Introducing the 3D challenge – Debt, Demographics and Disruption (with a US case study)

Abstract: As a response to the Financial Crisis of 2008, central banks have been running persistent loose monetary policies (NIRP and aggressive asset purchase programs) in order to generate some growth and inflation. Even though the measures chosen by policymakers mainly came from the burst in the housing market (US and Europe), developed economies have also been cornered with another long-term big issue: the 3D problem – Debt, Demographics and Disruption. Demographics reveal a dramatic aging of the developed world’s population (‘Baby Boom effect’), which has been playing a role in the desire of consumers to save more than actually spend. In addition, the long-term solvency of public and private plans has also been a growing concerns across the developed nations, adding pressure on current workers to increase their amount of savings based on a shift in expectations of higher taxes to sustain the secular change in demographics. The effect of an increase in savings have been one of the main factors of a decrease in inflation expectations across the world in addition to a sluggish growth, forcing policymakers to maintain a loose monetary policy, cutting rates to even negative territory and diversifying the asset purchase programs (corporate bonds, ETF and Real estate). The slowdown of inflation, and even deflation for some countries, is an issue for developed nations as it increases the country’s debt in real terms, putting the country under pressure and questioning its long run sustainability.

We then looked at the US economy for our case study on the 3D problem. Our analysis is composed of three sections: in the first one we quickly review US demographics challenge, then in the second section we present the US Federal and Household debt, and in the third part we introduce Disruption in different sectors of the US economy.

Link ==> 3D Problem

Brazil, on the menu of the next FOMC meetings?

With the VIX index trading 10 points lower at 17.08 and a very rangy USDJPY (trading sideways at around 120), I believe there isn’t any new outstanding topic to talk about, therefore I decided that a little article on Brazil could do it ahead of this new week.

Brazil’s summary on a chart

I would like to start this review by first commenting the chart below, representing the key elements that I usually like to watch. As you can see, the SELIC (Blue/White line), Brazil’s central bank (CBB) target rate, stands now at a 9-year high of 14.25%. Since the end of 2012, CBB policymakers have started a tightening cycle and has been forced to maintain it especially over the past 12 months as the currency – Brazilian Real – is collapsing. The real (yellow line) has depreciated by 56% in one year and now trades at 3.76 against the greenback. Looking at the range over the past 9 years, it reached a low of 1.5360 in July 2011 and a high of 4.2480, which represents a 178% devaluation. This aggressive depreciation of the currency has led to inflationary pressures (CPI YoY – green line – printed at 9.5% in September) and the CDS spread 5 year rose from 126bps to 418bps (with a high of 545bps in the end of September).


(Source: Bloomberg)

Brazil’s dollar-denominated debt…

Clearly, the central bank has been constantly intervening in order to calm investors’ fear of a potential default. Based on a study from the Bank of International Settlement (Working Paper No 483), dollar borrowings in Brazil has reached more than 300 billion dollars (with giant Petrobras holding one third of the shares). Holding a dollar-denominated debt (Loans, debt securities or offshore issuance) means basically that you are short US Dollar. Therefore, if the Brazilian Real keeps depreciating against the US Dollar over the long-term, all these non-financial Brazilian companies will have difficulty in meeting their debt obligations. For instance, the chart below shows the consequence on a Brazilian Company – Petrobras – that holds almost USD100bn of US-denominated debt. Its 5-year CDS spread (White Line) more than doubled over the past 6 months from 390 to 830 bps (with a high of 1025bps in the end of September), the equity price (Yellow line) almost decreased by half of its value and the company’s perpetual 2115 bonds are now trading at 71 cents on the par.


(Source: Bloomberg)

Brazil’s fiscal situation

As we are looking at the country’s financial stability, let’s review how the government is handling its budget. Brazil has an on-balance-sheet debt-to-GDP ratio of roughly 65% (as of July 2015), which has been constantly rising over the past 5 years due to the end of the commodity super-cycle. Based on article from the The Economist, the country’s budget deficit was projected to grow to 9% of GDP in 2015, with interest payments reaching an outstanding 8% (as a share of GDP). Higher short term rates to protect the currency and higher long term rates as investors lose confidence on the country’s sustainability, this situation can only deteriorate in my opinion.


(Source: The Economist)

Its projected 2.3% contraction for this year (Brazil has now printed two quarters of negative growth QoQ, -0.7% in Q1 and -1.9% in Q2) has ‘forced’ rating agencies to downgrade its credit rating to junk status (S&P reduced it to BB+ with negative outlook last September). As you understand, the country has now entered in the so-called ‘negative spiral’, which usually leads to a long recessionary period. Economist are already projecting a zero-growth for the year 2016, and this is assuming the country’s institutions respect their debt obligations.

Political instability: Congress and Rousseff divergence

On the top of the current catastrophic situation for this used-to-be prosperous EM country, Brazil faces a political turmoil. President Dilma Rousseff currently faces many enemies in Congress (i.e. Congress blocking budget proposals) which can only worsen the country’s financial stability . For instance, her plan to reinstate a tax on financial transactions last month (38bps levy, known as CPMF) which could have raised 70bn Reals a year in revenue was eventually withdrawn as Congress would never have approved it. We saw on Wednesday that Congress postponed for a fourth time voting on whether to overrule President Rousseff’s vetoes on extra spending. The bills she vetoed would increase public spending by over 100bn real over the next four years. The central bank recorded a primary fiscal result (government budget balance before interest payments of 0.75% of GDP in August, therefore cannot afford to spend more than.

To conclude, both the political and financial situations are to follow closely over the next few months and we will see if the Fed will look at Brazil as an additional threat for the EM crisis.

Quick update on the ‘Grexit’

Not only last year was a bad year for Greek market, Greece Athex is one of the worst 2014 performers (total return) with a 29% drawdown, but the country has suffered from political instability since the beginning of June. Since Syriza’s triumph in European elections on May 25th, the 10-year bond yield has soared from a low of 5.5% on June 10 to over 10% on ‘Grexit’ fears (the 3-year bond yields trading at 13.6%, up 10% over the past four months). The – Hellenic Republic – 5-year CDS, a good measure of the country’s default risk, is up more than 1000 bps, now trading around 1500bps. There has been some speculation of a possible ‘Grexit’ scenario; and as Der Spiegel news reported lately, German Chancellor Merkel is ‘prepared to let Greece leave the euro zone’ if the country abandons fiscal discipline and does not repay debts to its creditors.

2015: another difficult year for Greece

This year, according to Nomura’s analysts, Greece will face total payments (Principal + Interests) of 22.3bn Euros; €8bn scheduled to be paid to the ECB (mainly in July and August). As you can see it on the chart below published by Eurostat, which shows EuroZone debt and deficit by country, with a debt-to-GDP ratio standing at an all-time-high of 175% (despite the debt ‘haircut’ back in March 2012) and a deficit of 12.7% in 2013, there is no doubt that the country’s debt is unsustainable.

EZfiscal(Source: Eurostat)

There is nothing to stop it growing except haircuts, i.e. ‘partial’ default. Even though Greece’s recession has ended last year after almost six years of misery (the economy is now 30% less than in 2008), financial conditions (unemployment rate at 26% in total and 50% for youth, deflation for the past two years) will weigh on the economy longer than many analysts expect, especially now with the global macro conditions.

How strong is the anti-austerity party in Greece?

To sum up briefly the events of the past few weeks, Greece failed to approve a president (Stavros Dimas) nominated by PM Antonis Samaras as the number of votes didn’t reach 180 after three consecutive rounds (in the last round, 168 Greek lawmakers voted in favor of Dimas, 132 against). Therefore, as the Parliament failed to elect the President, Greek Constitution provides that the Parliament is being dissolved and snap earlier elections.
Greek elections will take place in a couple of weeks (on January 25) and the question is What could it look like?

In the last days of 2014, I remember that a first poll done by Alco for Proto Thema suggested that no party will have a clear majority in the new parliament (as one party will need roughly 35% of the Greek votes in order to gain an absolute majority). At that time, Syriza, a leftist anti-austerity party led by Alexis Tsipras, was ‘leading’ the league with 28% of the votes, followed by liberal-conservative New Democracy (ND) with 23%.

The market’s reaction was quite brutal as I said earlier as many investors fear that Greece may be forced to leave the Euro. The Syriza party wants to abandon the austerity measures imposed by the Troika as part of the €240bn bailout and wants a writedown on the nominal value of Greek Debt. I like the chart below (Source: Bloomberg) that gives you an idea of the government exposures to Greek’s public debt. The main bloc is held by official creditors (Euro-area governments: 62%; followed by the IMF, 10% and the ECB 8%). As you can see it in the chart, Germany is the major government-creditor of Athens and has more than €60bn in total exposure.

GreeceExpo(Source: Bloomberg Brief)

Greece bank shares (Alpha bank, Piraeus) all collapse over the past few weeks as fear of bank solvency and bank runs surged (Cyprus ‘bail-in’ regime continental template?). As a matter of fact, interruption of liquidity by the ECB to Greek banks will potentially lead to a ‘Cyprus type’ bank holiday.

Latest update: An article from the WSJ came up earlier this morning, and says that in nine separate opinion tools that were published in the Greek media in the last couple of days, Syriza is still on top and would garner ‘between 27.1% and 31.2%’ of the votes.

ECB meeting and consequences on the Euro.

As we know, any spike in Euro peripheral (or core) bond yields has usually bad consequences on the single currency. Even though Greece doesn’t represent a major risk for the 19-nation economy, I strongly believe Greece is and will be the ‘hot’ topic of the next couple of weeks (with the Yen as usual). And at the moment, Greece makes ECB policymakers’ life complicated, concerning the central bank’s introduction of its public QE in order to counter deflation now (yes, you read it, deflation of -0.2% in December).

EUR/USD broke its 1.20 psychological support earlier this year and is now trading slightly above 1.1800 (a 9-year low). The next support that traders will target now stands at 1.1640, which corresponds to 2005 low.

I don’t think the market will react aggressively at the next ECB meeting on January 22nd, and even though we don’t hear any update concerning its QE, the Euro is still capped on the topside. I added below a timeline from Morgan Stanley that sums up the Key risk events for the EZ this quarter.

EZrecaps(Source: MS Research)

Below is another chart posted by SG Research that shows the ‘global macro’ euro are agenda for January and the downside/upside risk scenarios. As you can see, it includes the (forgotten) OMT case with the European Court of Justice’s decision on the legality of the ECB program for sovereign bonds.


(Source: SG Research)

The Fed’s 2015 dilemma: Equity market VS Oil prices

Even though the FX market is usually considered as an esoteric asset class, it happens that a lot of opportunities were in currencies last year. I mainly think about the Yen and the Euro, but the chart shows the main currency performances against the Dollar.


(Source: Hard Assets Investors)

We saw a couple of weeks ago that the economy increased at an annual rate of 5 percent according to the third estimates, the highest print since Q3 2003 when GDP rose by an outstanding 6.9.%. In addition, we saw in October that the final numbers for FY2014 federal deficit was $486bn (or 2.8% as a share of GDP), $197bn lower than the $680bn recorded in FY2013 and the lowest deficit since 2008 as you can see it on the chart below.


(Source: CBO)

On the top of that, the unemployment rate stands at a multi-year low of 5.8%, down 2.1% over the past couple of year. The only scary figures is US debt [like any other country], which now stands at a record high of 18tr+ USD, up 70% under Obama (10.6tr USD back in January 2009).

Another Good Year for equities…

I have to admit that with the Fed’s exit at the end of October, I was a bit anxious on the consequences it could have on the equity market, especially after the several ‘swings’ we saw (January, October). In my article Could we survive without QE (Part II with US yields), I added a chart (S&P 500) where you can see the impact on the equities each time the Fed stepped out of the bond market. Clearly not good.

But it didn’t. And after the 2013 thirty-percent rally, the S&P500 increased by another 11 percent in 2014 [and closed at records 53 times].

It looks to me that there are a lot of positive facts and the Fed can eventually start its tightening cycle. However, the collapse in oil prices will weigh on US policymakers’ decision in my opinion.

I think the question now is: which one will weigh more on US policymakers’ decision to tighten (or not)?

I strongly believe that the two main indicators the central bank is watching are the equity market and oil prices. An increasing equity market tends to have a positive effect on consumer spending (through the wealth effect). As a reminder, consumer spending represents 60 to 70 percent of GDP for most of the well-developed economies.

However, falling oil prices, with now Crude Oil WTI Feb15 Futures trading at $51.80 per barrel, is problematic. First of all, problematic for oil exporters’ countries (i.e. Chart of the Day: Oil Breakeven prices). We saw lately that Saudi Arabia announced that it will face a deficit of $38.6bn in FY2015, its first one since 2011 and the largest in its history (no projected oil price was included in the 2015 budget, but some analysts estimated that the Kingdom is projecting a price of $55-$60 per barrel).

I am just back from Kuwait City where I met a few investors there with a friend of mine (Business Developer in the Middle East), and most of them agreed that there were comfortable with a barrel at $60.

To me, falling oil prices reflect the weakening global demand and real economy effects. With the Chinese economy slowing down (GDP growth rate of 7.3% in Q3 is the slowest in five years), major economies back into recession (Triple-dip recession for Italy and Japan) and rising geopolitical instability, forecasts are constantly reviewed lower and problematic for debt stability [and sustainability]. I like the chart below (Source: ZeroHedge) which clearly explains that oil prices and global demand are moving together. In fact, lower growth projections combined with low oil prices and [scary] low yields are problematic for the Fed.


(Source: ZeroHedge)

Moreover, falling oil prices is problematic as it will drive US [and global] inflation lower. The inflation rate is slowing in most of the developed economies: in November, UK inflation fell to a 12-year low of 1% in November, EZ policymakers are still working on how to counter rising deflation threat (prices eased to a 5-year low of 0.3%) and US CPI fell at the steepest rate in almost six years to 1.3%. Most of the countries whose central banks target inflation are below their target.

2015: New Board, new doves…

In addition, as you can see it below, the ‘hawks’ members – Fisher and Plosser – are out this year and this could change the tenor of debate within US central bank’s policy-setting committee.


(Source: Deutsche Bank)

Japan and the Yen, where do we stand now?

On October 31st, Governor Kuroda announced that the BoJ will raise (by a 5-4 majority vote) its bond-buying program. We saw the reaction since then; USDJPY soared from 112+ then to 120 (with a high of 121.86 on December 7). Some analysts think that the move was/is exaggerated, but if you put the figures on table, it looks reasonable to me. By announcing that the Bank of Japan will buy between 8 and 12 trillion JPY of JGBs each month, it means that it will purchase the total 10tr Yen of new bonds issued by the Ministry of Finance; in other words, full monetization. As a reminder, the central bank is the largest single holder of JGBs (with 20%+ of the shares), and could end up owing half of the JP bond market within the next 3 to 4 years.

With the country now in a triple-dip recession (GDP contracted by 1.9% in the third quarter) and the inflation rate slowing down for the fourth consecutive month in November (core CPI, which excludes volatile fresh food but include oil products, rose 2.7% in November, down from 2.9% in September and 3% in October), I see just more ‘power’ coming from Japanese policymakers. Elected in December 2012 as Japan PM (the seventh one in the last decade), I am convinced that Abe (and Kuroda/Aso) cannot fail this time and will (and must) continue to go ‘all-in- on his plan. That will mean aggressive easing, therefore constant depreciation of the currency JPY in the MT/LT. Remember the graph I like to watch: Central Bank’s total assets as a percent of the country’s GDP (see article It is all about CBs).

In fact, as many analysts have stated, the hit from the sales tax increase back in April turned out to be bigger than expected. The second one, which was set for October 2015 and would have seen a 2-percent rise to 10 percent, has already been postponed for early 2017 according to Abe’s announcement last month. When will the country work on its budget balance? As a reminder, Japan has been showing a 8%+ budget deficit over the past six years, which rose the level of its debt to a ‘unsustainable’ 230% as a share of GDP.

Another major problem that the third-largest economy will have to deal with in the long term is its population. The chart below (Source: the Economist) shows the evolution of Japan’s population from 1950 to 2055 (forecast). It is aging, and that is terrible news for all the pension or mutual funds as many people from the Japanese workforce will switch from being net savers to net spenders.

20141213_gdc700(Source: the Economist)

With a population of 127 million in 2013, the number of people is expected to fall below 100 million by the middle of this century due to the low birth of rate (total fertility rate of 1.4 in 2013).

In my article last month on the Japanese Yen History, I added a quick ‘technical’ chart and stated that we may see some take profit a 120 and that the pair should stabilize at around that level based on the downtrend line. And each time I have some discussion about the Yen, I always say there are two ways to play it:
– either keep it short (against USD or GBP) for those who are looking for a medium or long term view;
– or buy the pair (USDJPY) on dips if you try to catch nice trends. Don’t try to short it, unless you are really confident and have been doing it for a while. All traders I know are looking for buying opportunities on the pair.

Speaking of that, it looks to me that the core portfolio I have been carrying over the past few months now – Short EUR (1/2) , JPY (1/2) vs. long USD (2/3) and GBP (1/3) – has been quite profitable, and I still believe there is more room. At least, it makes sense on the idea I had about ‘monetary policy divergence’, with the US and UK considering raising rates (no printing/QE) while EZ and Japan aggressively printing with NIRP/ZIRP monetary policies. I will try to write a piece shortly on the Euro while I am working on my 2015 outlook.