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posted on 08 September 2017

Synchronized Global Growth

Written by

Macro Tides Monthly Report for Septmber 2017

The Pace of the Synchronized Global Recovery

According to the Organization for Economic Development (OECD), 33 of the 45 countries it tracks are likely to grow faster in 2017 than in 2016. In the past 50 years synchronized growth has been relatively rare, only happening in the early 1970’s prior to the OPEC oil embargo in 1973 and in the late 1980’s.

synchronized.swimming


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In 2007, 26 countries posted better growth than in 2006, but in 2009 36 of the 45 OECD countries contracted. The global economy rebounded after the financial crisis in 2010, but that spurt quickly gave way to a slowdown and an increase in the number of countries whose economy contracted in 2011 and 2012. Not only are more countries growing faster than in 2016 but no countries are expected to contract in 2017 for the first time since 2007.

welsh.monthly.2017.sep.fig.01

The synchronization of growth in so many countries is a good thing for the individual countries and for the global economy, so the optimism it has generated is understandable. What has received far less attention is the actual pace of global growth which seems as important as the level of synchronization.

welsh.monthly.2017.sep.fig.02

As the table above indicates, global growth in 2006 and 2007 was 5.5% and 5.6%, and in 2010 5.4%. If the IMF estimate for 2017 proves accurate, global GDP will only grow by 3.6% in 2017. Compared to 2006, 2007, and 2010, global GDP growth in those years was 50% faster than the projected growth of 3.6% in 2017. The pace of the synchronized recovery may not warrant the level of bullishness the synchronization aspect has generated.

One of the primary reasons global growth is weaker than in 2006, 2007, and 2010 is the ongoing slowing in China’s economy. In 2006 and 2007, China’s GDP grew by 12.7% and 14.2% and by 10.6% in 2010. The IMF is estimating that China will grow 6.5% in 2017 and just 6.0% in 2018. In dollar terms, China’s GDP has grown from $2.752 trillion in 2006 to $11.203 trillion in 2016. With China’s economy growing faster than global GDP since 2006, China’s proportional impact on global growth has increased. This is why the slowdown in China’s GDP growth rate is progressively weighing on global GDP growth. Instead of adding to an increase in global GDP, China is now adding less and contributing more to the overall slowing in global GDP.

welsh.monthly.2017.sep.fig.03

Global growth is 1.8% slower than in 2007 but global debt levels are higher. According to the Institute for International Finance (IIF), household, government, and corporate debt climbed by more than $70 trillion from 2006 to $215 trillion at the end of 2016 representing 325% of global GDP. The increase in total debt was driven by a ‘spectacular rise’ in emerging market debt. From 2006 emerging market debt soared from $16 trillion to $55 trillion in 2016, and amounted to 215% of emerging market GDP compared to 146% in 2006. Debt in developed countries rose to 390% of GDP from 348% in 2006.

welsh.monthly.2017.sep.fig.04

Most of the increase in emerging market debt was due to the explosion in debt in China. An analysis by the New York Federal Reserve published in March provided some eye opening details behind the surge in Chinese debt:

  • Debt in China has increased dramatically in recent years, accounting for roughly one-half of all new credit created globally since 2005.
  • The country’s share of total global credit is nearly 25 percent, up from 5 percent ten years ago. China’s credit boom has reached the point where countries typically encounter financial stress, which could spill over to international markets given the size of the Chinese economy.
  • Nonfinancial debt in China has increased from roughly $3 trillion at the end of 2005 to nearly $22 trillion.
  • Banking system assets have increased six fold over the same period to over 300 percent of GDP.
  • In 2016 alone, credit outstanding increased by more than $3 trillion, with the pace of growth still roughly twice that of nominal GDP. As a result, the “credit-to-GDP gap" - the difference between the debt-to-GDP ratio and its long-run trend - has reached almost 30 percentage points. The international experience suggests that such a rapid buildup is often followed by stress in domestic banking systems. Roughly one-third of boom cases end up in financial crises and another third precede extended periods of below-trend economic growth

welsh.monthly.2017.sep.fig.05

Since 2013, China’s bank regulators have tried to slow the growth of the shadow banking system within China. The shadow banking system is included in official data and accounts for about 15 percent of total credit - 31 percent of GDP - compared with 5 percent ten years ago. Despite regulators efforts, nonbanks within the shadow banking system have found ways to circumvent the new rules. Lending by non-bank financial institutions (NBFI) has grown significantly since 2013.

welsh.monthly.2017.sep.fig.06

Many small and medium sized banks in China count NBFI transactions as investments rather than loans. Investment assets carry lower risk weightings (25%) than loans to non-financial corporations (100%), so the banks are required to set aside far less than for loan loss provisions. NBIF’s understate the actual level of indebtedness within China’s economy since many of them are not classified as loans.

I’ve discussed Wealth Management Products (WMP) and Negotiable Certificates of Deposit (NCD) previously noting that they have provided banks avenues to circumvent banking rules since 2013. The Peoples Bank of China (PBOC) earlier this year revealed that the shadow banking system is far larger than they had estimated. If the shadow banking volume of lending, masquerading as something else is included as debt, China’s debt to GDP ratio would be even higher.

The growth in global debt, emerging market debt, and China’s debt isn’t a problem now since growth is strong enough to provide the cash flow to service the mountain of global debt, and interest rates are still quite low. The record high level of debt relative to GDP, suggests it will take less of an increase in interest rates to slow global growth as the cost of debt service consumes a greater share of cash flow. The increase in debt also leaves the global economy vulnerable to another financial shock as defaults rise and central banks have less ammunition now than in 2008 to contain a contagion. The seeds of the next financial crisis have been sown but won’t be visible until global growth slows.

Consequences of Central Bank Manipulation

Quantitative easing and negative real interest rates have been a staple of central bank monetary policy since the financial crisis. Central banks have effectively been holding a volley ball underwater in an attempt to spur economic growth and higher inflation. To varying degrees the central banks have succeeded.

According to Mario Draghi the ECB’s bond buying program had been “very successful", as he modestly proclaimed during his speech at Jackson Hole on August 25. Success is a relative term so it depends on how low or high the bar is set to measure success. A review of how various countries in the European Union have performed since 2011 would suggest the citizens of Germany might agree with Mario, while those in Greece, Italy, and Portugal not so much. Germany’s GDP is not even up 10% since 2011 so one might have to label the outcome in Germany as a qualified success.

welsh.monthly.2017.sep.fig.07

Very successful or not, EU GDP growth has improved enough that the degree of monetary accommodation provided by the ECB will need to be dialed back in coming months from $60 billion a month in bond purchases to something less. The question is, when does the ECB communicate the reduction in monthly purchases? Will the ECB say something specific after its September 7 meeting, or just hint that the tapering is coming? Does Mario note that inflation is under the ECB’s 2% target and mention how a strong Euro puts downside pressure on inflation, which is counter to the ECB’s inflation goal?

In the August MT published on August 7 I thought the strength in the Euro might affect how fast the ECB might curb its monthly purchases:

“One of the reasons why the ECB may only lower their monthly bond purchases to $50 billion, rather than $40 billion, is the strength in the Euro, which is up more than 12% since January and more than 5% since June. The stronger Euro will put additional downward pressure on inflation which is comfortably below the ECB’s target of 2.0% and trending lower. Export growth will slow in 2018 as European products cost more due to the rise in the Euro, which will be a headwind for growth throughout the Eurozone."

The minutes of the ECB’s meeting on July 9 were released on August 18 and the strength of the Euro was discussed:

“Regarding exchange rates, while it was remarked that the appreciation of the euro to date could be seen in part as reflecting changes in relative fundamentals in the euro area vis-a-vis the rest of the world, concerns were expressed about the risk for the exchange rate overshooting in the future."

On July 9, the Euro was trading under 1.15 and last week traded above 1.20 an increase of 4.8%. Whatever concerns that existed on July 9 would be heightened by the recent increase and could represent the ‘overshooting in the future’ described.

A review of how Mario and the ECB have manipulated markets to achieve the outcome they desired could be instructive. In conjunction with Draghi’s “Whatever it takes" statement in July 2012, the ECB announced plans for its Outright Monetary Transactions (OMT) program. Under the OMT program, the ECB would buy sovereign bonds of EU members in the secondary market. There were no limits on the amount of a country’s outstanding bonds the ECB could buy, as long as that country stuck to the agreed plan for budget deficit reduction. The ECB didn’t want its OMB program to lessen a country’s commitment to fiscal austerity.

Knowing the ECB would step in to backstop any rise in bond yields for EU countries, hedge funds and international money managers bought sovereign bonds aggressively before the OMB program was launched. Within six months, bond yields had come down dramatically, and the ECB didn’t have to spend a dime in achieving their goal. The ECB used Other People’s Money (OPM) to get their desired result.

After ECB president Mario Draghi said the ECB would do “Whatever it takes" to stem the sovereign debt crisis on July 24, 2012, the Euro had rallied more than 15% versus the Dollar by March 2014. The initial rebound in the Euro was welcome and a sign that international confidence in the sustainability of the Eurozone was increasing. The strengthening Euro was a helpful tailwind, which brought borrowing costs down for the country’s most affected by the sovereign debt crisis - Greece, Portugal, Spain, and Italy. Lower borrowing costs helped their economies stabilize and narrow budget deficits.

However, I made this assessment in my April 2014 Macro Strategy Review (MSR) that I was writing as the Tactical Strategist for Forward mutual funds:

“With the Eurozone economy on the mend, the Euro’s strength has shifted from being a tailwind to a headwind. Given the ECB’s prior success with the OMT program, all the ECB may need is for Draghi to state the desire for a lower Euro and willingness of the ECB to sell Euros if necessary. Currency traders would be happy to accommodate the ECB’s wishes, since they could sell the Euro short knowing they were doing so with the blessing of the ECB, and with almost zero chance the ECB would intervene. The ECB wouldn’t have to sell a single Euro to achieve their goal."

I also discussed in the April 2014 MSR commentary where the Euro might top out:

“The 50% retracement of the decline from 160.50 in July 2008 to the low in June 2010 at 118.79 is 139.64."

In the first week of May 2014, the Euro traded as high as 139.93. In the May 2014 MSR commentary, which was published before May 8, I concluded my discussion of the Euro with this comment:

“Shorting the Euro has potential of being a profitable trade over the next year."

After the ECB’s policy meeting on May 8, 2014, Mario Draghi was asked about the Euro’s exchange rate. He responded:

“The strengthening of the exchange rate in the context of low inflation is cause for serious concern in the view of the Governing Council."

After hearing Draghi’s comment currency traders aggressively sold the Euro. By Friday May 9, the Euro had generated a three week negative key reversal. By March of 2015, the Euro had declined by more than 20% against the Dollar. The ECB used Other People’s Money (OPM) to get their desired result of a lower Euro.

As noted previously, EU GDP growth has improved enough that the degree of monetary accommodation provided by the ECB will need to be dialed back in coming months from $60 billion a month in bond purchases to something less. The ECB must be concerned that the appearance of ‘tightening’ monetary policy might cause the Euro to strengthen even more and overshoot even more. Given the ECB’s success with using Other People’s Money to get what they want, jawboning the Euro lower, and potentially insinuating currency market intervention by the ECB, could swing enough traders to liquidate long Euro positions and sell the Euro short. A decline of this type could be swift, sharp, and turn into a cascade. The positioning in the Euro futures market shows a multi-year high in Euro long positions, so a decline in the Euro could force longs to sell triggering even more selling pressure.

welsh.monthly.2017.sep.fig.08

The Federal Reserve is much further along the path of normalizing monetary policy than the ECB. Either way, both central banks will be attempting to let the volley ball rise to the surface in a controlled manner so it doesn’t pop out of the water and create a splash. This is not going to be as easy. When the Fed and ECB wanted to repress interest rates they could enlist the help of market participants to ride their coattails since investors would profit from the collaboration. welsh.monthly.2017.sep.fig.09

Unwinding negative real interest rates and curtailing bond purchases will cause interest rates to rise and create losses for bond holders. Rather than being coconspirators, market participants will be combatants with the central banks and more importantly with each other.

welsh.monthly.2017.sep.fig.10

No matter how gradual the process unfolds, and I’m sure the central banks will try to make it glacial, at some point the markets are going to get away from the central bankers. The potential is that it won’t be a Taper Tantrum but more like a stampede with every investor acting in their own best interest. It’s not a question of if this is going to happen, just when.

welsh.monthly.2017.sep.fig.11

A review of the three charts above shows just how distorted bond markets have become due to central banks. These distortions represent a risk to financial stability and may become as important as inflation to central banks. Central bankers may use the goal of maintaining financial stability as a reason to reduce the current level of monetary accommodation, while downgrading the need for inflation to reach 2.0% before acting. The financial markets have not priced in this potential, so monitoring references by central bankers to financial stability could be an important clue to the timing of rate hikes by the Fed and tapering by the ECB.

The term premium (fourth chart above) is the excess yield that investors require to commit to holding a longterm bond instead of a series of shorter-term bonds. In early 2013, the global term premium for holding bonds in the U.S. Europe, Japan, and Great Britain was more than 1.5%. After years of central bank balance sheet expansion, it recently fell to less than 0.1%. An increase to 0.75% would shake up the bond markets in each of these countries. European junk bond yields are nearly equal to the Merrill Lynch / Bank of America Treasury Bond Index. This is an example of the greater fool theory in action.

Volatility in the bond market fell to its lowest level in August since 1988, when Merrill Lynch first created the MOVE Volatility Index. This seems extraordinary since the Fed and ECB are on the cusp of a major shift in the monetary dynamics of the last 8 years that will result in an increase in volatility that could cause bond owners whiplash.

It’s an accident waiting to happen. Sometime in the future, financial historians will wonder “What were those investors thinking?" My guess is that they will answer their question with the assessment that the problem was that investors weren’t thinking.

Federal Reserve

According to many economists and a number of the FOMC members, once the actual unemployment rate falls to below the Non-Accelerating Inflation Rate of Unemployment, or the natural unemployment rate (NAIRU), the rate of inflation tends to accelerate and economic activity becomes overheated.

The logic of NAIRU is pretty straightforward. Companies will begin to bid up wages when the unemployment rate is below NAIRU. Higher wages increases the demand for goods and services, and before you know it, inflation is moving up. At least that’s how it works in the world of academia, but NAIRU hasn’t performed as expected in the real world, especially during the recovery since 2009. The U3 Unemployment rate has been below the NAIRU rate for some time which is why so many economists have been forecasting that wage growth was about to improve for at least the last two years.

welsh.monthly.2017.sep.fig.12

As the Federal Reserve’s wage growth estimates in 2015 and 2016 failed to pan out based on the NAIRU rate, the Fed simply moved the NAIRU rate lower. Since early 2015, the Fed has reduced the upper boundry rate for NAIRU rate, (also known as the Phillip’s Curve), from 6.0% to 5.0%. If and when wage growth does accelerate, the Fed can point to the lower NAIRU rate and say the Phillips Curve theory was once again validated.

In academia, there are no wide right or wide left field goal kicks. One just moves the field goal and proclaims the field goal was good.

In August 2017, the US unemployment rate stood at 4.4% versus the NAIRU rate of 5.0%. Average Hourly Earnings (AHE) for Non-supervisory and production workers were up 2.37% from a year ago. The FOMC is perplexed by the refusal of wage growth to accelerate despite 8 years of extraordinary monetary accommodation. Flagging wage growth isn’t the only issue that has flummoxed the Fed. Inflation has floundered well below that Fed’s inflation target of 2.0% since 2012. Some FOMC members have suggested that the Fed should publically announce that their inflation target has been raised to 3.0% in the belief that inflation would subsequently increase to 3% if the Fed just proclaims it so. Only an academic could think inflation would appear by proclamation, despite an incredibly competitive global economy which is growing one-third slower than it was in 2006, 2007, and 2010.

If the Fed is able to get inflation up to 2% from the current Core PCE rate of 1.4, but AHE wage growth fails to rise from 2.37%, the average worker will be pushed further behind the eight ball as higher inflation erodes their purchasing power by .6%. This raises an interesting question for the Fed. Rather than using 2% as their stable price target and NAIRU as the guidepost for guesstimating when the labor market has become tight enough to produce inflation, why not use a moving target for inflation based on wage growth. The Fed should determine the official inflation target by subtracting 1.0% from actual wage growth. I chose 1% since real wage growth is healthy if it is at least 1.0% above inflation. With wage growth holding near 2.5% for many months, the Fed’s inflation target would currently be 1.5% rather than 2.0%. If wage growth does rise to 3.0%, the inflation target would become 2.0%.

welsh.monthly.2017.sep.fig.13

As noted, the majority of economists and the Fed have been forecasting a pick-up in wage growth for at least two years that has failed to materialize. They have been focused on the U3 Unemployment rate which has been below 5.0% since January 2016. In March 2015, I discussed using the spread between the U3 and U6 unemployment rates as a better guide to the amount of slack in the labor market than just focusing on the U3 rate:

“While the (U3) gets the headline every month, the U6 unemployment rate, an alternate measure of the labor market, probably provides a better measurement of the actual amount of slack in the labor market. The U6 unemployment rate includes those working part time but who would prefer full-time employment. In January2015 there were 6.8 million workers who fit into this category, so this is not an insignificant group. The U6 rate also includes those who are marginally attached to the labor market, since they still want to work but have become discouraged."

By definition, the U6 rate is always higher than the U3 rate, but the spread between the U3 and U6 rates fluctuates significantly depending on the economic environment. In August 2017, there were 7.132 million people out of work as measured by the 4.4% U3 rate, and another 6.7 million workers who were underemployed reflected in the U6 rate of 8.6%. The spread between the U6 rate and the U3 rate in August was 4.2%.

welsh.monthly.2017.sep.fig.14

The average monthly spread between the U3 and U6 unemployment rates was 3.85% from January 1994 and August 2008 based on data from the Bureau of Labor Statistics. The average annual gain in monthly wages from January 1994 through August 2008 was 3.32%, using data from the Federal Reserve Bank of St. Louis. I found that when the U-3 - U-6 spread was less than 3.85%, average monthly wages grew faster than 3.32%. This indicated that when the U3-U6 spread was below 3.85%, the labor market was tight enough to cause wages to rise faster than their longer term average.

Conversely, when the U3-U6 spread was above 3.85%, wage growth was less than the long term average of 3.32%.

Based on this research my conclusion in March 2015, was that wage growth was not likely to accelerate in coming months from the 2.2% it had averaged since 2010. Since March 2015, AHE have only increased from 2.2% to less than 2.5%, which is certainly in line with my research and the historical spread between the U6 and U3 rates. The spread between the U6 - U3 rate has been a better predictor of wage growth than either the U3 rate or NAIRU. The 4.2% U6 - U3 spread is the lowest since January 2008. If the spread falls below 4.0% in coming months, upward pressure on wages should intensify and result in Average Hourly Earnings growing faster.

U.S Economy

The Bureau of Economic Analysis increased its estimate of second quarter GDP from 2.6% to 3.0% and 1.2% in Q1. In the first quarter, inventory liquidation subtracted -1.46% from GDP. Inventories in Q2 were basically unchanged and added 0.02%. The swing factor in inventories added almost 1.5% to Q2 GDP versus Q1. Personal consumption of goods increased in Q2 and added .25% to the first estimate of 2.6%. Business investment rose from 0.36% to 0.58% adding 0.22% to BEA’s first estimate of 2.6%. The increase in consumption of goods is interesting since car sales declined in each month during Q2 and vehicle sales are the largest component of goods purchased. According to the BEA, the Personal Saving Rate is a lot lower than previously estimated. Since the beginning of 2016 the savings rate has fallen and was just 3.5% in July 2017. This suggests that consumers have been maintaining their consumption since early 2016 by saving less.

welsh.monthly.2017.sep.fig.15

It would have been healthier if consumption had been maintained without a drop in savings. Business investment has been MIA for years, so the pick-up in business investment is a positive. It is troubling that the amount of excess capacity in the economy, as measured Capacity Utilization, is so high with the Unemployment Rate so low. This has never happened before and suggests the expected increase in business investment may not be as robust as expected, even if tax incentives are eventually passed by Congress. Companies will want to use up their excess capacity, before committing to a significant increase in spending beyond targeted investments that receive special tax breaks.

welsh.monthly.2017.sep.fig.16

GDP growth is likely to hover around 2.4% in coming quarters unless wage growth strengthens and Congress enacts cuts in taxes for individuals and corporations. If wage growth does pick up, some of the increase is likely to be saved. The best outcome would be wage growth and tax cuts so consumers could save a bit more and spend more. Auto sales have slowed and are not likely to increase much since more cars will come off lease in 2018 than in 2017. This will continue to pressure used car prices. Ride sharing services are lowering the demand for car rentals, so demand for new cars from Hertz, Avis, etc. will be less in coming years.

For the first time since Henry Ford, there is a generation of young Americans who do not look at car ownership as a symbol of independence and status worth the cost. Instead, they view ride sharing as a cost effective way to have access to transportation when needed, without bearing the cost of monthly car payments, insurance, maintenance, and parking. As Baby Boomers ride off into the sunset, they won’t be buying a new car. All of these factors suggest the auto makers will be facing cyclical headwinds in coming years that MSRP discounts won’t fully address.

In July household formation fell to the lowest level since 2009 when the economy was at its lowest point. More 18 to 34 year olds are living with their parents than ever before, which is probably due in part to the amount of student loans. The average age of when men and women are getting married has increased from 26.1 for men and 25.1 for women in 2000, to 29.2 and 27.1 in 2015.

For the first time, women in their 30s are having more children than those in their 20s, according to preliminary 2016 data released by the Centers for Disease Control and Prevention last May.

Home prices have been rising far faster than incomes for years. In July, Housing Affordability fell to the lowest level in 9 years, even though mortgage rates are still historically low. Those looking to leave the nest will need more money for their down payment and mortgage payment. None of these trends suggest that housing activity will add much to GDP growth in coming months.

welsh.monthly.2017.sep.fig.17

Demand for loans from large and midsized companies continues to fall, as it has since the election. My guess is the decline is due more to companies waiting to see what Congress passes, than a negative reflection on the economy. The litmus test will come if Congress does pass tax cuts and investment incentives. If demand for loans doesn’t improve, the decline in lending will be a concerning negative for the economy.

welsh.monthly.2017.sep.fig.18

Despite the incompetence of Congress to get anything accomplished since January, and a record level of political partisanship, a lot of people (43%) still expect a tax cut to arrive in 2018. Hope springs eternal!

welsh.monthly.2017.sep.fig.19

Partisanship Poison

The prior period of high partisanship extended from 1890 into the mid 1920’s. The level of cooperation between the political parties didn’t materially improve until the Great Depression forced both parties to abandon ideology in favor of doing what was best for the country. I suspect that something similar will be necessary to offset the growing level of divisiveness on display every night during the evening news and 24/7 on social media.

welsh.monthly.2017.sep.fig.20

The escalation of extremism (Neo-Nazis and the black hooded members of Antifa) in our country is occurring even though the economy has been growing for years. Granted the pace of growth has been relatively weak, but growth is far better than no growth, or worse a recession. Should growth falter in coming years, social stress could build until it reaches a crescendo. Income inequality, imbalanced wealth distribution between the top 1% and everyone else, and the demographic demands of Social Security and Medicare on government promises have the potential to result in dramatic changes that may or may not be good, but will be disruptive. This challenge is coming, and whenever it appears, most people will be surprised it seemed to come so suddenly.

Eurozone

In early 2017, elections in the Netherlands and France generated a high level of apprehension as they were viewed as a vote of confidence on the future of the European Union. When the anti-EU factions fared poorly in both elections, confidence throughout the EU jumped. This optimism was reinforced in June when French President Macron’s party La République en Marche (the Republic on the Move) and its allies won 350 seats in the 577 member National Assembly, the lower house of Parliament. The overwhelming majority raised hopes that Macron would be able to reduce government spending and pass labor market reforms. Government spending in France is 57% of GDP and rigid labor laws have paralyzed France’s labor market for decades.

welsh.monthly.2017.sep.fig.21

However, as details have emerged of Macron’s unpopular budget cuts and plans to make it easier for French firms to hire and fire workers, his popularity has plunged from 59% in late June to 37% in mid August. When Macron submits his plans to the national Assembly in September, there is a good chance of crippling labor strikes. The odds of meaningful changes in Europe’s second largest economy will sink and dampen the growth prospects for France and the EU.

The Eurozone Economic Surprise Index has been falling since mid May as economic reports fell short of estimates.

welsh.monthly.2017.sep.fig.22

Lending by European banks to Households and Businesses have crested well below the levels of 2007 and 2008. Although economic sentiment has reached the highest level since 2007, companies and consumers are not comfortable enough to borrow for investments or buy consumer goods.

welsh.monthly.2017.sep.fig.23

welsh.monthly.2017.sep.fig.2

One factor that is also inhibiting bank lending is the amount of nonperforming loans in the European banking system. The EU average rate of non-performing loans (NPL) was 5.1% in December 2016, down from 5.7% in December 2015. The level of NPLs of larger European banks was 6.17%, according to the Supervisory Banking Statistics Fourth Quarter 2016. Italy’s NPL’s totaled $276 billion, which represented 25% of total EU NPL’s, and amounted to 15.3% of all Italian bank loans.

In comparison, the World Bank reported NPL ratios of about 1.5% for the United States and Japan at the end of 2016.

As the chart of Eurozone GDP illustrates (shown earlier,above), Italy is the third largest economy in the EU and its GDP is still 3% below where it was in 2011. The hobbled state of Italy’s banking system is one reason why growth has been so weak, and why it won’t materially improve until the amount of NPL’s are significantly reduced.

welsh.monthly.2017.sep.fig.25

Year over year growth in the 19 nation Eurozone bloc rose to 2.1% in the second quarter, which was the best growth rate in 5 years. The ECB initiated its QE program in March 2015. GDP growth has ‘accelerated’ from 1.9% in the first quarter of 2015 to 2.1%, which diminishes Draghi’s assessment of the ECB’s QE program as having been “very successful." GDP growth in the Eurozone is not likely to accelerate much unless bank lending picks up which doesn’t seem likely.

Emerging Markets

As noted in the January 9, 2017 issue of Marco Tides:

“If the Dollar weakens as I expect, the Emerging Market ETF (EEM) could rally to $42.00 - $44.00 during 2017 in a wave C rally."

The Emerging Market ETF (EEM) closed at $35.91 on January 9 and traded above $44.00 in late July.

Last month I cited a number of fundamental reasons why lowering exposure to EEM seemed appropriate:

“The economic outlook is starting to soften based on the EM Economic Surprise Index, and debt levels in EM ex China relative to GDP have increased. This has led the ratings agencies - S&P, Fitch, and Moody’s - to increase the number of their downgrades. Finally, the Dollar’s decline was supportive of the rallies in EM equities and debt, but that may reverse soon since the Dollar Index is approaching major support near 92.00 and 119.00 on the Trade Weighted Dollar Index."

Click for large image.

I am a big fan of using contrary opinion in helping identify lows and highs in various markets. Money flows into EM equities and EM bonds has soared since January, which suggests that EM equities and EM bonds have become a crowded trade.

welsh.monthly.2017.sep.fig.26

welsh.monthly.2017.sep.fig.27

Conversely, the contrary opinion trade for the Dollar is to look for a rally since the short position in Dollar futures is the highest in years, as most traders expect the downtrend in the Dollar to continue. The Trade-Weighted Dollar Index (TWDI) has come down to the green support line connecting prior lows. Last week, the TWDI made a lower price low, but its RSI did not confirm and posted a higher low (green trend line). In April and May of 2016 a positive RSI divergence developed just as the TWDI was making a solid trading low (green trend line). The combination of price support and positive momentum divergence, as measured they the TWDI’s RSI, suggests that a rally in the TWDI is likely.

Since 2011, the Emerging Market ETF (EEM) has attacked the black trend line which is at $44.00. On five separate occasions (red arrows), the rally in EEM has run out of steam just above or below the trend line. The weekly RSI is more overbought now than at any time in at least the last 10 years, and did not confirm the recent new high in price. The rising blue trend line on EEM from the low in December is still intact and comes in near $43.50. Until EEM closes below this trend line, the intermediate trend is still up. The odds seem high that a break of this trend line is coming. Selling into strength makes sense, rather than waiting for EEM to drop 5% and break the trend line.

Click for large image.

welsh.monthly.2017.sep.fig.29

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