by Chris Kimble
CLICK ON CHART TO ENLARGE
Well the first half of 2013 is behind us and the S&P 500 had a great first half, gaining over 12%. Two of the broadest index's that had a good first half as well, ran into an confluence of Emotipoints dating back several years recently at (1) in the above chart.
For the NYSE, Wilshire 5000 to have a good second half, they need to... hurdle above the key resistance lines a (1)!
by Erik McCurdy
Gold closed sharply lower today, moving down to a new low for the cyclical downtrend from 2011. As expected, the breakdown of the descending triangle formation last week has been followed by a severe decline during the last five sessions.
Follow up:
Click on any chart for larger image. 
In September 2011, our cycle analysis predicted the formation of a long-term top in the gold market. Following the development of a consolidation formation from late 2011 until early 2013, prices moved below congestion support in the 1,550 area. As expected, the breakdown was followed by a severe decline of 23 percent during the last three months. However, the cyclical downtrend is moving lower at an unsustainable rate and it will almost certainly be followed by a violent oversold reaction.
The Gold Miners Index has lost two-thirds of its value during the cyclical bear market and it is also experiencing an unsustainable decline.
Given the historic expansion in the monetary base since 2008, the fundamental foundation for the secular bull market in gold remains intact and we are likely several years away from the terminal phase of the rally.
Cyclical corrections such as this one are healthy developments as they purge speculative excesses from the market, thereby preparing it for the next phase of the advance. Additionally, they provide long-term investors with opportunities to add to their positions. As always, those accumulation opportunities are best identified through the use of optimal entry points as defined by the judicious application of chart analysis and we will report those opportunities as they develop.
by Tyler Durden
Following the Friday plunge in the ISM-advance reading Chicago PMI, it was a night of more global manufacturing data, which started off modestly better than expected with Japanese Tankan data, offset by a continuing decline in Chinese PMIs (which in a good old tradition expanded and contracted at the same time depending on whom one asked). Then off to Europe where we got the final print of the June PMI which continued the trend recent from both the flash and recent historical readings of improvement in the periphery, and deterioration in the core. At the individual level, Italy PMI rose to 49.1, on expectations of 47.8, up from 47.3; while Spain hit 50 for the first time in years, up from 48.1, with both highest since July and April 2011 respectively. In the core French PMI rose to a 16-month high of 48.4 from 48.3, however German PMI continued to disappoint slowing from 48.7, where it was expected to print, to 48.6. To the market all of the above spelled one thing: Risk On... at least until some Fed governor opens their mouth, or some US data comes in better than expected, thus making the taper probability higher.
More PMI by country:
Overall, at the macro level Markit reported that the Final Eurozone Manufacturing PMI at 16-month high of 48.8 in June up from a flash: 48.7, with the PMIs rising in all nations except Germany. How sustainable is this latest bifurcation at a time when the periphery-supporting carry trade is ending will be seen very soon.
The above manufacturing data, together with hope that China's liquidity situation may be normalizing following yet another drop in Chinese SHIBOR reats (it isn't, and once the market realizes that China is effectively undergoing a $1 trillion deleveraging the eye of the hurrican will shift) has set a mood of optimism for the first day of the second half, sending US futures sufficiently high to nearly offset all of Friday's losses.
More on sentiment from Ransquawk:
Stocks in Europe continue to edge back toward their best levels of the session, as market participants react positively to reports that Japonica Partners amended its Greek bond offer and increased total size of offer to EUR 4.0 bn from EUR 2.9 bn, however at a price of 40% of par, compared to 45 cents a month ago.
On today's docket we have Manufacturing ISM which should make for interesting reading in light of last Friday’s
disappointing Chicago PMI print which came in at 51.6 vs the previous
month’s reading of 58.7 and consensus expectations of 55.0. In keeping with the tradition of Baffle with BS, we expect the ISM to come in well above expectations to offset the major Chicago PMI disappointment.
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Goldman has more on the European June PMI data:
Bottom line: The Euro area final manufacturing PMI for June printed at 48.8, 0.1pt higher than the Flash reading (and consensus expectation). The June final manufacturing PMI stands 0.5pt higher relative to the May reading and 2.1pt above the April reading. Among the large Euro area economies, material increases in June were registered in France, Italy and Spain, while a somewhat noticeable (0.8pt) decline was recorded in Germany.
1. The final reading of the June manufacturing PMI for the Euro area was 48.8, one tenth above the flash reading released on June 20. This Final/Flash difference is somewhat consistent with developments since January, where the final manufacturing PMIs have been 0.2pt higher than the Flash print on average.
2. The final Euro area manufacturing PMI was up half a point in June, building on previous gains in May. The index now stands at its highest level since February 2012 and has generally been trending upwards since reaching a trough of around 44 during last summer.
3. The forward-looking orders-to-stocks difference rose further as the increase in the 'new orders' sub-component (0.3pt) was higher than the increase in the 'stock of finished goods' sub-component (0.1pt). New orders rose more materially in May and with the (small) increase in June, Euro area new orders now stand 4pt higher than in April and at the highest level since mid-2011.
4. The figure for Germany was revised down marginally relative to its Flash reading. The German manufacturing PMI came in at 48.6, 0.1pt down relative to its Flash and 0.8pt down on the month. In contrast, the French PMI came in one tenth above the Flash reading, and the index rose 2pt on the month to 48.4 (Chart 1). The German manufacturing PMI decline in June may be related to the flooding, and other German business indicators, such as the flash services PMI and the Ifo, showed robust increases in June.
5. Unlike Germany and France, the Italian and Spanish manufacturing PMIs do not provide a flash reading. Both the Italian and Spanish PMI showed a monthly gain; now for the third consecutive month. The June Italian manufacturing PMI rose from 47.3 to 49.1, notably higher than expected (Cons: 47.8). The Spanish PMI also surprised on the upside in June, improving from 48.1 to 50.0 (Cons: 48.5).
6. Manufacturing PMIs outside the four major Euro area economies rose modestly on the month. The largest increase was registered in Ireland which rose half a point (to 50.3). The manufacturing PMI for Greece and the Netherlands also ticked up (Chart 2).
7. In our macroeconomic forecast, we expect the Euro area recession to continue in the first half of 2013, with a stabilisation of economic activity in the second half of the year and a very modest recovery in area-wide GDP towards year-end. Both our PMI-based indicator and the Euro area CAI improved for a third consecutive month after declines in February/March.
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DB's Jim Reid has the full weekend event recap, and what to look forward to:
The week ends with a payroll report that will have the market on tapering tenderhooks although Independence Day the day before might leave the markets more sparsely populated than usual for such a big release. As we stand, consensus is forecasting a 165k and 175k gain in the headline and private payrolls respectively (vs 175k and 178k previous). The unemployment rate is expected to tick down to 7.5% from 7.6%. A number around this level won't really settle the tapering argument but one notably below or above will certainly lead the arguments fairly aggressively one way or the other. So with time running out until the September FOMC, such prints are going to be huge for markets. Other important data releases include today's ISM manufacturing (consensus 50.5) and all the usual equivalent PMI numbers from around the globe. China has kicked off proceedings this morning with an official manufacturing PMI reading for June of 50.1. Though in line with consensus estimates, the result is the lowest in four months. Meanwhile the final HSBC manufacturing PMI came in at 48.2, slightly below a preliminary reading of 48.3 and 1pt below the final May reading of 49.2.
The reaction from Asian markets this morning to the Chinese data has been relatively muted. Most Asian equities are trading about half a percent lower but this was partly driven by the late sell-off in US equities on Friday which saw the S&P500 (-0.43% on the day) lose 0.6% in the final half hour of trading. The Hang Seng is closed for a public holiday today while the Shanghai Composite (-0.8%) and ASX200 (-1.4%) are both softer. The Nikkei is +0.4% helped by a strong Tankan quarterly survey which continues the recent run of better Japanese data. The large manufacturers’ index improved to 4 versus estimates of 3 and Q1’s reading of -8. The large manufacturers’ outlook component increased to 10 (vs 7 expected and -1 previously). The dollar-yen’s creep back up to 100 (99.4 as we type) is also helping sentiment in Japanese equities.
Aside from the PMIs there was also a fair bit other China-related news over the weekend. Firstly, there were some interesting comments from President Xi over the weekend on growth. The state news agency, Xinhua, quoted President Xi as saying that the performance of government officials shouldn’t be judged solely on their record in boosting GDP growth and more importance should be placed on improving people’s livelihood, social development and environmental quality.
Some commentators have taken this to mean that top officials are legitimising the case for slower growth. As far as bank liquidity is concerned, the Chairman of China’s banking regulator said in a speech over the weekend that banks had about RMB1.5trillion in excess reserves as of June 28th that could be used for payment and settlement needs, or 2x normal requirements.
We should also note the ECB meeting this week which could be interesting even if the general consensus is for no changes in refi/deposit rates. At moment only one economist surveyed by Bloomberg is expecting the ECB to cut the refi rate, and no economists are expecting a cut in the deposit rate to negative territory at this meeting. Nevertheless, Draghi's press conference usually offers up something for the market to pounce upon. Also worth watching out for is chatter about redemptions now we've passed H1 end. This has been scaring a lot of people I've talked to over the last week or so. Will there be a deluge post month/half year end in EM (equities and FI), rates and credit? That's the billion dollar question.
Over the next 24 hours, final Euroarea PMIs (including the first readings for Spain and Italy) and the US ISM manufacturing will be attracting most of the attention. The ISM should make for interesting reading in light of last Friday’s disappointing Chicago PMI print which came in at 51.6 vs the previous month’s reading of 58.7 and consensus expectations of 55.0. Over the course of the rest of the week, there will be plenty of economic data releases as we build up to the Thursday’s ECB meeting and Friday’s all-important payrolls.
Starting with Tuesday, we have US factory orders and the RBA’s board meeting. On Wednesday, the focus will be on the services PMIs for China and the Euroarea. The US non-manufacturing ISM and ADP employment prints will provide the final indications on the trend in employment ahead of Friday. US equity markets shut early on Wednesday ahead of Independence Day on Thursday. On Thursday, we have the ECB meeting/Draghi press conference together with the BoE’s first MPC meeting with Carney at the helm. Friday will be all about payrolls, but we should also highlight that German factory orders and Spanish IP will be released on the day.
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SocGen's macro highlights see, not surprisingly, the ECB's wednesday meeting the the Friday NFP as the key events of the week.
Anything but a quiet start to the week and the second half of the year is pencilled in for today in the wake of Friday's whipsaw price action across different asset classes. A good deal of anxiety has returned to the market after a deceptive bounce in risk assets in the middle of last week, and which has accordingly seen positions adjusted in the light of dovish central bank speak (Fed, ECB, BoE). Gold in particular (and the ZAR as a result in EM FX) continues to bear the brunt of corrective flows and technically the slide may not be over until stability returns around the $1,155 level even as prices are staging a decent $20 bounce overnight.
This week is indeed all about the ECB and US non-farm payrolls, two events separated by the 4th of July holiday in the US, and so there will be a 24-hour stint where liquidity could be poor and thus have a significant bearing on the price action. If the ECB was surprisingly neutral last month, risk/reward suggests a more candidly dovish message this time despite a round of better data. As we pointed out on Friday, the constellation has changed after the spike in periphery yields and council members gave the game away last week by stressing the importance of accommodation in the light of rising US yields to keep control of funding and borrowing rates in the periphery. Fresh policy initiatives are unlikely to be on the table, but press reports that a ‘360-degree review' of the ECB's tools is underway means concrete measures may soon be presented if the periphery sell-off worsens. Ironically, US payrolls data on Friday may be the judge of that. Solid data will nudge the Fed closer to tapering and could bring about another leg of higher yields. The SG forecast of the manufacturing is 51.5, above the consensus of 50.5. Also due today are final EU PMIs, CPI, unemployment and the UK manufacturing PMI.
Ahead of the RBA decision tomorrow, AUD/USD sank to a 33-month low on Friday and, briefly trading below 0.9144, will have pushed bulls deeper into hibernation. Technicians are targeting a 6% move to 0.8550 from here, and could get some help from the central bank if another dovish message is rolled out in the statement. Given the weak data from China lately, there could be another push lower in short-term Australian yields.
by Agrimoney.com
Commentators such as Allendale, Goldman Sachs and RJ O'Brien warned over the potential for US farm officials to cut a forecast for corn sowings, amid questions over the methodology used in compiling the estimate.
The US Department of Agriculture on Friday sent prices of Chicago's best-traded corn futures contract tumbling 5% by revealing that growers had sown 97.4m acres with the grain, a rise of 100,000 acres from initial intentions.
Investors had expected a figure of 95.3m acres, reckoning that a spring which was record wet in some areas had forced farmers to abandon some areas, or at least switch them to later-sown crops such as soybeans.
However, while December corn futures on Monday came under further selling pressure, driving them to a near-18-month low at one point, losses were limited to 0.9% as of 12:30 UK time (06:30 Chicago time) amid doubts over the accuracy of the data.
"Many are looking at the planted acreage number as unbelievable," Paul Georgy at Allendale, the Illinois-based broker, said.
Timing issue?
The report came under criticism for its methodology, in including plantings completed as of, at the latest, June 15 during a sowing season when, thanks to the delayed sowings, many farmers were still in the thick of seeding activity.
"We must remember that the data for Friday's report was taken from a survey of producers in early June at a time when producers still believed they were going to get their crops in the ground," Mr Georgy said.
At Rice Dairy, chief feed grains analyst Jerry Gidel restated "concern about the USDA's timing of this year's survey of acreages not revealing the total impact of 2013's wet spring".
Goldman Sachs also flagged that risk that farmers chose "to abandon corn planting after the USA survey was conducted".
… or would area have been bigger still?
However, another theory for the apparent discrepancy emerged too, supporting the idea of higher sowings - that growers may have understated corn sowing intentions in the USDA's initial survey, in March.
"The reason the corn acreage actually increased from the March Intentions report of 97.3m acres is that actual corn acres would have been over 99m acres if the weather had been supportive," Darrell Holaday at Country Futures said.
"We have talked endlessly about the fact that USDA was not picking up the increased acreage from pasture ground and [released from environmental programmes] that had become crop ground over the last couple of years. They have finally begun to reconcile those numbers."
Goldman Sachs also highlighted the possibility that the "USDA's March forecast had underestimated true planting intentions", with the 97.4m-acre forecast "actually reflecting the acreage cut contemplated by consensus".
Nonetheless, Goldman analyst Damien Courvalin said that the bank expected the sowings data "to be revised, with our bias towards a lower corn acreage", but showing wider plantings of soybeans than the 77.7m acres indicated on Friday.
Chicago broker RJ O'Brien raised its forecast for corn sowings in 2013, but to 96.65m acres, some 750,000 acres short of the USDA estimate
Wheat question
Separately, the USDA data on wheat sowings, showing farmers planted 12.3m acres with spring wheat, some 200,000 acres more than investors expected, also attracted questions given the extent to which waterlogging affected farmers in some northern US areas.
"I didn't see a big push to plant wheat the later it got," Brian Henry at Benson Quinn Commodities said.
At Macquarie, Chris Gadd said that even the 12.3m-acre number, "in conjunction with the loss in spring wheat planting area that was reported in Canada last week breeds further concern for global supplies of quality wheat".
Macquarie has, among other commentators, cautioned that while the world wheat harvest looks like turning out strong on volume this year, ample supplies of high-quality grain are not yet assured.
by Jim Welsh
Forward Markets: Macro Strategy Review
Macro Factors and Their Impact on Monetary Policy,
The Economy and Financial Markets
U.S. Economy
Although corporate earnings were decent in the first quarter, they could be vulnerable if revenue doesn’t pick up in coming quarters. According to Global Equity Analytics & Research Service, sales growth fell for two-thirds of the companies in the Dow Jones U.S. Total Stock Market Index in the first quarter. The index includes every U.S. stock traded in the U.S., excluding bulletin board stocks. As such it includes more companies than any other index. Capital weighted average sales growth for the companies in the index fell for a fifth straight quarter to 3.1%. The last time sales growth was this weak was during 2001-2002, which was not a good time for equities. Average net profit margins fell to 24.3%, their steepest decline in 20 years. Profit margins are falling due to rising inventories and receivables, while selling, general and administration costs have begun to rise after companies had cut them to the bare minimum during the recovery. This suggests any further slowing in sales growth will immediately hit a company’s bottom line. Earnings in the first quarter were aided by a special factor: corporate stock buybacks. Corporations purchased $345 billion of their own company stock, which reduced shares outstanding at an annual rate of 8% through May, and contributed more than 30% to first quarter earnings. Boosting earnings through stock buybacks may look good in the short run (and increase the value of executives’ stock options), but the strategy seems to be lacking in the longer-term vision and commitment most companies need to innovate and prosper in the future.
In April and May, good and bad news alike were treated as good news by investors since the Federal Reserve was likely to maintain the third round of quantitative easing, or QE3. This one-way psychology was reflected in surveys of investor sentiment. We cited the Barron’s Big Money Poll in our April commentary, which found that 74% of responding money managers described themselves as bullish or very bullish for the balance of 2013. This was the highest level of bullishness in the 20-year history of the Big Money Poll. Incredibly, 86% were optimistic for the next 12 months, and 94% thought the next five years would be good. In our April commentary we thought the bullish psychology surrounding QE3 could lead to a blow off in the stock market that might carry the S&P 500 Index to between 1680 and 1700. The high on May 22 was 1687.
The bullish psychology generated by QE3 was also manifested in other markets. Leveraged loans are used by heavily indebted companies to finance growth, acquisitions and capital investments. Banks underwrite the loans, but distribute most of the debt to investors, including high yield bond funds. As demand increased in 2012 from investors looking for higher yielding alternatives to government bonds or certificates of deposit, Wall Street distributed $465 billion in leveraged loans, not much below the all-time record of $535 billion in 2007. According to data provider S&P Capital IQ, Wall Street sold $78 billion in leveraged loans in February 2013, eclipsing the prior record of $71 billion in February 2007. In addition, the quality of the loans deteriorated. The average borrower of leveraged loans carried a debt load of 4.8 times earnings, near the average ratio in 2007, and up from 4.3 last year. More than half of the loans sold in the first quarter didn’t include basic investor protections, compared to a peak of 25% in 2007. Who says history doesn’t repeat itself?
Despite the record supply of leveraged loans of ever-decreasing quality, demand was nearly insatiable. On May 8, the yield on the Barclays U.S. Corporate High Yield Bond Index fell to a record low of 4.97%. With the stock market scaling new heights, stock investors decided it was time to leverage their equity investments. In April, margin debt rose to a record $384 billion, surpassing the prior peak of $381 billion achieved in 2007, according to the Financial Industry Regulatory Authority. Margin debt has only exceeded 2.25% of gross domestic product (GDP) on three occasions: December 1999, March 2007 and January 2013. In 1999 and 2007, the stock market rallied for three to six months before topping, while the high in May this year was four months after margin debt reached 2.25% in January.
Since the beginning of 2013, the debate within the Federal Reserve about the benefits of QE3 and its negative unintended consequences intensified. Members of the Federal Open Market Committee (FOMC) have expressed concerns about its potential to spark inflation, create distortions in the credit market and increase risk-taking by investors reaching for yield. In recent months, a number of FOMC members have publically discussed the activity in the leveraged loan market, real estate investment trusts (REITs) and the overall reach for yield by investors into more risky investments. More evidence of this activity was seen in the issuance of leveraged closed-end fund structures and the increasing appetite of Japanese investors for levered U.S. REIT portfolios. We think the Federal Reserve concluded it was time for the markets to receive a sobriety checkup, which is why Chairman Ben Bernanke discussed the conditions under which the Federal Reserve would begin scaling back the amount of its QE3 purchases in his congressional testimony on May 22. Within minutes of Bernanke’s comments, the stock market reversed from all-time highs and the yield on the 10-year Treasury bond jumped above 2%. Investors were shocked that the free lunch quantitative easing has provided investors since 2009 might actually come to an end some day. When Chairman Bernanke reaffirmed the Fed’s commitment to “tapering” QE3 after the FOMC meeting on June 19, financial markets convulsed, sending stocks plunging and bond yields soaring.
Here’s our take on the situation. Given the current level of economic growth, unemployment rate and inflation, the Federal Reserve will not scale back their QE3 purchases next month. Any action will be dependent on incoming data and whether GDP growth, the unemployment rate and rate of inflation trend toward the Federal Reserve’s forecasts. The Fed expects GDP growth of 3-3.5% in 2014, the unemployment rate to fall from 7.5% to 6.5-6.7% and inflation to rise toward 2%. Our expectation is that QE3 may continue at its current level through 2013 since growth is unlikely to accelerate as forecast, muting the expected improvement in the unemployment rate. And weak global aggregate demand and excess capacity will keep inflation from rising as forecast. The sharp increase in mortgage rates only reinforces our view.
Since the recovery began in June 2009, the number of jobs has increased just 3.9%, versus the 9.7% average for all post-World War II recoveries. This is why 11.8 million people remain unemployed after four years of recovery.
There are two million fewer people working now than in December 2007. The U.S. needs to generate 100,000 new jobs each month just to keep up with population growth and new entrants coming into the labor market. This means another 4.8 million jobs would have been needed over the past 48 months just to accommodate new workers. The true job shortfall in the number of jobs since 2007 isn’t two million jobs, but 6.8 million jobs. Since “real” job growth begins above 100,000 and not zero, actual job growth has been 72,000 per month over the last year, not the 172,000 as reported. This is one reason why the average jobless person remains out of work for 36.9 weeks. Annual growth in hourly pay for production workers and non-supervisors has been below 2% for 21 of the past 22 months. The earnings of the majority of those who are working are not keeping up with the increase in the cost of living. According to the Bureau of Economic Analysis, disposable personal income as of the end of March has climbed a total of 10.5% over the last five years. That is the smallest increase over any five-year period going back to 1959.
The Federal Reserve’s preferred measure of inflation is the core index of personal consumption expenditures (PCE), which excludes food and energy. The Fed would like to see the core PCE near 2%, but not above 2.5%. 
However, since early 2012, the core PCE has been trending lower, falling from just under 2% to 1.1% in May—one of the lowest readings in the index’s 54-year history. Inflation is the result of rising wages and too much money chasing too few goods and services. Neither is happening now and there is nothing on the horizon that suggests a pickup in inflation is right around the corner. Globally, there is an overcapacity of labor and production capacity. Between inflation and deflation, deflation is the greater risk.
China – An Echo Credit Bubble
In the United States between 1982 and 2007, total market credit as a percent of GDP grew from 165% to 350%. This means that for each $1.00 of GDP there was $3.50 of debt. The surge in debt during this 25-year period assisted economic growth and enabled GDP to grow faster than it would have without the extra boost from debt-fueled demand. The prime beneficiary of the increase in debt was home prices, which jumped from 3.2 times median income in 2000 to 4.7 times median income in 2007. The deflation of home values was the primary cause of the 2008 financial crisis, as leveraged bets on home prices blew up. More than 11 million homeowners were forced into foreclosure, as more than 8 million workers lost their job and others, still employed, were undone by ballooning mortgage payments. Investment banks were forced to seek a taxpayer bailout after the use of 30 to 1 leveraged dispelled any misguided notion they were “masters of the universe.” European bankers proved they were no smarter than their U.S. counterparts, and European consumers were just as gullible in their willingness to buy overpriced homes. In response to the financial crisis, the U.S. government and governments throughout Europe significantly increased government spending. The resulting large budget
deficits were used to replace the loss of consumer demand as unemployment soared in every developed nation and to prevent a far deeper recession from developing.
In 2009 China instituted a two-year, $586 billion stimulus program (equal to 16% of GDP). However, the Chinese government has in recent years relied more on forced lending through state-run banks to maintain growth to offset the impact of Europe’s recession and slow U.S. growth. According to McKinsey Global Institute, a global management consulting firm, China’s debt-to-GDP ratio rose to 183% in mid-2012 from 153% in 2008. However, if lending by trust companies and other sources in China’s “shadow banking” system is included, the debt-to-GDP ratio is above 200%, according to estimates by Nomura Holdings, a Japanese financial holding company. Total social financing, China’s broadest measure of credit since it includes bank lending and credit created outside formal banking channels (i.e. trust companies), increased an extraordinary 52% in the first five months of 2013 as compared to 2012. This suggests Nomura’s estimate is likely more accurate.
Compared to the United States’ total market credit ratio of 350%, and many European nations whose ratio of total debt-to-GDP exceed 400%, China appears a paragon of credit prudence. However, under the surface there are a number of cracks in China’s growth foundation that are concerning. According to the International Monetary Fund (IMF), rapid increases in a country’s total credit to GDP ratio can prove problematic. An IMF analysis of quick increases in credit growth over the last 40 years found that about one-third of the occurrences ended in a crisis, and subpar growth in subsequent years in another one-third of instances. China tried to slow credit growth in early 2010 and quarterly GDP growth weakened in 10 consecutive quarters through the third quarter of 2012. Credit growth resumed in April 2012 and continued through the first five months of 2013. Since economic activity lags changes in monetary policy by about six months, the recent surge in credit should continue to stabilize China’s GDP growth between 7 and 8% through the third quarter. The risks are to the downside since electricity output rose 4.1% in May versus 6.2% in April. Electricity output is a proxy for industrial activity and suggests recent GDP data may be overstating China’s actual growth.
In April and May, the People’s Bank of China (PBOC) moved to curb the explosion of credit growth that began in April 2012. In May, total social financing fell by one-third to $194 billion, after also declining in April. New bank lending, which is a subset of total social financing, also registered a significant decline. Despite the pullback in credit growth during the last two months, total social financing is still up 52% from May 2012. If the PBOC maintains its less accommodative stance in coming months, China’s economy will likely show signs of slowing sometime in the fourth quarter.
Since the 2008 financial crisis, the People’s Bank of China has alternated between stepping on the gas in 2009, hitting the brakes in early 2010, putting the pedal to the metal in April 2012 and in the last two months, at least tapping on the brakes. Despite this on and off approach, total debt as a percent of GDP continues to climb at a fairly rapid pace. It is not a good sign that the increase in lending since April 2012 is merely stabilizing growth, rather than generating a gain in the rate of GDP growth. In our view, this is a warning sign that China is progressively creating its own credit bubble. This was certainly the case in the U.S. when credit growth rose significantly during the 2004-2007 period without a commensurate jump in GDP.
In the IMF analysis of prior rapid increases in a country’s total debt-to-GDP ratio, a growth slowdown occurred one-third of the time. China experienced this after they slowed credit growth in 2010. The risk that China could experience a more significant slowing or a credit crisis within the next three years is rising, especially since the imbalance between fixed investment and domestic consumption remains large. As we discussed in our November 2012 commentary, the surge in China’s growth from 2000 until 2008 was the result of a significant increase in fixed investment that expanded China’s infrastructure and export capacity. Cities for millions of inhabitants were built along with the power grid and power generation to keep these new cities humming. The expansion in export capacity allowed China to capitalize on its low cost of production, so it could increase its exports to Europe and the United States. As a result, fixed investment as a share of GDP rose from 34% in 2000 to 49% by the end of 2011, while domestic consumption contracted from 46% to 34%. By comparison, consumption in the U.S. is 70% of GDP, while fixed investment is 16.2%, according to the IMF.
We noted last November that it was likely to take China many years to correct its overreliance on fixed investment, and that the transition would be made more difficult by Europe’s recession and slow growth in the U.S. Europe is China’s biggest export market, with the U.S. a close second. The slowdown in export sales has created an excess capacity problem that is plaguing China’s export dependent sectors, while domestic demand has not increased sufficiently to offset the slowdown in exports. This is why GDP growth has not picked up and why the surge in lending this year is, in part, a reflection of China reverting to its old ways. According to the National Bureau of Statistics of China, fixed investment has only dipped from 49% to 46.1% since the end of 2012, while household consumption only experienced a modest increase from 34% to 35.7%.
According to a survey of 4,000 companies by the ManpowerGroup, a workforce solution provider, the net percentage of firms planning to hire workers in the second quarter fell to 12%,
from 18% in the first quarter. This is the lowest increase since the end of 2009. Year-over-year growth in disposable income for China’s urban households fell from 9.6% in 2012 to 6.7% in the first quarter. Weaker job and income growth suggest a meaningful pickup in domestic consumption is unlikely. Export growth was up only 1% in May from a year ago. We expect Europe to remain in recession for the balance of 2013, while growth in the U.S. holds near 2%. The recent decline in the value of the Japanese yen versus the Chinese yuan is also likely to further pressure China’s export competitiveness. A meaningful increase in exports during the balance of 2013 is not likely, nor is a big increase in domestic demand. This suggests that China will not add appreciably to global aggregate demand in the next two quarters.
In the last few years, the reliance on fixed investment to generate GDP growth has resulted in excess capacity in many industries, which is being exacerbated by slowing export growth and relatively tepid domestic demand. Before the 2008 credit crisis, steel, coal, glass, aluminum, cement and solar panels were all sectors that boomed, since these sectors provided everything needed to build out China’s infrastructure and export capacity. Mae West once said that, “Too much of a good thing can be wonderful.” That certainly is not the case in China as the amount of excess capacity in some industries is staggering. According to the National Bureau of Statistics of China, there are currently 3.7 billion square meters of property under construction in China, which is enough to satisfy demand for almost four years without starting a single new property. Steel production overcapacity is becoming a chronic problem. Domestic demand for steel was 684 million tons in 2012 compared to the production of 800 million tons, according to global investment banking firm Jeffries. Since there is more supply than demand, Chinese steel prices have fallen almost 15% in 2013. In a search for buyers, Chinese producers have been exporting some of their excess production to Europe, which has caused European steel prices to fall. Aluminum Corporation of China reported a $158 million loss in the first quarter and said more than 90% of the aluminum produced in China is produced at a loss. In early May, Huaxin Cement said cement makers need to shut down old plants to avoid “catastrophe” for the industry. According to the China Enterprise Confederation, a non-governmental representative of employers, the utilization rate for cement producers in 2012 was 65%.
Firms with government connections are not likely to close excess capacity since they expect to get ongoing financial support. And this is what may prove to be China’s undoing. Chinese state-run banks have lent enormous sums to Chinese state-run companies who have continued to expand capacity, even if it means selling goods at a loss. Part of the 52% increase in total social financing through May was the result of Chinese state-run banks rolling over or extending
bank loans to state-run companies, even those companies running at 70-80% of capacity and barely profitable. Although China can easily continue this charade, international investors may not be so forgiving. At some point (perhaps 2014 or 2015) China could prove vulnerable to large capital outflows that will undermine its growth story and create liquidity problems for China’s state-run banking system. It could also potentially deflate the credit bubble that has been expanding in China since 2008.
Falling prices as a result of excess capacity are reflected in China’s consumer price index, which has dropped from 6.5% in late 2011 to 2.1% in May. More importantly for Chinese companies, producer prices have declined year-over-year for 15 consecutive months and were -2.9% lower in May than in 2012. If the second largest and fastest growing economy on the planet is experiencing a whiff of deflation, what are the deflationary risks for developed countries with much slower growth and far more debt as a percent of GDP?
Japan — Winning in a Zero-Sum Growth World
As we wrote in our February 2013 commentary, Japan’s effort to depress the yen’s value was not only risky but had the look of desperation after 20 years of monetary and fiscal policies failed to rejuvenate the Japanese economy. Since last November the yen has lost more than 20% of its value versus the dollar and is down more than 25% against the euro. As we pointed out, there isn’t much difference between a country that cheapens its currency by 20-25% and a country that slaps imports from competing countries with tariffs of 20-25%. This is 1930s protectionism masquerading as 21st century monetary experimentation pioneered by the Federal Reserve with quantitative easing. The Bank of Japan (BoJ) has no idea how this will eventually play out. The bank must be encouraged with the initial impact of “Abenomics,” so named after Prime Minister Shinzō Abe. In the first quarter, GDP surged 4.1%, powered by a pickup in domestic consumption and exports, which grew 10.1% in May from last year. Global equity investors have learned from the Federal Reserve and European Central Bank that quantitative easing is good for stocks. From a low below 8,700 last November, the Nikkei 225, a stock market index for the Tokyo Stock Exchange, soared to 15,760 on May 22, before dropping 20% by mid-June. Interestingly, the Nikkei reversed just below a trend line going back to 1996.
Amid all the hoopla surrounding the BoJ’s adoption of quantitative easing, global strategists have overlooked the potential negative fallout from the weaker yen. Global economic growth is not likely to increase materially over the next year. Gains in Japan’s GDP will come at the expense of other countries, which are heavily dependent on exports. Exports represent 56% of South Korea’s GDP, 50% of
Germany’s, 37% of Portugal’s, 31% of China’s, 30% of Spain’s, 29% of Italy’s, 27% of France’s and 14% of the United States’ GDP. Given the concentration of export dependence in the European Union, the 25% increase in the euro versus the yen represents another hurdle for Europe as it deals with its recession. Global investors responded to the adrenaline rush from the BoJ’s move to implement quantitative easing. However, the drag from the yen’s depreciation is likely to take six to nine months to ripple through the global economy. In a zero-sum global growth world, Japan’s gain will come at the expense of other nations.
Eurozone
According to Eurostat, the unemployment rate in the 17-nation eurozone rose to 12.2% in April, the highest since records began in 1995. Car sales fell again in May to the lowest level in 20 years, as reported by the European Automobile Manufacturers’ Association. Bank lending continues to contract so any turnaround is still months away. Contrary to most strategists, we expected the eurozone to remain in recession during 2012, and for the recession to continue at least in the first half of 2013. The good news is that the recession is likely to bottom in the last half of 2013. The bad news is that meaningful growth is unlikely anytime soon. The eurozone may not be the drag it has been on global growth since late 2011, but it isn’t going to add much to global aggregate demand in the second half of 2013. 
Stocks
When the S&P 500 Index reversed on May 22, every major market average had just made a new all-time high, as did the advance/decline line, along with 925 stocks that established a new 52-week high during the week of May 20. Normally, market prices peak after peak momentum, so it is would be unusual for market prices to top out coincidently with such strong upside momentum. Last month we thought the S&P 500 was likely to retest the break out level of 1,600 at a minimum, which it has done. The initial decline was 89 S&P 500 points to 1,598. After rallying to 1,654, an equal decline of 89 points targeted the index at 1,565, which is just below the 2007 peak of 1,575. Since the March 2009 low, the S&P 500 has marched higher to new highs, with each intermediate low higher than the previous low. This is the classic definition of an uptrend. As long as the S&P 500 does not breach the April 18 low of 1,536, the long-term trend remains up.
Markets don’t top because there are too many bulls. Markets top when investors are given a reason to sell and doubts about QE3 provided a reason. If the economy fails to validate the Federal Reserve’s forecasts, as we expect, investors will realize their expectations that QE3 will be ending soon are unfounded. That could provide the story that supports another rally and tests the May peak.
Treasury Bonds
The yield on the 10-year Treasury bond has risen above the peak of 2.4% during March 2012, which is a negative for the long-term trend and lowers the probability that the 10-year yield might challenge the all-time low of 1.39% reached in July 2012. There are a number of trend lines that converge in the area of 2.55% and 2.70%. The initial increase from the July 2012 low of 1.38% was 0.70%, bringing it up to 2.08%. If the current move is a “Fibonacci number”—1.618 times that 0.70% rise—the yield would reach 2.74% (May 3, 2013 low of 1.61% + 1.13%). Technically, the 10-year Treasury bond is approaching an area that could provide intermediate support. If the economy fails to validate the Federal Reserve’s forecasts, as we expect, Treasury bonds could enjoy a nice rally in coming months, especially since bearish sentiment is reaching an extreme.
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