Blog/Sovereign Debt Crisis
Posted Jun 29, 2015 by Martin Armstrong
The Greek drama of Greek Tragedy continues with a rumored agreement to continue the stimulus in return for promised reforms, only to have Greek Prime Minister Alexis Tsipras announce a surprise referendum on July 5 after June 30, which puts the IMF payment into default. Late last week EurAsia group’s Ian Bremmer remained confident that the Greek Parliament will approve the agreement at the last minute. Meanwhile, Greek politicians demonstrate their commitment to election promises of anti-austerity while the Troika talks tough on reforms to appease their own electorate. Monday is the Eurozone Summit, and on Tuesday the Greek IMF payment will go into default. Next week promises to be a volatile week in the markets with the arrays showing a turning point in many markets on Wednesday.
Summer volatility has continued as the market gyrates with subsequent news reports on Greek negotiations. The entire Greek debt tragedy began precisely on the pi target to the day of our Economic Confidence Model. Everything remains stunningly on track.
Global stock markets (MSCI WD) were flat on the week ending June 26 up 13 bps as strength in Europe (MXEU up 2.78%) offset declines in North America, which fell 41 bps. European markets were led by the DAX which ended the week up 4.1% holding onto gains early in the week. Despite recent strength, the MXEU is down 4.8% from highs in mid-April led by the DAX down 8.3% from its peak. Meanwhile, German bund futures continued to fall 1.2% on the week, bringing QTD losses on bund futures to 5.4%. In a sign of geographic divergence, the S&P finished the week down 40 bps. Meanwhile, strength in the Japanese stock market (NKY up 2.64%) offset weakness in Hong Kong and Australia as the MXAP finished the week relatively flat at +43 bps.
Precious metals gold and silver rallied to resistance in mid-June as peripheral bond yields rose. They have since turned back down as European political risk subsides with the expected Greek agreement. Industrial metals continued their sell-off demonstrating global economic weakness. Palladium prices are down 12.6% MTD while copper prices are down over 10% since mid-May despite the recent bounce.
While Greek negotiations captured the attention of the media, the big shift in trend is the sell-off of Chinese stock indices with the Shanghai composite down 7.4% on Friday bringing losses to 19% since the peak on June 12. While we elected the Daily Bearish Reversals from the high, we have not yet elected a Weekly Bearish. The rally to the high was right on target 17.2 weeks from the February low (2 x 8.6).
The Chinese A share market has been historic, rising 150% in less than a year versus the 1928–1929 U.S. market rally of 100%, which occurred over the course of 18 months. This rally has been fueled by margin trading, with margin debt up 464.57% over the past year — from $R400 million last June 19 to $R2.2 billion on June 19 of this year. In an apparent response to the stock correction, China lowered benchmark interest rates and reduced bank reserve requirements on Saturday.
While the Chinese market has been the global outperformer over the past year, long-term performance has lagged, with the Shanghai index failing to break the high of 6,124 set on October 16, 2007. The recent rally halted after hitting the Monthly Bullish Reversal at the 4695820 closing May at 4611744. Penetrating the low of May technically will bring the market back through the Breakout Channel. Indeed, the market has not exceeded the Breakout Line from the 2008 low.
Bond Markets Flash Caution
Much like the Chinese share market, developed world economies have been sustained by debt. While the press emphasizes high equity valuations, the debt market is the bubble. According to the Institute for International Finance, developed economy debt/GDP is at 245% excluding financial debt. While the financial sector has reduced leverage materially, the public sector debt-to-GDP ratio has increased 50 percent points in aggregate since 2000.
While emerging markets have stronger balance sheets, the rapid rise in debt is concerning, as total debt to GDP has risen precipitously from roughly 50% in 2000 to 80% at the end of 2014, as shown in the chart to the right. China has been a major driver, as debt has risen 72 percentage points versus GDP excluding financial companies.
Today the bond market displays the warning signs of rising volatility with low volumes on rallies. The German bund has broken through its upward channel from the beginning of the 2014, testing the 2008 trend line. Liquidity in the bond markets is dismal as brokerage houses continue to reduce inventories, reminiscent of the 2008 bond market collapse. This time, the lack of liquidity has spread to sovereign bonds including the German bund and U.S. treasuries. The Central Banks assume they can control the sovereign bond markets, yet rates continue to rise despite OECD rate cuts and continued bond purchases in Germany and Japan.
So what will cause the bond market to correct in the absence of growth? Fixed income investors have enjoyed a 34 year (4 x 8.6) rally with rates falling since 1981 (1980 for the U.S.). The bond market, like all markets, is based upon confidence. When bond investors start losing money, they begin to realize that governments may not be able to repay their debts, and they will lose confidence. Tax increases only cause economic contraction as seen in Japan and Europe. Low sovereign yields fail to protect investors from falling prices, causing corporate bonds to outperform. U.S. HY has a total return of 3.3% YTD meanwhile the Barclays 20+ treasury total return index is down 6.9%.
Central Bankers in Norway, Russia, South Korea, and New Zealand have all cut rates in the past month. Yet developed market interest rates continue to rise. Eventually central bankers will be forced to raise rates to attract capital as the emerging markets are doing now. Brazil and several African countries (Namibia, Uganda, and Kenya) raised rates in June to stabilize FX markets. The Brazilian real is down 15% YTD and almost 30% over the past year. While central bankers speak of inflation, the inflation is partially a consequence of a falling currency as seen in the graph above correlating inflation rates with the exchange rate of the Brazilian Real. Higher interest rates will add further pressure to government finances globally given short-term financing.
Assuming a temporary agreement is made which is looking bleak, look for Greek pressures to intensify once again in the fall along with the turn of Martin Armstrong’s Economic Confidence Model on October 1, 2015.
So why remain so confident of an eventual Greek default? With no fiscal union, the currency union is merely a currency peg. ALL currency pegs break under their own weight. While Greek polls suggest the Greeks want to remain in the EU, a large percentage of the population either works for the government or receives a government pension, which are being supported by support from the Troika. According to the Brookings Institute, roughly one million people were either employed by the Greek Government or were pensioners of the public sector in 2013, as compare to a total working population of 3.8 million total workers; this is unsustainable. The Brookings institute reports, “The pension of a 55-year-old retired senior police officer is around 1,650 euros per month. A lecturer working in a university is earning around 1,200 euros [net, after tax and social security contributions].” Has anyone else noticed the absence of youth in the Greek protests? A Grexit will be painful as the government will be forced to shrink due to the lack of capital. Meanwhile, increased visibility and attractive prices will create an opportunity for entrepreneurs to bring investment capital to Greece.
Weak economic growth is fueling civil unrest globally, while austerity in Europe is causing increased discontent with the EMU throughout Europe. One of the frontrunners for France’s Presidential elections, Marine Le Pen, is appealing to the anti-euro movement calling for a Frexit if the EU does not return “monetary, legislative, territorial and budget sovereignty.” When the Greek economy recovers following a Grexit, anti-euro sentiment will only increase.
Most developed countries would be envious of 2.9% GDP growth in today’s environment, Iceland is doing just that with 1Q 2015 GDP growth of 2.9% supported by consumption and investment up 6.4% and domestic demand up 10%. Recall Iceland allowed its banks to default. In addition, Iceland only spends 9.1% of GDP on healthcare whereas the U.S. spends 17.9%, according to the CIA World Factbook on August 2014.
Markets are expected to remain volatile through the summer leading to the ECM of October 1, 2015 so pay attention to the arrays and reversals. This week of June 29 has been a target on the arrays for months in Greece, euro, and bond markets. However, the first week of July has been a target in the Greek share market and curiously we have the referendum suddenly called for July 5. A Grexit will cause investors to question the viability of other periphery countries, such as Portugal, Spain, and Italy, thus pushing capital to the U.S. While a rally in the euro through the summer is possible, economic weakness and political issues in Europe will continue to fuel a further rally in the USD, hurting countries and corporates with USD denominated liabilities. While the bond markets may benefit from a risk-off scenario, now is the time to study corporate balance sheets and understand their exposure to higher interest rates and currency movements. All this uncertainty and volatility should cause one to pull back waiting for some clarity this next week. We remain bearish in the metals and the Chinese indices.