European Bailout: The facts Financial Markets are ignoring

Financial market professionals and the media are placing high bets that Germany will effectively assist financing the bond program in Europe. The program as most are aware of, is designed to assist nations in desperate need of assistance – Spain and Italy – to stay afloat for another couple of months.

One should look far deeper than the surface before starting to believe that Germany will be able to participate in the program without facing some serious criticism by its own citizens and opposition parties.

There are some facts being ignored; among the most important is the fact that in order to have a REAL PLAN implemented by the ECB; what the media doesn’t talk about or focus on is the very Harsh reality behind European Central Bank Rules.

In order to use the Financial Stability Facility there has to be a UNANIMOUS agreement between all participants.  There is one country opposing the plan without showing any signs or intentions to change its position: Finland!

As long as one participant disagrees, the ECB hasn’t got the ability to explore the facilities.

Another important aspect hardly mentioned is the fact that the ECB must respect a limit on amounts they can lend to Europeans Banks, therefore drawing a limit for funds available to European Central Banks.  If that is not an  important detail to be mentioned in terms of the entire bailout Feasibility, I don’t really know what is.

Mario Dragui – an Italian formal Italian Central Bank president - is doing his ultimate best to get funds to Italian Central Bank.  He states often that the ECB must take a Aggressive Action in terms of supporting the European Union and the Euro. Easy said, difficult done.

I have mentioned in a previous article that Germans – and the Dutch + Finnish Citizens – are very unhappy about seeing their money being use to pay somebody else’s debts.  Angela Merkel may be willing to change her views, but it doesn’t imply that it will get broad support. Elections will take place next year in Germany and she may be using an alternative strategy to gain votes but the response from the public has been far from positive.

A couple of weeks ago, The Germans & The Dutch voted against granting a Banking License to the ESM ( Bailout Bank). ECB president Mario Dragui was beyond upset and literally pointing fingers to Dutch and Germans alike stating that they were old fashioned and narrow minded.

 I guess it isn’t necessary to mention that Finland has opposed the License granting, but I am just making sure everyone knows.  To add more fire to this entire situation, Olli Rehn, EU Commission Vice President , has openly stated that as Finland will oppose any plans regarding Spain and Italy.  

Mr. Mario Monti, Italian prime minister was campaigning for support from Germany, The Netherlands and Finland early in August.  The results were far from expected. He was met with skepticism and criticism instead of support. There are sound reasons for the skepticism. Italian economic results are worsening by the day and show very little sign of improvement and efforts.

Mr. Monti’s reaction was one of retaliation: He stated that if the European Union and ECB don’t come to assist Italy, they can count on a NON-EU oriented, NON- EURO and NON Fiscal discipline oriented Italian Government.

Being very sincere, I don’t think that Germans, Dutch or Finns were surprised. Actually, for them, is just Business as Usual at this point. Put it very simply they don’t seem to be to concerned at this point. It is very bad as it is and even if they would do their best to Worsen the situation, the Italians would not do much worse.

Any changes in opinion from Germans, Dutch and Finns would come as huge surprise and complete unexpected. Fact of the matter is they are tired to pay for others mistakes. Wouldn’t anybody be quite frankly? They tighten belts, put pressure into businesses and citizens to try to get their home economies at better shapes and are dealt blows from neighbor’s sharing a complete different strategy. As I mentioned before, differences in mentality and behavior between European nations are huge. These are gaps difficult to fill and they tend to become more accentuated when things go wrong.

Financial markets are hoping that Germany Finland and the Netherlands will change their mind and will support the Bond Program and any additional Fiscal Bailouts. I doubt, but as I always say, nothing is impossible.

European Economic Figures:

The figures released earlier this month showed that Italian debt has expanded reaching almost 2 EUR Trillion. Italy's total government debt outstanding rose by + 6.637 billion EUR during the month of June and the debt outstanding increased by 21.7 Billion Euros. The situation has been accelerating since April.

To put things into perspective government Debt is 125% the size of GDP. If that doesn't come as Bad News, I don't really know what is...

Industrial Output does look any better:

and last but not least

The figures are dismal and provide little comfort for those willing to SUPPORT Italy’s spending.  If we translate that into layman terms, it is fair to say that Germans, the Dutch and Finn’s must work “Very Hard” to pay Italy’s bill? Is that fair? I don’t think that they agree and it is showing.

Germans are well aware that their support elsewhere is having a direct impact on their domestic economy. Below an extract of the latest press release from the Zew Report:

-          The erosion in business confidence comes on the heels of the

seventh consecutive fall in Germany's composite PMI to its lowest level

(47.0) in over three years.

     "August PMI data highlights the weakest German private sector

performance for over three years, with a return to falling services

activity offsetting an easing in the manufacturing downturn," said

Markit Economics senior economist Tim Moore.

     "Overall, the latest survey indicates that the German economy is

sailing into greater headwinds as the third quarter progresses, with PMI

readings slipping deeper into territory normally associated with GDP

contractions," he added.

     The Bundesbank warned last week that the risks to Germany's

economic outlook have "increased notably" for the second half of 2012,

given the recent escalation of the Eurozone sovereign debt crisis.

There is deterioration on the 5 and 10 year Bond Yield Spread express clearly what the expectations are for the near future. 

Here is the Graph from the 10 year Bund:

GERMAN INDUSTRIAL OUTPUT 2004 to 2012

GERMAN Debt to GDP

How Markets interpret data stays completely detached from the current situation. Markets are discounting mechanisms. While situation in Europe has not improved - actually it has worsened if one reads economic data across Europe, the Euro has reached 8 week highs yesterday. 

Certainly for the public, it is difficult to follow this mechanic. It leaves people rather confused and  asking themselves what defines the value of investment instruments. In short, what the latest appreciation of the Euro represents is nothing but the perception of market participants that the European Central Bank will intervene and find solutions for the current situation.

The speculation is based upon the promises made by the ECB president as well as the overall perception that the Europeans HAVE TO DO something about it. Now, the HAVE TO is just a perception; by law they are not obliged to intervene. In fact, they don't have to do a single thing. 

Market valuations today express the view that member countries will support the members with problems and the situation will improve in the future. That is far from clear, however being as it may, the market has a BID tone and the Euro is appreciating against other currencies. Helping the cause is the fact that the Federal Reserve should engage again on further monetary easing, therefore depreciating the dollar and automatically appreciating the euro.

Making it far more clear, the Euro is a single instrument created to facilitated trade and somehow set standards for those willing to participate. If the regulations would really apply, many countries would have already been  sanctioned or expelled from the Euro Economic zone due to their economic results. 

The Debt as ratio to GDP, Budget deficits, low inflation and interest rates have all been breached by several member countries. So far, there have been no sanctions. Exceptions are being made and most likely the ECB will continue to do so for the foreseeable future. 

The euro was established by the provisions in the 1992 Maastricht Treaty. To participate in the currency, member states are meant to meet strict criteria, such as a budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP (both of which were ultimately widely flouted after introduction), low inflation, and interest rates close to the EU average. In the Maastricht Treaty, the United Kingdom and Denmark were granted exemptions per their request from moving to the stage of monetary union which would result in the introduction of the euro.

The situation has not improved; The European economy is not expanding and the countries aren't facing brighter futures. All that is at this point are promises - in my opinion difficult to be fulfilled - and hopes that things will turn around elsewhere. If that Elsewhere would be China, I think everyone should reevaluate their priorities, simply because things are far from Rosy in China. 

But, living in a world of hopes and promises, principally when we approach elections, reality has been placed second for the time being and will remain so until further notice.

The Chinese Economy and The rest of the World

With the global economic situation getting more complex and tense as time goes by, the focus of financial authorities – Namely the Federal Reserve and European central Bank - is China. In many ways they monitor close developments in China in search of signs of improvements.  China these days is almost synonymous to growth, stimulus and hope. All eyes turn to China when the topic of discussion is Global Economic Recovery.

Unfortunately, for both – ECB & Federal Reserve-  and leading policy makers elsewhere, the situation in China is not improving. On the contrary, if one takes a deeper look into the Chinese figures released, there are more reasons for concern than relief.

The People’s Bank of China (PBOC) is trying to do damage control by cutting official short term rates. They are cutting aggressively, but the problem is that INFLATION is falling faster than rate cuts, which means that in essence the real Deposit Rate is Not falling But Raising.

During the month of June, Chinese consumer Price index Deflated and declined for the 3^rd time in the last 4. The pace of the decline is accelerating; CPI has dropped from 0.3% in May to 0.6% in June, a sharp decline indeed. 

Consumer Price Index figures:

Contraction: June +2.2%  from May +3.0%. 80 basis points decrease on a monthly basis and the result represents a drop of - 430 basis points from the July 2011 CPI of +6.5%

The central Bank has cut rates by 50 basis points this year, but CPI has dropped 230 basis point since January – the same period – and that is not all. The 430 basis points drop in CPI July leaves nor room for discussion. The CPI inflation during June was 80 Basis points; So June alone surpasses the Interest rate cuts.

The contraction is broad based. It is affecting every single sector of the Chinese Economy.

CPI Consumer Goods:  June +2.3% down 130 basis points from May 3.6%:

CPI Food: +3.8% down 260 basis points from May +6.4%;

CPI Household Items: +1.9% therefore unchanged from May +1.9%;

CPI Transportation-communication: -0.4% deeper into negative territory from May 0.1%

The PPI inflation registered a drop of -2.1% in June down from -1.4% in May and deepening into negative since the last positive result in January ( +0.7%). The real concern here is the size fo the contraction since July 2011: 940 Basis Points! July 2011 result was +7.5%. In August

The macroeconomic dynamic is deteriorating. The balance of trade in China is showing surpluses due to the rapid decline in Import figures. The trade surplus in June was US$31.1 Billion one of the largest in the history of china. This simply means that the contraction on exports has been massive since January. The recent result is one the largest in Chinese history; Actually, it is the largest one into “NORMAL” economic conditions and only inferior to other historical results when compared to the figures from the period October 2008 to January 2009. Imports have declined by US$ 13.6 Billion in June.

The year-year rate-of-change in Chinese Imports fell to +6.3% in June, registering a substantial contraction from May when it reached +12.7% yr-yr. The result fell far below this year's seasonal high registered in February: +39.6%

Industrial Production in China increased 9.5 percent in June of 2012. Historically, from 1990 until 2012, China Industrial Production averaged 13.4200 Percent reaching an all time high of 29.4000 Percent in August of 1994 and a record low of -21.1000 Percent in January of 1990. Industrial production measures changes in output for the industrial sector of the economy which includes manufacturing, mining, and utilities. Industrial Production is an important indicator for economic forecasting and is often used to measure inflation pressures as high levels of industrial production can lead to sudden changes in prices

One particular figure is Very significant in regards to the current state of affairs in China: The Crude Oil import figures. China's crude imports in June sagged to 5.29 million bpd, the lowest daily rate this year and 12 percent lower than the record 6.0 million bpd in May, reinforcing concerns about slowing demand for oil.The monthly decline in the volume of Chinese Imports of Crude Oil dropped by 3.76 million tons.

The decline in commodity imports was broad, as noted below (monthly changes):

 Steel Imports: down (-) 16.7% 

 Copper Imports: down (-) 17.5% 

 Copper Scrap Imports: . down (-) 11.9% 

 Iron Ore Imports: down (-) 8.7% 

 Refined Oil Product Imports: down (-) 15.6%

The only exceptions in the Commodity sector are grains:Soybean was the real exception. Demand for Soybean and Soy Meal has expanded dramatically.

The demand for Corn also remained solid, in spite of an overall drop, in percentage terms.   The demand for commodities still exist, however, the pace has slowed quite significantly.

To put it mildly, this shift should make entrepreneurs in Brazil concerned and serve as warning for possible changes in the near future. If the contraction in Chinese demand won’t be considered a reason for concern, I don’t really know what will!  

It is not a secret that we rely heavily on China as customer. The largest two economies in the world today are Europe (Eurozone) and China.  China is by far “Our Best Customer”;and now it has some serious problems.Therefore, we have problems.

Surprisingly, Brazilian Government officials and Entrepreneurs alike seemed confident that situation would be only temporary until recently. when asked about the current situation, It is a bit surprising, given the role China plays in the world economy. Either they know something we don't or they have found a very good replacement ready to step up and replace China as customer when the Chinese are not performing as expected. 

 I just wonder who that replacement might be and from which PLANET it is coming from? As far as I am concerned, in the planet we live, there isn’t a single CLIENT with the power and stature of China. The only potential replacement for China at this stage would be India; But India has to travel a long way before reaching the level of China .

Moving to the Financial markets, the 5 year swap rates have dropped dramatically.

Rates in june were 2.57 down from 3.50 in March. The rates dropped below the previous low of December 2011. The 5 year rate has dropped below the 1 year Deposit Rate. 

However, with all being considered, the rate has dropped slower than CPI. Therefore, the Shanghai overnight borrowing rate has INCREASED.  Along with the drop in rates, so does the Strength of the Chinese Currency against the US dollar. For the first time, the Chinese currency is really experiencing pressure – real pressure – from the open market and not from PBOC intervention.

The pressure is also spreading towards the Equities index in China. Chinese stocks have under-performed the SP500 and several European Indexes. It is a fact that most of so called Emerging markets have had terrible performance this year. Chinese stocks are performing poorly; how they will perform on the near future leaves room to large speculation. The exceptions amongst the emerging markets have been Thailand, Philippines, Indonesia and Singaporean markets. All relatively small exchanges, also called a satellite or peripheral markets.

This pressure means that performance from Chinese companies have been below expectations and means that for the time being, we should not expect any significant recoveries on the short term. Many would argue that the current low levels are so attractive that investors would be losing another Rare or ONCE IN A LIFETIME opportunity to invest in Emerging Countries/ stocks. There are certainly very interesting companies providing good opportunities at current levels. However, one must look into it, case by case, and not simply buy because it is relatively cheap! What is cheap or a bargain in financial markets becomes very relative.

Stock markets, such as any other speculative markets are DYNAMIC. They change constantly. Valuations should be made in relation to other possible opportunities within (not Only)Equities Markets, but also other asset classes. That is true for Chinese, Brazilian, European or American Stocks.

The PBOC is moving slowly and acting according to its own agenda and sentiment. It is taking actions at a pace that satisfies their own views of what is acceptable and what is not. The fact that other nations are RELYING on China for their own recovery IS NOT a priority to the Chinese. Their main concern is China.

Certainly, pressure is being exerted by International leaders (heads of states) principally with  elections approaching in the USA and Germany, in efforts to see the Chinese DO SOMETHING and try to change the current climate of uncertainty. In my opinion, they are wasting their time. As much as they try, we can rest assured that what concerns the Chinese, these are empty attempts and will do little to influence decision makers.

How this will play out for Brazilian Companies?

If all stays the same, Brazilian companies relying heavily upon China will face some difficult times in the short term future. China will not stop to acquire raw materials; however, they will change the pace and operate at slower fashion. 

They will be more cautious in terms of future commitments. There is little doubt that the Chinese will continue to acquire large quantities of commodities and raw materials they are not able to produce. They will hold the the position of Key Customers for commodity exporting nations for the foreseeable future. However, how much, how, who and when, is now a matter of speculation.  They will build alliances - strategic alliances - that will serve mutual interests.

Will they meet the targets and expectations set by corporations worldwide in terms of volumes of sales? Nobody knows. Real figures could differ wildly from the projections, leading to disappointing results for companies relying on Chinese counterparts as key revenue driver.