CHINA'S SLOWDOWN: the "flu" is now inevitable, which means that the world needs to be ready for "pneumonia".

Over last Summer someone said that when China sneezes the world catches a cold.
I believe that China has gone beyond sneezing and it has a "flu", which means the rest of the world is about to catch pneumonia.

While all media outlet are focusing on China as it was an isolated problem kindly note that the Chinese economic slowdown and the cover up over real economic performance is ONLY one of the several problems currently plaguing the global economy: distorted monetary policies, failed monetary experiments like the EUR, geopolitical risk in the Middle East just to name a few.

For the purpose of this writing though we will focus only on the reasons why an economic slowdown of the Chinese economy is so impactful on the global economy.

In statistical terms the picture below gives you an idea of the commodity consumption of China in 2015:

China has been fueling an unprecedented INVESTMENT-LED infrastructure expansion that has been prompting an economic expansion across all emerging markets.
Merely as an example Australia benefited greatly from the Chinese economic expansion by exporting its iron ore and adding capacity along its way.

To understand the value of 1% of economic Chinese below are the GDP rankings based on PPP valuation.
Since 2008 China has been contributed the largest share of global growth, the IMF has been projecting that China would contribute double the global GDP growth than the USA. And China and the USA together are expected to generate as much growth output as the rest of the world put together with the third largest contributor being the European Union if taken as a WHOLE.

BUT the game is now coming to an end. Or better yet, the bluff has been called and as China tries to make a transition into a middle income country global economy is about to face significant headwind.

The official GDP numbers published by the Chinese authorities keep on being revised down, nobody believes the official numbers anymore and everybody tries to estimate the REAL value of the Chinese GDP.
Estimates on the street depending on the outlets range from -1% to +2.5%.

Indicators confirming the Chinese slowdown lie in the amounts of commodities truly absorbed by the economy. On the ground witness confirm that China is no longer absorbing the same amount of commodities as before, in many cases output production is cut.
I.e. Chinese steel is now dumped on the international markets decreasing price.
Kindly note that as recently as yesterday the oil contango widened signaling a further oversold sentiment. The contango in the front end of WTI crude forward curve widened to the highest level since 2008. This signals a significant sell-off in the physical market as demand is weak and inventory levels are high. (for a definition of "contango" kindly follow this link)

The most affected by the slowdown will be the commodity exporters that used to supply China with their raw materials:

• Australia: China accounts for 1/3 of all Australian exports;
• Sub Saharan countries: 1/8 of total exports goes to China; but the impact will be concentrated since five countries account for three-quarters of all of Africa’s exports to China: Angola, the Democratic Republic of the Congo, Equatorial Guinea, Republic of Congo, and South Africa.
• Latin America: China has surpassed the US as the most important trading partner for Latin America.

Next in line to be affected are the European luxury brands that have counted on the Chinese market for a silver-lining in the face of a general slow growth global economy.

The EU is China’s largest trading party, and China is the second-largest trading partner of the EU after only the US. The Chinese slowdown is therefore reflected in the profit warnings issued by European companies such as Burberry and BMW as their sales in China slows down.

Last but not least FINANCIAL MARKETS will be dragged down by the evident slowdown.

It is likely that one of the hardest hit will be the FTSE where a large portion of the commodity stocks are listed.

As shared at the beginning of this writing the Chinese slowdown is ONLY one of the ingredients bound to push the global economy into a bear market. We have strongly believed that we needed just a trigger to call in the bluff of the equity markets and we have gone many potential triggers in place.

I am afraid the China related first trigger have just being pulled.

The financial markets will now begin a long and painful process of deleveraging that will once again point out the fragility of our global financial systems and staggering amount of non serviceable debt accumulated across all markets.

Opportunities for profits available in this environment:

• Low risk: algorithmic based spread arbitrage on selected commodities and fx pairs across multiple exchanges;
• Medium risk: transactional funding of agricultural based commodities.

More to it on our next post.

Oil prices - short term considerations & long term perspective

As recent oil news make headlines we have decided to take a closer look at the OIL price and provide a perspective in considerations of few significant industry and geopolitical trends.

Fossil oil is and will play a significant role in satisfying global energy demand. The medium to long-term trend is determined by multiple factors such as among others: the status of the global economy, geopolitical events, technological advances as well as consumer choices. The two main variables impacting supply and demand have been on the one hand a significant increase in the energy demands of developing countries, and on the other hand the emerging of a wider variety of energy supply typologies (i.e. oil sands, fracking technology) altering the traditional energy supply routes and therefore also geopolitical choices.

1.     OVERVIEW OF THE OIL SUPPLY AND DEMAND

In 2013 crude oil global consumption grew around 1.3 million b/d (+1.4%), with an average of 90.4 million for year. The Energy Information Administration forecasts an increase of 1.1 million b/d in 2014 and 1.4 million b/d in 2015.

In the medium-term period (2012-2018) Reference Case Demand could increase by an annual average of 0.9 mb/d, reaching 94.4 million b/d in 2018. Europe, Asia and Russian demands are rising very slowly, as illustrated in Table 1 while developing countries demand rise faster, with an increase of 1.1 mb/d every year.

The outlook for the second half of 2014 shows that the oil demand of non OECD countries will be higher compared to the OECD countries.

Table 1 Medium-term oil demand outlook in the Reference Case[1]

Source: World Oil Outlook 2013

In the long-term period (2012-2035) Reference Case Demand could reach an increment of 20 mb/d each year, this value could rise up to 180,5 mb/d in 2035. The biggest share of this forecasted increase should come from developing countries.

Table 2 World oil demand outlook in the Reference Case

Source: World Oil Outlook 2013

Oil and other liquid combustibles global supply is estimated to grow 1.5 mb/d in 2014 and will decrease to 0.9 mb/d in 2015. Nevertheless, Non-Opec countries supply presents an estimated upward trend, with forecasts assessed at around 1.8 mb/d in 2014 and 1.1 mb/d in 2015.

Figure 1 Change in non-OPEC supply, 2012–2018

Source: World Oil Outlook 2013

In the medium-term 2012-2018, as illustrated in Figure 1, total non-Opec supply is expected to constantly rise by 5.7 mb/d. The two main variables impacting these estimates are the supply of “tight oil” and “oil sands”.

These could create additional supply, in particular in Latin America (Brazil and Colombia), in Middle East and Africa, even if in those countries supply may be negatively affected by political instability.

EIA’s data show that crude oil Opec production had an average of 29.9 mb/d in 2013, with a decrease of 1 million with the respect to the year before, due to the oil production outage in Libya, Nigeria and Iraq. This decrease is partially mitigated by a strong growth in non-OPEC country supply.

The EIA outlook indicates that Opec production should decrease of 0.3 mb/d in 2014 and by other 0.2 mb/d in 2015.

In fact, 8 of 12 Opec members, present a negative production in 2013, such as Libya. The other 4 countries try to maintain a stable production, furthermore, Iraq increase its production from 1.75 mb/d to 3.25 mb/d starting from 2005 to 2013. OPEC conservative production allowed to preserve oil price around 100-110 dollars per barrel during the last few years.

The graphic below, reported by Kent Moors, Phd, in Money Morning, shows that demand will continue to grow until 2025, while supply instead is expected to decline. Based upon these estimates it is possible to experience  a shortfall between demand and supply.

Figure 2 World oil demand and supply

Source: Money Morning 2014

2.     FORECASTING OIL PRICES

Lately crude oil forecasts depend heavily on the oil exporters geopolitical uncertainty. The reduced risk to Iraqi oil exports and the news regarding increasing Libyan oil exports contributed to a drop in the Brent crude oil spot price to an average of $107 per barrel in July2014, $5/bbl lower than the June average, as reported in EIA outlook of August 2014.

The Saudi active intervention in price setting over the past few weeks, coupled with further signs of a weakening of the Chinese economy have both contributed to driving the price to a 4 years low ($80 USD/bbl). Some add that there may be geopolitical interests at play to further weaken Russia by virtue of keeping the price of oil particularly low. Regardless of the geo-political reasons behind this short term oil price low, it is reasonable to expect a medium term increase to a more reasonable price level, especially if the US economy confirms its acceleration as indicated by the latest indicators released by the Federal Reserve.

Based upon recent events oil price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecasted levels. Implied volatility averaged 16 %, establishing the lower and upper limits of the 95% confidence interval for the market's expectations of monthly average WTI prices in November 2014 at $84/bbl and $111/bbl, respectively. Last year at this time, WTI for November 2013 delivery averaged $103/bbl and implied volatility averaged 21%. The corresponding lower and upper limits of the 95%confidence interval were $85/bbl and $125/bbl.

Figure 3 Uncertain oil prices are expected to fall

Source: IMF 2014

According to World Oil Outlook (2013), the nominal OPEC Reference Basket price[2] will be remain on an average of $110/bbl until 2020, and then it will increase in both real and nominal terms.

In nominal terms, we suppose that the nominal price will reach $160/bbl within 2035, whereas in real terms it will reach $100/bbl. It represents a slight shift upward than WOO 2012 expected.

Table 3 OPEC Reference Basket price assumptions in the Reference Case

Source: World Oil Outlook 2013

3.     CONCLUSIONS

Eventually, oil price is set to rise, influenced by fear and uncertainty from Middle Eastern and North African countries. The new geopolitical instability of the late 2014, continued nowadays in Iraq and in all Middle East, causes oil production shortages that could take oil price back up to $110-120/bbl.

We judge the existing low price as temporary and due to the following conjunction of few geopolitical and economic events: a slow down in Chinese manufacturing output, Saudi oil discounting IS heavily discounted although limited supply. We acknowledge the above as short-term temporary factors.

Although we expect oil prices to rise in the long-term (2014-2035) we forecast that any sustained price above $150 USD maintained for a long period of time is going to accelerate the oil for gas substitution trend. We therefore believe that the probability of high OIL prices for a sustained period of time is be quite low.

Oil price is closely connected to the futures market, that forecasts an increase oil price and it is minor influenced by the production.

As political instability grows in key oil producing areas and extraction technology progresses, oil companies have more incentives to explore and extract oil in international waters away from conflict areas. Thanks to new technologies these new offshore areas are now within reach.

REFERENCES

EIA, Short-Term Energy Outlook August 2014, Energy Information Administration, U.S. Department of Energy: Washington, DC.

Kent Moors, Money Morning, August 2014

IMF (2014), Regional Economic Outlook. Update: Middle East and Central Asia Department, International Monetary Fund: Washington, DC.           

OPEC (2013), World Oil Outlook, Organization of the Petroleum Exporting Countries, Publications: Vienna.

Authors: Marta Pezzoni & Luca Gorlero

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[1]The Reference Case scenario in the World Oil Outlook 2013 indicates that demand for energy is expected to increase by 52% over the projection period 2010–2035. As for oil, its demand increases by around 20 million barrels a day (mb/d) in the years to 2035, representing the first upward revision in oil demand growth since the WOO was first published.

[2]Introduced on 16 June 2005 from World Oil Outlook, is currently made up of the following: Saharan Blend (Algeria), Girassol (Angola), Oriente (Ecuador), Iran Heavy (Islamic Republic of Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arab Light (Saudi Arabia), Murban (UAE) and Merey (Venezuela).

Economic Outlook for 2014

Dear friends, following are some of the important economic themes for this 2014.

As always we welcome any feedback, I have mode detailed information about each of the topic discussed below but I have summarised the content to fulfil the purpose of this blog which is meant to be informative but not the place where to analyse in depth each subject. If anybody is interested in additional information please connect with me directly using the contact form at www.affinitasconsulting.ae or info@affinitasconsulting.ae.

Overview

We recommend a cautious investment approach to 2014. While at the turning of the year many media outlets run big optimistic titles for 2014 we remain instead very prudent and skeptical about the health of the global economy. We see several reasons for weakness especially in the equity sector. Clearly, as always even weaknesses or a downturn uncover opportunities for successful money making but we leave those strategies to the people in the field and we would rather concentrate the following analysis on long term trends likely to affect economic growth instead.

The tapering of the US QE exercise is bound to have ripple effects globally, especially across the emerging market economies.

We reckon the US economy is not as healthy as mainstream media believes and we expect the Feds to evaluate tapering sometimes after Summer when additional signs of weaknesses are going to appear. Now that the elections in Germany are over and done with, and the upcoming banking stress test from the ECB looming we expect the Eurozone to create some waves again. Spain and Italy are bound to catch the spotlight: the first because of weaker than expected banking system and the latter because we expect the government to be challenged in the coming months.

Bottom line: it may be time to cash out on the equity gains accrued over the last few months and wait for bargains during the volatility that is bound to take place due to the tightening moves of the next few months. Some institutional investors or asset allocators may look into specific infrastructure projects which have demonstrated a low correlation with equity markets oscillations.

Investors or asset allocators may also explore and evaluate financial instruments that have as objective the isolation of the interest rate differentials.

A STRONGER DOLLAR

The tapering program announced by the Federal Reserve is going to be one of the key elements behind a likely appreciation of the USD against the other G10 currencies.

I believe we will see an even appreciation of the currency throughout 2014. While portfolio flows in 2013 definitely favoured Europe we believe that strong equity valuation discounts eliminated any chance for further growth hinderances. 

In addition US Banks are decreasing their exposure against foreign borrowers and we see this as a clear sign that the USD is no longer used as a funding currency but rather as a destination for investment.

With specific regard to the USD/EUR rate we simply believe that in spite of the PR coming from the EU there are significant unresolved problems in the Eurozone that are bound to flare again at any time (more below on this topic - EU problems all over again).

We are forecasting the following key rate: 1.20 $/EUR 

USD Investment Destination (Graph)

PRESSURE ON CORPORATE PROFITS

This topic is directly linked to a phenomenon that many economists have been discussing for more than a decade: the decoupling of productivity and wage growth, the so called Jaw of the Snake.

The decoupling between productivity and wage started to appear around the beginning of the 80s, we believe that the spread of the personal computer and the adoption of information technology greatly favoured this trend. 

Fundamentally: since 1990 German labor productivity increased by 25% with no appreciable difference in wage growth; in the US labour productivity has increased to-date 85% versus only 35% of the hourly wage. In a study published in 2012 & 2013 by the International Labour Organisation we learned that the share of labor as part of the gross national income has declined since 1975 by more than 10% across the 16 high-income economies.

This allows for a redistribution of the national income away from labor and in favour of capital owners.

ILO (International Labour Organisation) research goes therefore at the core of the problem: the decline in the labor share of the national income hinders aggregate demand; that is because the consumption propensity from labour income is much higher than the propensity to consume out of capital income.

We therefore believe that pressure on corporate profit will come directly from the spreading income inequality that is accelerating in many of the G10 economies. In fact, lower aggregate demand lowers government tax collection, and further hinders the ability and willingness of companies to invest.

Adjusted Labor Income Shares (Graphs)

Increasing Income Inequality (Graph)

EU PROBLEMS ALL OVER AGAIN

While the marketing machine hails the Banking Accord of 2013 we believe that its positive effects will take very long time to take effect, and during this time a lot can and will happen. Be aware that the resolution fund part of the accord will not reach its target till 2026! 

Throughout 2014 there are going to be several junctures testing the solidity of the union and especially its banking system. We expect the upcoming banking stress test by the ECB to be one of such tests. It is likely that the test is going to uncover the requirement for additional capital especially in Spain, Greece and Italy. The stress test is promised to be more stringent than the previous one, especially since the previous one proved to be inconclusive since after passing it with flying colors the Spanish Bankia, the Cyprus Laiki and the Franco-Belgium Dexia went belly up just months later.

We also believe that the Spanish economy hasn’t sufficiently deleveraged, especially in its real estate sector.

The figure below shows that notwithstanding the collapse of property prices, Spanish mortgage debt has adjusted by only half the magnitude of the US adjustment. 

Any alarm in the banking sector would have repercussion on the valuation of the sovereign debt. The vast amount of Spanish government debt is in fact held internally by domestic banks.

IMF projections give the Spain structural deficit as one of the worst globally over the next five years. It is likely that additional fiscal tightening is going to be required in the upcoming future to meet the required targets.

We remain quite pessimistic in the future of the Euro zone in spite of the victory speeches of some of its leaders. 

Since the local governments are going to be forced to fund their own bank bailouts till the European fund gets up-to-speed we expect a continuing shortage of credit. With a chronic shortage of credit given to the private sector we expect growth to remain weak or non existent for most of the EU countries and deflationary forces will remain at play during the entire year.

Reality will seep through in 2014 and equity returns should start to be driven by corporate earnings instead than Quantitative Easing operations by the central bank. 

It is clear that Eurozone leaders have addressed some of the issues on hand and made significant steps forward, especially steps that have been blessed by the German leadership. Nevertheless these steps remain insufficient to resolve the disparity between the different countries in the zone and time may be running out before additional shocks are going to rock the system.

Reverse globalisation

Global trade hasn’t recovered to the same levels prior of the 2008 crisis and its growth remains below trend since 2011. Further note that additional data leads us to believe that there is an underlying trend of re-shoring currently in place.

The Manufacturing Advisory Services survey show that among 500 UK small and medium size companies interviewed a significant percentage of them was in the process of reshoring or thinking about it.

15% of the manufacturing business in the South East was already reshoring and an additional 25% of the companies was considering reshoring activities over the following 12 months.

Shipping Remains Subdued (Graph)

Similar trends are not exclusive to the UK manufacturing industries but also in the USA where industrial reshoring has been a key theme of 2013. In the USA the trend is predicated on the falling energy prices (“fracking revolution). 

Over the next decade as labor cost rise in China and other Asian exporters we predict this trend to gain pace.

Shipping Indexes (Graph)

Reasons for Re-Shoring (UK)

DEBT SERVICE BURDENS

As the monetary stimulus keeps on being retracted the lid that was put on government bond yields is going to be lifted little by little. It is therefore normal that interest rates sooner or later are expected to be raised.

Our point is that as this happens we expect service burdens for household to rise and therefore depress consumption expenditures.

Debt Servicing Costs

We indicate few countries that are likely to hit particular consumption degradation at the rising of interest rates: Canada, Netherlands and Sweden. These countries experienced a fair amount of household leverage during the last 10 years with no sign of decrease since 2008.

A study from the Canadian Chartered Accountants found that 29% of the respondents would struggle to keep up with payments if interest rate rose by 2% and further 29% would consider challenging more than 3%.

Canada, the USA and Sweden have a high proportion of non mortgage variable debt outstanding that is used for consumption. As monetary policy keeps on tightening over the course of 2014 investors are best to avoid any consumer centric type of equities.

Interest Rate Vulnerability (Graph)

Please contact the Affinitas Consulting team (www.affinitasconsulting.ae) for any additional query or information.

Cyprus: a dangerous precedent. Another step forward toward the end of the EURO.

Dear all, after reading the latest news arriving from Cyprus I couldn't help but getting onto the blog and share these few lines.

In spite of the relative quiet stand taken by the European media the bailout news is HUGE and deserves to be absorbed in all its frightening details.

If approved by the Cyprus government tomorrow this is going to be first time that the European authorities are going to apply a levy on account holders regardless of income but purely on the amount of deposits held: 6.75% for all account holders with up to 100,000 EURO in deposits an 9.99% for all account holders with deposits above 100,000 EURO.

It is hard to say whether this measure was passed onto Cyprus citizen because the European authorities wanted to collect as much money as possible out of the deposits of Russian citizen holding cash in the country. Regardless, the implementation of such measures are bound to have significant ripple effects in other countries of the periphery. Nonetheless it will be interesting to see the Russian reaction to these measures after they contributed more than 5B EURO in previous bailout money to preserve a special status with Cyprus (please note that Cyprus and Russia have a taxation treaty and Cyprus has been the not too hidden destination of much of the money taken offshore by Russian oligarchs). Perhaps the real reaction we will see only next Winter when Russian gas will need to flow into Europe.

In consideration of the following:

• current record bottom interest rates'
• real risk of government appropriation of funds, whether mandated by the European Union or the IMF truly doesn't matter;

Most people in Greece, Spain and Italy are better off rushing to their bank and pick up as much cash as possible to keep it under the pillow or in the mattress. Better yet convert it into gold or buy diamonds with it....

As our reader generally know when have always been bearish against the EURO and we keep on holding our ground. The lack of proper planning and proper imagination is pushing all periphery countries into the same deflationary spiral that is currently in place. Bailout like Cyprus is nothing but another stepping stone of the same policy: austerity -- contraction -- austerity -- contraction and so on.

As we repeated in other occasions the reaction to this will be political and will not be of conciliatory nature. It doesn't matter how many EUROs the ECB will keep on printing.
This is a deck of cards destined to failure.

Critical juncture - Euro & USD

Dear all, I was preparing the new blog article on a completely separate topic when I started to pick up from the press the convergence of a series of issues that require immediate attention.
I will therefore leave on this occasion the general analysis of the emerging market economies to focus on the impending "perfect storm" that is brewing across Europe and the USA.

We are in fact fast approaching a series of events that if not carefully thread could have a profound impact on the global economy the way we know it, more specifically:

1. the Euro crisis is spreading and it has INEVITABLY included Italy;
2. the USA is about to vote on a structural piece of their economic system and its timing is indicative of a very fragile system; 

Let's briefly analyze each item separately and then try to make sense of what is happening.

The Eurozone debt crisis

In talks with friends and clients we have sustained for the past 2 years two fundamental claims: the Euro was an experiment that unless strong political changes supported couldn't be supported long term.

We also claimed that the critical moments in which the crisis would have accelerated was the moment in which Italy was going to become the focal point of the crisis, or the tipping point. The issue is a matter of size: while Greece barely represents the GDP of a German Land, the Italian economy is the 4th largest economy in Europe and the 8th largest economy in the World. An Italian bailout is bound to create significant ripple effects both politically and financially.

Please note how the debate on the global media with regards to the Eurozone crisis has started to include Italy no more than a month ago. Nowadays all newscast globally, other than the one in Italy of course, seem to have recognized the size of the problem looming.

For the first time I have noticed going "mainstream" some of the "what-if" scenarios that we have been kicking around for quite some time now: the idea of multiple euro currencies: a "core euro" and a "peripheric" euro. I think that the fact that these scenarios are reaching mainstream talk is a sign that time is maturing for some bigger event. For additional information about scenarios like the one mentioned above please follow this posting by Izabella Kaminska of July 15.

As predicted earlier the list of "endangered" countries now comprises:

- Greece

- Spain

- Portugal

- Ireland

- Italy

Long before than the media investors have started moving, please look at the latest spreads.

From Bloomberg:

"Italian two-year note yields surged the most in over a year, as the nation’s borrowing costs rose at a debt sale and contagion from Greece’s debt crisis spread across the 17-nation euro region.

Yields on notes from Ireland, Portugal and Greece soared to euro-era records, while German bunds advanced for the fifth time in six weeks as Europe’s politicians clashed over how to craft a new rescue plan for Greece involving private bondholders. Spanish and Italian 10-year bonds slumped, sending yields to the most since the euro’s inception in 1999, as borrowing costs rose to a three-year high at a sale of five-year Italian securities. France, Spain and Germany plan to sell debt next week."

Italy’s two-year yield climbed 75 basis points over the week to 4.26 percent as of 4:40 p.m. in London yesterday. That’s the biggest weekly increase since the five trading days ending May 7, 2010, the week before Europe’s leaders announced a $1 trillion backstop for the euro. Yields on 10-year notes advanced 48 basis points to 5.75 percent. They reached 6.02 percent on July 12, the most since 1997.

Ireland’s two-year bonds plunged after Moody’s Investors Service cut the nation to Ba1 from Baa3 on June 12, saying it is likely to need a second bailout. The country’s two-year yields climbed 6.9 percentage points to a record 23.12 percent, while its 10-year bond yields advanced 1.13 percentage points.

Greek 10-year yields climbed 71 basis points over the week, while the nation’s two-year bond yields soared 2.69 percentage points. Fitch Ratings slashed Greece’s credit rating on July 13 to CCC, its lowest grade, and said that a default is a “real possibility.”

Spain’s 10-year bonds dropped, pushing the yield up 39 basis points to 6.06 percent. Spanish debt may continue to fall next week as the nation prepares to auction 5.5 percent securities maturing in 2021 and 2026 on July 21. It will also sell 12- and 18-month bills on July 19.

What does it mean the trending of the spreads for Italians? It means that the 40B Euro in economic cuts and additional taxes will be all but wiped out by higher borrowing costs that the country will need to face in the future. More corrections will be required. 

Let's take additional data from Italy: the money supply over the past 6 months has fallen drastically. M1 and cash deposits over the last 6 months has contracted at an annual rate of 7%. To put this in perspective: this is faster than the build up leading to the great recession of 2008. Such dramatic figures typically indicate an economic contraction approximately 6 to 10 months away. What is also important to report is that the numbers in the core eurozone has started to deteriorate as well, and in spite of this ECB has recently increased interest rate. It does seem that the leadership of the ECB is battling political and financial issues but the end result is that there is still a fundamental denial about the gravity of the situation that is building up.

Remember: once the situation will be mature, we will require a small event to unravel the euro and send shockwaves across the global economy. Will China commit to save the Euro? Please remember that China has been one of the supporters of the Euro note over the past year.

My prediction is that the "endangered" countries of the Euro will turn the issue political sooner rather than later and that economic matters may take a backseat.

Now let's briefly take a look at what is happening on the other side of the Atlantic.

US debt ceiling debate

Raging right now in the US is the debate to change the debt amendment and raise the current deficit ceiling. In essence Congress must raise the $14.3 trillion limit on US borrowing by Aug. 2nd. If that doesn't happen the US may face a downgrade in his credit rating and send significant shockwaves across the the financial system, or at least many believe so. 

President Obama and the Republican opposition have been fiercely fighting over two fundamentally different approaches towards this matter.

I personally believe that like the ex chairman of the Federal Reserve Paul Volker: "reason will prevail" and the politicians will find a compromise. In fact history leads us to believe that it will be so: in the past 30 years the limit has been raised already a significant amount of times.

The real important issue for me is timing and the fact that uncertainty at this time in the global economy, and especially uncertainty surrounding its largest economy, is adding onto very negative investor sentiments. The message here is economical as much as political: the transition between a world dominated by the G7++ economies into a world led by China & India is fast in the making. While the trends are undeniable the transition is froth of peril for such an interconnected world and the aftershocks of a new order may excerpt sacrifice on many parties.

Again, pragmatically: what does it mean for the investors right now?

My advice in the short term is to stay liquid, please look at currencies like the Swiss Franc and the UK Pound. Leave the equity market to its woes and play out some of the uncertainty unless you are a good trader. 

In the long run evaluate different type of investments altogether: food commodities are a sure bet in the long run but you need to brace yourself for a bit of a roller coaster ride. In some of the most uncertain countries or where financial instruments are limited, focus on building business ventures that satisfy local needs.

Related posts on this blog that explained the fundamentals of what is happening:
- Geopolitical & economic shift eastbound: underlying trends fueling long term growth in an economy - December 19, 2009
- emerging markets: by choice or mandatory evolution? - December 27, 2009


Related posts from other sources:
- Italy money supply plunge flashes red warning signals - The Telegraph, July 14, 2011
- U.K. Pound Approaches One-Month High Versus Euro Before Bank Stress Tests - Bloomberg, July 15, 2011
- Barack Obama’s extravagant Ancien Régime tells the American people: let them eat taxes - The Telegraph, July 15, 2011
- Moody's: U.S. faces default on debt payments not 'technical', - Reuters Video
- Volcker: Common sense must prevail in U.S. debt debate - Reuters Video

Emerging Markets: the privileged relation between China & Sri Lanka

The 30 years old conflict between the government of Sri Lanka and the LTTE (Liberation Tigers of Tamil Eelam, often simply called Tamil Tigers) ended on May 2009.

Since then the country has been often in the Western newspapers due to the investigations of the alleged abuses committed during the last months of the war.

The investigations over alleged war crimes and the tones of Western diplomats during the last phase of the war have strained the relations with Western countries.

Please refer to this article from the BBC to witness the status of the relationships between the Sri Lankan government during the last phase of the war in 2009 (BBC: http://news.bbc.co.uk/2/hi/south_asia/8026639.stm).

Further on the conditional aid: http://www.lankanewspapers.com/news/2009/2/40069_space.html

As the West stepped up the amount of conditions for aid, and limited any military support, China stepped in filling the void with a much lower profile set of demands for the Sri Lankan government. With fresh support from the East the Sri Lankan government was able to hold firmer in front of the Western demands.

As a country Sri Lanka holds a strategic geographical position and it is a country that is host of good natural resources waiting for strong partners to be developed, now that the north is under direct control of the government this entire area of the country is in desperate need for basic infrastructure: roads, power plants, railways, etc.

Further, the Indian Ocean is not the largest ocean on this planet but is, by far, the busiest. Countries around the Indian Ocean produce 40% of the world's oil. Seventy percent of the world's oil shipments and 50% the world's container cargo go across this Ocean. One hundred years ago, the US Admiral Alfred Maher rightly said, 'Whoever controls the Indian Ocean, dominates Asia'

The Times said: "Sri Lanka signed a classified $37.6 million deal to buy Chinese ammunition and ordnance for its army and navy ... China gave Sri Lanka — apparently free of charge — six F7 jet fighters last year, according to the Stockholm International Peace Research Institute, after a daring raid by the Tigers' air wing destroyed ten military aircraft in 2007."

It isn't hard to see China's motivation. The Times said: "China is building a $1 billion port that it plans to use as a refueling and docking station for its navy, as it patrols the Indian Ocean and protects China's supplies of Saudi oil.

The Chinese say that Hambantota is a purely commercial venture, but many US and Indian military planners regard it as part of a “string of pearls” strategy under which China is also building or upgrading ports at Gwadar in Pakistan, Chittagong in Bangladesh and Sittwe in Burma.

The strategy was outlined in a paper by Lieutenant-Colonel Christopher J. Pehrson, of the Pentagon’s Air Staff, in 2006, and again in a report by the US Joint Forces Command in November. “For China, Hambantota is a commercial venture, but it’s also an asset for future use in a very strategic location,” Major-General (Retd) Dipankar Banerjee of the Institute of Peace and Conflict Studies in Delhi said.

"Ever since Sri Lanka agreed to the plan, in March 2007, China has given it all the aid, arms and diplomatic support it needs to defeat the Tigers, without worrying about the West."

As the influence of China grows in Asia, its sphere of influence, it is likely going to be harder for Western companies to secure government related projects and tenders unless there is a major realignment of interests in the region. It is clear that India has a much larger role to play to balance the power equation.

Supporting materials:

“The Times” (http://www.timesonline.co.uk/tol/news/world/asia/article6207487.ece)

Lanka Newspapers: http://www.lankanewspapers.com/news/2009/2/40069_space.html

The Long Sunset of Europe

As we are witnessing a consistent stream of bad economic news from the Eurozone, I am a bit puzzled at the relatively shortsightedness of the analysis of the experts broadcasted across most of TV networks.

The main highlights surrounding Greece, Spain, Portugal and eventually Italy tend to focus around problems of fiscal nature.
In reality, fiscal problems are only an effect and rather not the cause of the matter.
In my modest opinion, the fundamental problem that is shared by many economies in the Eurozone is a fundamental lack of competitiveness. Cost of labor have soared, cost of welfare with it, productivity has decreased and the long term demographic trends, as shared in previous posts, are negative with no possibility of reversal.

The resolution of this matter is further complicated by the limited range of monetary policy options at the country level now that the EURO is in effect.

While in the old days each country made ample use of the monetary policy to boost competitiveness of goods and services, today the government of these countries need to come to terms with the fact that this option is no longer available. The ECB is working on a set of monetary policies that are to address the needs of a wide area of countries at times radically different from each other (look at the spread on the 10 years notes to witness the differences first hand). The end result is in fact a bit of an improbable exercise of equilibrium that tends to lack effectiveness.

Now it is the time in which the Eurozone needs to come to terms with a fundamental dilemma: one central bank setting monetary policies for all members but no strong political centre with the necessary powers and support to make difficult choices. The problem is therefore one of political nature just as much of economic one.

While Germany has been working very hard over the past 10 years to increase productivity without increasing the cost of labor (successful exercise, data shows), other countries have grappled with a consistent decrease in competitiveness and soaring costs. Moving forward given the fundamentals the differences between the central and periphery of Europe are going to unravel with: Germany/France on one side, the Mediterranean and Eastern Europe on the other.

I guess the concern that I would like to share is with regards to the remedy currently implemented.
From a birds-eye view, the liquidity offered in the forms of various loans by the ECB/IMF to Greece has a cost of 5%, hardly favorable terms. The loans can be activated in various forms upon implementation of structural reforms which are bound to further decrease internal consumption, which are going to drive down production and increase employment as well as decrease money velocity. (internal devaluation)

Aren't we running the risk of prolonging the agony, destabilize a country (people unrest is a real side effect) and arrive again at a point in which new injections of money is required?

It is indeed hard to evaluate other solutions given the existing exposure of German banks for example to both the Greek and Spanish debt. A potential return to the dracma for Greece would signify the failure of the EURO experiment. Nonetheless, sooner or later German & French voters are going to call for a better understanding of what is in it for them to bail out Greece now and who knows tomorrow.

Jean-Claude Trichet, President of the ECB, rightly said: "there is a need for a quantum leap in the governance of the Euro area". The real question is whether there is the political might and willingness of the single countries to make this necessary quantum leap. If I have to give odds to the Euro today, I would bet against its existence over the next five years, but let it be clear: as a European myself, I hope to be proved wrong.