow economy cannot be counted. Thus, the need for a better yardstick, one that is not as affected by cheating on taxes.

My personal favorite is energy consumption (after all, every activity requires energy), and in this post I will try to provide a better estimate for real Greek GDP in 2017.

British Petroleum publishes an annual energy statistics study, widely considered the most authoritative of its kind.  Doing a quick division of official real GDP to energy consumption, I come up with the chart below: Greek GDP per unit of energy consumed.

We see that it varies between 6.1 to 7.1 billion euro per million metric tons of oil equivalent (MTOE).  There is a  good explanation for the large rise between 2006-10: during its bubble years the Greek economy was driven mostly by housing construction, a notorious source of tax cheating;  it is also very energy intensive.  Therefore, while energy use was increasing, reported GDP wasn't following pace, hiding in the shadows instead.  This changed abruptly when the construction business tanked following 2010.

Construction is now moribund (down almost 90%), so I'm pretty comfortable with using an average of 6.7 billion euro per MTOE as a useful correlation factor between economic activity and energy consumption.  The variation has been quite small, between 6.5 and 6.9 in the last five years and even smaller during 2014-16.

Moving right along, I'll also assume that in 2017 total energy consumption increased 3.8%, i.e. the same as for electricity alone (total energy data won't be available by BP until later in the year).

It all boils down to this: in 2017 my estimate for real (i.e. inflation-adjusted) GDP is

 GDPe =1.038 x 6700 x 25.9* = 180.1 billion euro

 or +2.4% over 2016, double the growth rate reported thus far (up to 3Q) by ELSTAT (1.2%).


Is this figure supported by other data? Yes, it is: for example, we know that tourism accounts for approx. 20% of all economic activity in Greece by direct, indirect and induced effects. Since we saw a 10.6% increase in tourism receipts during 2017, it follows that GDP growth from tourism alone should be +2.12%.

Bottom line: by my calculation real GDP growth in Greece during 2017 was +2.4%, give or take.

(* 25.9 MTOE was 2016 energy consumption as per BP)