Joe Friday….Global Markets Look Vulnerable to these!

by Chris Kimble

CLICK ON CHART TO ENLARGE Three years ago I did a post titled "Look Alikes, Dominoes and Slipper Slides" which highlighted that the key stock markets around the world were all creating bearish rising wedge patterns. (see post here) Check out how much today's patterns look similar to the patterns of three years ago. Results 5 months later....Each of these markets were lower, S&P 500 lost over 15% from high to low. The 4-pack above reflects that popular stock markets around the world have created bearish rising wedge patterns.  This pattern, as with all patterns, aren't correct 100% of the time. Rising wedges are correct two-thirds of the time and wrong one third. Markets have broken above rising wedge resistance before and will do it again. Joe Friday....However, the world looks vulnerable to these rising wedge patterns.

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Europe After Ukraine

by Zaki Laïdi

PARIS – When unexpected crises erupt, people tend to assume that nothing will ever be the same – exactly the conclusion that many Europeans have drawn in the aftermath of Russia’s annexation of Crimea. Are they right? Though European leaders have almost unanimously condemned Russia’s actions in Ukraine, assessments of the security threat that Russia poses vary widely. Poland and the Baltic countries are among those most worried by Russia’s behavior, while the Czech Republic, Slovakia, Hungary, and Bulgaria remain circumspect about adopting a confrontational approach – a stance shared by countries like Spain and Portugal, which do not rely on Russian energy supplies. These divergent attitudes can be explained by the vast differences between European countries’ histories and strategic perspectives. Poland and Russia have invaded and occupied one another’s territory for centuries. Estonia, Latvia, and Lithuania were all Soviet republics, for which opposition to Russia was an essential feature of the rebuilding process. With large Russophone minorities in Estonia and Latvia, Russian President Vladimir Putin’s justification for annexing Crimea – the need to defend supposedly threatened ethnic kin – plays directly to these countries’ deepest-seated anxieties. Of course, the Czechs, Slovaks, and Hungarians – all former Soviet satellites – also have bitter memories of Russia. But their response to their difficult histories has been to adopt a low profile and avoid taking a stand on major international issues. Branded by their proximity (if not vulnerability) to more powerful neighbors, they have internalized their political and strategic marginalization. And, to some degree, these countries’ stance reflects an accurate perception of European politics. After all, Europe’s position toward Russia will ultimately be decided by four major powers: Germany, Russia’s major industrial and energy partner; the United Kingdom, Russia’s banker; France, Russia’s military collaborator; and Poland, Ukraine’s sponsor. Of the four, Germany is by far the most influential. By cutting ties with Germany, Russia would effectively sever all links with the West, thereby accelerating its own decline. Worse, national decline would likely strengthen, rather than weaken, the Putin regime’s predatory, chauvinistic tendencies. The fact is that Russia is not an emerging power. It is a rentier power living off its limited natural-resource assets – with a shrinking population, no less. Former Russian President Dmitri Medvedev seemed to understand this; in an effort to modernize and diversify Russia’s economy, he sought to strengthen the bilateral relationship with Germany. Since Putin returned to the presidency, however, that initiative has been shelved. This is not to say that Putin is entirely oblivious to Germany’s value. He recognizes that threatening an energy-export freeze to strong-arm Germany – which is highly dependent on Russian gas – would cause permanent damage to Russia’s commercial credibility, weakening the industry that forms the backbone of its economy. Moreover, such a move could boost Iran’s appeal in the European energy market, creating unwanted competition for Russia. Even without adding energy exports to its diplomatic arsenal, Russia may take steps to mitigate that risk, by encouraging Iran to delay reaching a final nuclear agreement with the international community. The UK’s position on Russia is more ambiguous. While Prime Minister David Cameron’s government has staunchly opposed Russia’s actions in Ukraine, the City of London is determined to retain the Russian oligarchs as clients. If tensions in Ukraine continue to escalate, Cameron, whose tenure so far has been characterized by weakness and hesitancy, will be forced to assert himself. For its part, France has experienced a distinct reversal in its relationship with Russia. Historically, France viewed Russia as a useful counter-balance to the United States. But, in recent years, France and Russia have repeatedly been on opposite sides of major international issues – such as Libya, Syria, and Iran – while French interests have become increasingly aligned with America’s. Though France will avoid any unnecessary confrontation with Russia, the Ukraine crisis has underscored the demise of the Franco-Russian alliance. Poland’s role in the current crisis is slightly different. It is responsible for defending Ukraine’s interests, while helping to moderate the fervor of nationalist hardliners. Led by these four powers, Europe will face two strategic tests. The first concerns energy. Efforts to reduce Europe’s dependence on Russian supplies have so far failed to yield impressive results, though Europe is in a slightly better position than it was a few years ago. The only way to ensure further progress is to adopt alternative resources and build a unified energy market. Though the Russian threat alone will not be enough to harmonize national energy interests entirely, European leaders should take advantage of the opportunity to move closer to that goal. The second test concerns security. Europe needs a coherent doctrine that goes beyond the current European Security Strategy. Drafted in 2003, after the outbreak of the Iraq War, it includes only weak operational content and does not consider the Russian energy risk seriously. Here, too, crisis breeds opportunity. But the most likely strategic outcome of the Ukrainian crisis is not an end to Europe’s inertia; rather, it is the revitalization of transatlantic ties, with America, having underestimated Europe’s importance, recommitting to NATO. While Europe would be better served by bolstering its own defense capacity, a reinforced transatlantic relationship could offer other benefits. For example, it could help to accelerate negotiations on the Transatlantic Trade and Investment Partnership. It may well turn out that the international order will never be the same in the wake of the Ukraine crisis. The question now is whether Europe’s leaders can ensure that whatever outcome emerges enhances European security. For that, a unified approach must be the first step.

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The Growing Divide Within Developing Economies

by Dani Rodrik

PRINCETON – When researchers at the McKinsey Global Institute (MGI) recently dug into the details of Mexico’s lagging economic performance, they made a remarkable discovery: an unexpectedly large gap in productivity growth between large and small firms. From 1999 to 2009, labor productivity had risen by a respectable 5.8% per year in large firms with 500 or more employees. In small firms with ten or fewer employees, by contrast, labor productivity growth had declined at an annual rate of 6.5%. Moreover, the share of employment in these small firms, already at a high level, had increased from 39% to 42% over this period. In view of the huge gulf separating what the authors called the “two Mexicos,” it is no wonder that the economy performed so poorly overall. As rapidly as the large, modern firms improved, through investments in technology and skills, the economy was dragged down by its unproductive small firms. This may seem like an anomaly, but it is in fact an increasingly common occurrence. Look around the developing world, and you will see a bewildering fissure opening up between economies’ leading and lagging sectors. What is new is not that some firms and industries are substantially closer to the global productivity frontier than others. Productive heterogeneity – or what development economists used to call economic dualism – has always been a central feature of low-income societies. What is new – and distressing – is that developing economies’ low-productivity segments are not shrinking; on the contrary, in many cases, they are expanding. Typically, economic development occurs as workers and farmers move from traditional, low-productivity sectors (such as agriculture and petty services) to modern factory work and services. As this takes place, two things happen. First, the economy’s overall productivity increases, because more of its labor force becomes employed in modern sectors. Second, the productivity gap between the traditional and modern parts of the economy shrinks, and dualism gradually diminishes. Agricultural productivity increases during this process, owing to better farming techniques and a decline in the number of farmers working the land. This was the classic pattern of postwar development in the European periphery – countries like Spain and Portugal. It was also the mechanism that generated the Asian growth “miracles” in South Korea, Taiwan, and eventually China (the most phenomenal example of all) One thing that all of these high-growth episodes had in common was rapid industrialization. Expansion of modern manufacturing drove growth even in countries that relied mostly on the domestic market, as Brazil, Mexico, and Turkey did until the 1980’s. It was structural change that mattered, not international trade per se. Today, the picture is very different. Even in countries that are doing well, industrialization is running out of steam much faster than it did in previous episodes of catch-up growth – a phenomenon that I have called premature deindustrialization. Though young people are still flocking to the cities from the countryside, they end up not in factories but mostly in informal, low-productivity services. Indeed, structural change has become increasingly perverse: from manufacturing to services (prematurely), tradable to non-tradable activities, organized sectors to informality, modern to traditional firms, and medium-size and large firms to small firms. Quantitative studies show that such patterns of structural change are exerting a substantial drag on economic growth in Latin America, Africa, and in many Asian countries. There are two ways to close the gap between leading and lagging parts of the economy. One is to enable small and microenterprises to grow, enter the formal economy, and become more productive, all of which requires removing many barriers. The informal and traditional parts of the economy are typically not well served by government services and infrastructure, for example, and they are cut off from global markets, have little access to finance, and are filled by workers and managers with low skills and education. Even though many governments exert considerable effort to empower their small enterprises, successful cases are rare. Support for small enterprises often serves social-policy goals – sustaining the incomes of the economy’s poorest and most excluded workers – instead of stimulating output and productivity growth. The second strategy is to enlarge opportunities for modern, well-established firms so that they can expand and employ the workers that would otherwise end up in less productive parts of the economy. This may well be the more effective path. Studies show that few successful businesses begin as small, informal firms; they are started, instead, at a fairly large scale, by entrepreneurs who pick up their skills and market knowledge in the more advanced parts of the economy. Enterprise surveys in Africa by John Sutton of the London School of Economics indicate that it is often entrepreneurs with experience in importing activities who found modern domestic firms. Domestic subsidiaries of multinational firms or state-owned enterprises – which are repositories of skilled workers and managers – are also a source of such firms. The challenge is to create an economic environment in which there are incentives for local talent and capital to invest in firms in the modern, tradable parts of the economy. Sometimes, it is enough to remove certain of the more stifling government regulations and restrictions. At other times, governments need more proactive strategies – such as tax incentives, special investment zones, or hyper-competitive currencies – to raise the profitability of such investments. The details of appropriate policies will depend, as usual, on local constraints and opportunities. But every government needs to ask itself whether it is doing enough to support the expansion of capacity in the modern sectors that have the greatest potential to absorb workers from the rest of the economy.

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85% of Pension Funds to Fail in Three Decades

by Mike "Mish" Shedlock

Bridgewater Associates did an analysis of pension funds recently and concluded 85% of them will fail if returns average 4%. Bridgewater notes that public pensions have just $3 trillion in assets to invest to cover future retirement payments of $10 trillion over the next many decades. It would take an investment return of roughly 9% a year to meet those obligations. With the 30-Year long bond yielding a mere 3.5% and with stock valuation through the roof, I expect negative returns for 7-10 years. Stretched out over 30 years, 4% seems about right. 9% is out of the question. CNBC has further analysis in Report: 85% of pensions could fail in 30 years Influential and well-regarded hedge fund Bridgewater Associates Wednesday warns public pensions are likely to achieve 4% returns on their assets, or worse. If Bridgewater is right, that means 85% of public pension funds will be going bankrupt in three decades. Bridgewater came to these conclusions by stress testing the nation's public pension plans, much the way banks need to be evaluated on what could happen given a wide range out outcomes. Many pension observers make the claim pensions will achieve 7% to 8% returns. But even if that assumption is correct, which is unlikely, public pensions are looking at a 20% shortfall, Bridgewater says. A 4% return is much more likely, the firm says. Bridgewater set up a sophisticated model to simulate many of the possible market environments to see how they would affect public pension's resources. In 20% of those scenarios, public pensions run out of money in 20 years. And in 80% of the scenarios, public pensions run out of money within 50 years, Bridgewater says. Massive Number of Municipal Bankruptcies on Horizon I wonder what Bridgewater's model would predict starting with losses for the next seven to ten years, because that is what I think is highly likely. Given the only way to shed  pension obligations is bankruptcy, one hell of a lot of municipal bankruptcies are on the horizon unless some other legal maneuver is found.

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China’s Currency Conundrum

by Ronald McKinnon

PALO ALTO – The People’s Bank of China (PBOC), it seems, cannot win. In late February, the gradual appreciation of the renminbi was interrupted by a 1% depreciation (to $1:¥6.12). Though insignificant in overall trade terms, especially when compared with the volatility of floating exchange-rate regimes, the renminbi’s unexpected weakening sparked a global furor. The uproar was not surprising. After all, China has been under constant pressure from foreign governments to revalue, in the mistaken belief that a stronger currency would reduce China’s large trade surplus. And, since July 2008, when the exchange rate was $1:¥8.28 (and had been held constant for ten years), the PBOC has more or less complied, with appreciations approximating 3% per year through 2012. However, the international outcry obscured an unintended but perhaps more troubling feature of China’s exchange-rate policy: the tendency for sporadic renminbi appreciation (even small movements) to trigger speculative inflows of “hot” money. With short-term interest rates in the United States near zero, and the “natural” interbank interest rate in faster-growing China at near 4%, an expected 3% appreciation, for example, translates into an “effective” interest-rate differential of 7%. This is an enticing spread for currency speculators who borrow in dollars and circumvent China’s capital controls to buy renminbi assets. The hot-money problem is only made worse by the ongoing international pressure for further renminbi revaluation, usually from Western economists and politicians who blame the exchange rate for China’s current-account surplus with the US and other developed economies. In reality, the trade imbalance reflects the difference between China’s large savings surplus and the even bigger US saving deficiency (largely explained by the US fiscal deficit). Indeed, the wholesale price index – the best measure of tradable-goods prices in China – has been falling by about 1.5% annually, which suggests that the renminbi may even be slightly overvalued. Simply put, exchange-rate movements do not properly correct net trade (saving) imbalances between open economies; but they can increase hot money flows. So the PBOC tried to keep speculators off guard by introducing more uncertainty into the exchange-rate system, as occurred with February’s surprise devaluation. In mid-March, the PBOC announced that the daily movement in the renminbi/dollar rate would be increased from ±1% to ±2%, to further dampen hot-money speculators’ enthusiasm. While this is all well and good, speculative inflows would be further dampened if today’s central rate, say, $1:¥6.1, was stabilized into the indefinite future. There is another, less-discussed justification for holding the currency at a stable rate. The adjustment mechanism usually provided by exchange-rate movements could instead be delivered by wage changes. It is only in more sluggish industrial economies, where wages are assumed to be inflexible, that policymakers advocate exchange-rate movements as a means to overcome wage stickiness. However, in rapidly growing emerging markets, wages are often sufficiently flexible on the upside. For example, if an employer (particularly an exporter) fears future renminbi appreciation, he may hesitate to raise wages in line with productivity increases, in order to keep his costs under control. But if he can be confident that the exchange rate will remain stable, he will not need to restrain wages – and China has experienced 10-15% annual wage growth already. With faster wage growth at a stable nominal exchange rate, and by encouraging unit labor costs to converge to those in developed economies, China’s real international competitiveness would be better calibrated. As a result of policymakers’ heavy focus on the exchange rate, China’s State Administration of Foreign Exchange has now accumulated more than $4 trillion in reserves – far exceeding the amount needed to cover any imaginable currency emergency. Worse, the very act of currency intervention can undermine the PBOC’s control of monetary policy. Buying dollars increases the domestic base money supply, risking inflation and asset-price bubbles. Efforts to “sterilize” these purchases and dampen domestic credit expansion also have adverse consequences. The PBOC frequently does this by selling bonds to commercial banks or raising their reserve requirements. But this has reduced these banks’ effectiveness as financial intermediaries, while encouraging the rise of shadow banking to circumvent the restrictions. What, then, are the PBOC’s options? One approach might be simply to let the renminbi float without official intervention or controls on capital inflows. Again, this would inevitably trigger hot-money inflows, with speculators taking advantage of the spread between Chinese interest rates and the near-zero, short-term rates in developed economies, thereby driving up the renminbi further (and creating yet more opportunities for speculation). There would be no well-defined market equilibrium, or upper bound, for the renminbi/dollar exchange rate. Even without hot-money inflows, the renminbi’s exchange rate would face upward pressure, owing to the absence of corresponding outflows to finance the trade (saving) surplus. As an immature international creditor, China is unable to balance the inflows by making renminbi loans abroad. Nor would it want to make dollar-denominated loans. Private banks, insurance companies, pension funds, and so on have limited appetite for building up liquid dollar claims on foreigners when their own liabilities – deposits, insurance claims, and pension obligations – are denominated in renminbi. The potential currency mismatch would require the PBOC (which cares little for exchange-rate risk) to step in as the international financial intermediary and buy liquid dollar assets on a vast scale. Moreover, foreign investors remain reluctant to borrow from Chinese banks in renminbi, or to issue renminbi-denominated bonds in Shanghai. That will remain true as long as they fear continued outside political pressure to appreciate. China is therefore caught in a currency trap, owing to its own saving surplus (and America’s saving deficiency) and near-zero interest rates on dollar assets. Although fully liberalizing China’s domestic financial markets and “internationalizing” the renminbi may be possible one day, that day is far off. For now, if China tries to liberalize its financial markets, hot money will flow the wrong way – into the economy, rather than out. Thus, China must maintain controls on inflows of financial capital for the time being, with the PBOC intervening to stabilize the renminbi/dollar exchange rate. Until conditions in the world economy improve substantially, China’s policymakers will have no easy way out. But, even if they are constrained, the economy can continue to grow.

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European banks still pose global risks

By Darrell Delamaide

Opinion: IMF joins critics urging EU to act to force balance-sheet repairs MarketWatch Nonperforming loans at euro-area banks are a threat to global financial stability. WASHINGTON (MarketWatch) — The ship is scraping bottom as it sails through uncharted waters. What are the chances it will founder? This a picture that could fit European banks, according to the description given this week by top officials at the International Monetary Fund. The stressed condition of many euro area banks, due in large part to lingering and unresolved levels of corporate debt, poses a serious threat to the world financial system, the IMF said in its annual Global Financial Stability Report. “Further efforts need to be made in Europe to strengthen bank balance sheets, through the European comprehensive bank assessment exercise and its follow-up,” said José Viñals, head of the agency’s Monetary and Capital Markets Department. “Also it is very important to tackle the corporate debt overhang.” Read more from the IMF’s report. Other threats to global financial stability, the IMF official said, are posed by the U.S. exit from easy liquidity, an economic slowdown in China, disruption in emerging markets, and in light of recent events in Ukraine, geopolitical risks. But the situation with European banks presents an especially tricky challenge to policy makers. The large and growing amount of non-performing loans is weighing down the banks, the IMF said, limiting their profitability and ability to provide credit. The challenge is to clean up balance sheets across the board without alarming markets. “It is not enough to fix the banks,” Viñals said. “Policy makers also need to finish the job of repairing corporates.” The IMF is not alone in worrying about Europe’s banks. Former U.K. Chancellor of the Exchequer Alistair Darling said at a panel discussion at the IMF spring conference that while the U.S. and U.K. have largely cleaned up their banks, it is “still a work in progress” in Europe. Darling criticized the European Union’s proposed rescue fund for banks as totally inadequate at only 55 billion euros /quotes/zigman/4867933/realtime/sampled EURUSD +0.00%  . “In my experience, 50 [billion] doesn’t even save you one bank.” Because banks remain interconnected, the failure of one could pose a risk to the whole system. “This is a real, real problem,” Darling said. “This may be the last chance to sort it out.” Citigroup’s /quotes/zigman/5065548/delayed/quotes/nls/c C -0.02%  chief economist, Willem Buiter, also warned about the risk posed by the banks in Europe as well as by sovereign debt in the periphery. “Europe is simply too confident,” Buiter said during the same panel discussion. “Risks are being grossly underestimated.” The fact that markets seem to be buying the official hype about European recovery and solvency doesn’t faze this economist. “Markets are in denial,” he said dismissively. They may be powerful, but recent experience has shown they are “not wise,” Buiter said. “Investors are still sniffing the glue provided by Mario Draghi,” Buiter said, referring to the president of the European Central Bank and his pledge to do whatever it takes to preserve the euro. Anecdotal evidence seems to support this critical view. Financial Times reporter Sarah Gordon this week cited the example of the Spanish construction firm FCC /quotes/zigman/249334/realtime ES:FCC -1.70%  , which remains buried under a legacy of debt that is symptomatic of much of European industry in spite of improving business. IMF’s Viñal attached considerable importance to the EU’s impending stress test for banks and an appropriate follow-up to repair their balance sheets. The U.K.’s Darling said that estimates for closing the gaps in bank capital revealed by the stress tests range up to 700 billion euros. As the IMF stability report put it: “Although market sentiment regarding stressed euro-area banks and sovereigns has improved markedly, it may be running ahead of the necessary balance-sheet repair. Thus, European policy makers must push ahead with a rigorous and transparent assessment of the current health of the banking system, followed by a determined cleansing of balance sheets and the removal of banks that are no longer viable.” While European authorities have pledged to make this new stress test tougher than before, it is a tall order, given the timidity of both the European Commission and the ECB in addressing these issues so far.

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