Daily Note – Miss Sarajevo

Miss SarajevoSummary

United States: Small tick up in inflation as Industrial Production slows.

Turkey: Big surge in inflation exposes policy cul de sac and an opportunity for profits.

China: Strong new loan demand in January and there is risk to housing in Hong Kong, so we are watching our long position.

Eurozone: Merkel’s coalition is under pressure after Hans Peter Friedrich’s resignation.

Japan’s growth rate in final quarter is weaker than expected.

Good morning from Sarajevo.

It’s not every day, I can open the note from such an exotic location. I am sitting in a small café opposite the very bridge where Gavrilo Princip, the young Serb radical, assassinated Franz Ferdinand on the 28th of June 1914, triggering a sequence of events leading to the First World War.

One of the fascinating aspects of the First World War story is that we are always taught that the  war came almost out of nowhere. However, this is not actually true. The Serbs – dominated by the dream of a Greater Serbia – had been goading the Austrians  for some time and spoiling for a scrap. I have just finished a wonderful book on the era “The Sleepwalkers” by Christopher Clarke which can be bought on Amazon but I would prefer you to buy it from the wonderful Gutter Bookshop who are in situe below us in the office in Dalkey. (If you can, you should consider supporting local retail because if you don’t the very existence of our towns as thriving places is in doubt. Read here  how Amazon has led to the culling of 1 million retail jobs – that’s a lot of empty shops in once busy towns and no one benefits really other than the shareholders of Amazon.)

The fingerprints of the Serb military intelligence are all over Princip’s assasination and Serbia’s calculation that it could coax the Austrians into another limited Balkan War, proved to be a fatal gamble. Once the Germans decided to give the Austrians a “blank cheque” in terms of supporting unambiguously whatever action Austria took in retaliation, the dominos were set to fall.

However, the notion of the demented “lone wolf” acting on his own, sparking a military contagion which dragged my innocent relations (and probably yours) to fight in Flanders, doesn’t really stand up to much scrutiny. The political and military alliances guaranteed a conflict once someone lit the fuse.

Like many of these events which are apparently “out of the blue”, when you do a bit of digging you see they not only didn’t come “out of the blue”, but were in fact quite likely to happen.

Financial markets can operate similarly. When a currency crashes or there is a crisis in an emerging market, a housing slump or a whiplash in expectations, many people who are caught out resort to the “no one saw that coming” defence.

While investors can’t be right all the time, there are reasons to believe that  with a bit of analysis, you can minimise these “shocks” to your portfolio.

With that in mind, let’s see what’s happening in the US.

United States: Import prices heat up as Industrial Production slows

Table 1 17 Feb

Import prices rose 0.1% in January (vs. consensus -0.1%). Petroleum import prices fell 1.2%. There is little point nit-picking over the data, I think it is more worthwhile to seek a bit of altitude here and understand that slowly but surely the great period of very low price increases is coming to an end in the US. As unemployment falls steadily, wage pressures will emerge and prices have only been so subdued for so long because deleveraging after the sub-prime mortgage crises has taken five years to play out.

Prices tend to move in cycles and can only move down for so long before supply demand dynamics kick in – locally sourced price pressure may be subdued for a little while yet, but recent moves in commodities will spill over into imported inflation in time.

Have a look at the chart below. This shows one year US inflation expectations and the CRB commodity index (which tracks the prices of a basket of commodities).

Figure 1: US 1Yr Inflation Expectations & Commodity Prices

Chart 1 17 feb

In recent weeks, commodities – for so long unloved – have rebounded quite substantially and this is bearing on US inflation and wages will also rise as unemployment keeps falling.

This will have a significant impact on the long end of the US yield curve, particularly as I think Yellen will try to squeeze the last job out of the economy before she acts, leading to curve steepening.

The weather is continuing to play havoc in the US. (But given that I am in Sarajevo to ski and there is no snow, I’d fancy just a bit of weather our American friends are having!)

Headline industrial production in the US fell 0.3% in January (vs. consensus +0.2%). The Federal Reserve noted in the release that “severe weather … curtailed production in some regions of the country.”

How do these data affect our overall view that Yellen will not so much find herself behind the curve, but will be happy to set up shop there for a little while?

The recent data releases don’t change our central view and the Fed knows very well what it is doing right now.

I wish I could say the same for Turkey.

Sarajevo used to be the Balkan jewel of the Ottoman Empire, the most important Ottoman city west of Istanbul. The minarets attest to that, but so too do the synagogues and the Serbian Orthodox churches as well as the Catholic cathedrals of the city’s Croat population. You can feel Turkey here and the former tolerance of the Ottomans.

And it is to Turkey that I head next to see what exactly is happening there because I think there is lots of money to be made in Turkey this year. But you wouldn’t think that now.

Turkey: Further deterioration in inflation expectations reveals the need for additional tightening

The survey of expectations, released by the CBRT, indicates a further deterioration in medium-term expectations. Expected inflation over the next 12 months increased to 7.1% yoy from 7.0%yoy in January.

High inflation will force the Turkish central bank to keep rates high for the foreseeable future. We have talked in the past about the problems of high rates on the real economy but it also has a drag on asset prices in Turkey. As the chart below shows, the Turkish stock market only began to turn lower once rates were moved materially higher by the Turkish Central Bank.

Figure 2 Turkish Stock Mkt & the Price of 3mth Money

Chart 2

Our view on Turkey is that there will be a series of internal corporate defaults as growth slows, real rates remain high and the legacy of a borrowing binge in the past few years makes itself felt.

Dollar denominated debt has found a few buyers who are betting that the Turks can steady the ship. I don’t buy that. I have seen too many of these current account, internal debt, currency crises to bet on the centre holding.

The resulting clear out – currency falling further, corporate defaults and the stock market slumping – will present huge opportunities in equities in time. I will hold your hand on this in the next while, for now though, I head to Istanbul to talk to a few friends who know what is going on on the ground.

China: Strong new loan demand in January 

Table 2 17 feb

Chinese bank lending jumped in January. Banks in China usually front-load their lending at the beginning of the year, so large increases are common. Still, the stronger-than-expected data suggests government concerns about credit expansion aren’t affecting the appetite for credit. Money supply growth remained flat month over month but is still rising at a year on year rate of 13.2%.

Just one thing to flag: the housing bubble in Hong Kong. I remember flying into Hong Kong in 1997 when the housing market had crashed and talking to taxi-drivers whose savings had been wiped out. Is there a risk of this again?

Hong Kong property prices have doubled since their Lehman lows and even the IMF has now warned about a property bubble. The spectacular rise in Hong Kong property was due to the Federal Reserve’s epic monetary printing spree since the Hong Kong dollar is pegged to the US dollar and of course capital flight from China, Russia and even North Korea.

Like Singapore, the Hong Kong government has been unable to dampen rampant, leveraged speculation in the local property market.  Knight Frank data suggests Hong Kong prime property has risen by at least 25% in 2014 alone, at a time when a credit bubble in China’s shadow banking system is about to burst and the Federal Reserve has begun to decelerate its balance sheet expansions since 2008. This means a property market crash in Hong Kong is now becoming all the more likely.

We remain long our China ETF but will be happy to sell if we feel that Hong Kong’s dazzling property bubble is about to pop.

Eurozone: Merkel’s coalition is under pressure after Friedrich’s resignation

The Germans have got themselves into a terrible political flap over the weekend. Agriculture Minister and Christian Social Union member, Hans-Peter Friedrich, resigned yesterday over accusations that he leaked confidential data. The information derived from a prosecutor’s investigation into an SPD lawmaker suspected of possessing child pornography!

The lawmaker, Sebastian Edathy, has denied the accusations.

Horst Seehofer, head of the Christian Social Union, the conservative Bavarian wing of Merkel’s Christian Democrats, has demanded explanations from the Social Democrats.

Merkel’s governing “grand coalition” is potentially under serious pressure and could even risk collapse if the scandal undermines the position of SPD chairman Sigmar Gabriel, who was tipped off about the investigation by then-interior Friedrich in October.

What began as a small domestic scandal about Edathy erupted into a major political furore when the SPD said Friedrich had warned Gabriel that Edathy could become a target of an investigation.

Unlike the internal coup in Italy last week, the situation in Germany if it was to continue to worsen, would have potential to affect the price of the Euro. We remain short euro and are chilled about that position.

Japan: Fourth quarter growth expanded by 0.3% bringing GDP for 2013 to 1%, well below expectations.

Exports picked up, but not by much. This means more and more Abeonomics and more and more money printing from Tokyo. So there will be no change to the policies of the past year.

Portfolio: Our China long continues to make good progress

Table 3 17 feb

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