Economic Warning Signals Flashing in Europe
Overliquified?
By blackhedd Posted in Economy — Comments (22) / Email this page » / Leave a comment »
Generally speaking, I have a pretty good eye for stories that contain important clues about the future, and this one caught my eye. Inflation is heating up in Europe, and it's whipsawing monetary policy there.
What's changed in the last few months? Well, for one thing, the world has experienced a major financial crisis.
Read on...
For about half a year, I've been predicting stronger economic growth in Europe, and moderate to slow growth in the US. (Growth elsewhere continues hot as a firecracker, except for Japan and India.)
That can be a hard thing to say, since "everyone knows" that the economies of old Europe are permanently prostrate due to socialism. (Side point: the Europeans have been waking up and smelling the coffee, particularly in regard to the need to scale back social welfare and progressive taxation. It's easy for American policymakers to ignore success stories like Ireland, but the Europeans have to compete against them.)
And European growth has been strong. I'm still expecting between 4 and 5% nominal growth in the Eurozone this year. But now the inflation numerology is getting interesting.
From the article I cited above:
Germany's inflation rate, measured using a harmonized European Union method, rose to 2.7 percent from 2 percent in August, the Federal Statistics Office said this week. That's the most since June 2001...
Back around January, reports were indicating strong money-supply growth with contained inflation in Europe. On cue, the European Central Bank (ECB) has raised benchmark interest rates twice since then, from 3.5% to the current 4%.
I also took a look at monthly M3 rates in Europe. This is the monetary aggregate that the ECB prefers to use as its measure of inflation, and they publish time-series of raw and cooked M3 data. (Our Federal Reserve targets consumer-price measures instead. At least that's what they say.)
Sure enough, European M3 is now at very high levels, the highest in decades, and monthly M3 growth is now higher than it's been since 2000. It's also quite a bit higher than in January.
That means considerable pressure on ECB President Jean-Claude Trichet to ratchet up interest rates still farther. Especially since the inflation pressure is appearing in Germany, which is hyper [sic] sensitive about inflation (get it?).
So why are you getting cognitive dissonance? Because an overheating European economy is just about the opposite of what's happening here.
We've just had a 50-basis point cut in benchmark short interest rates. That has had the expected effect on the foreign-exchange value of the dollar, which is now at all-time lows against the euro, and cyclic lows against the yen.*
(The lower dollar also has the interesting effect of reducing the price of commodities like oil and industrial metals for everyone else in the world. Europe would experience this effect as a disinflationary pressure.)
The dollar weakness, combined with anticipated economic weakness in the US, matters quite a bit for the Europeans, because it makes their exports relatively less attractive. This was already a factor before the financial crisis, as you saw after the election of French President Sarkozy. From his first days in office, he's been loudly saying that he wants Trichet to lower interest rates, not raise them. Keep your eye on Sarko to see if he cools his jets now.
The economies of Europe will probably not be strongly affected by the Subprime Crisis. The ECB moved aggressively, far more aggressively than the Fed, to keep Europe's money markets liquid last month. The US economy is likely to be strongly affected, not by the financial crisis (which the Fed handled well), but by the underlying fundamentals that set the stage for the crisis: impairment of mortgage-backed assets. Consumer behavior in the US may also be weakened by the reduction in housing values, but this remains to be seen.
This has been an extremely interesting summer. Far below the surface-news of crisis and liquidity problems, there has been a lot of tectonic movement. Since the beginning of the year, even as inflation was steadily gathering in Europe, global investors have been systematically pricing risk higher. History suggests that this combination of events will result in significant economic slowdowns around the world as everyone licks his wounds and waits for a better day to put money to work. That may not happen this time, except in the US, and even here the effects may be muted.
So the knife edge that Trichet must walk is this: he must quell inflation, even though doing so will strengthen the euro. Since the euro may already be too strong, he risks increasing the chance of a slowdown next year.
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Update: I decided to add this addendum on the yen, in lieu of a separate story. Japan is now experiencing consumer price deflation, and their heavily export-driven economy now faces significant risk of slowing down. I'd be shocked if the Bank of Japan raises interest rates as they would like to do, given both the economy and the unsettled political situation.
But if you follow the forex value of the yen, you'll see something very interesting. The yen's value on any given day is now inversely correlated with the global demand for risk on that particular day, as people move in and out of carry trades.
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When I am elected President in about 30-40 years, you better be around to be my economic advisor...
:)
Carlos: "What? Were they [Democrats]?"
Seth: "They look like [Democrats]? Is that what they looked like? They were vampires.
"[Democrats] do not explode when sunlight hits them."
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Underlying most arguments against the free market is a lack of belief in freedom itself. - Milton Friedman
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Underlying most arguments against the free market is a lack of belief in freedom itself. - Milton Friedman
What I meant was that the brief burst of economic optimism in Japan over the last 12 or so months seems to be dissipating.
Japan's most recent consumer-price index report came in showing lower prices in most consumer sectors, including food and nondurables, but excluding energy.
Everyone over there (and I mean everyone, from politicians to analysts to talking heads) is talking about inflation heating up, but I think it's a load of baloney.
Blackhedd -- I've been wondering about an issue that you touch on above. You say that the drop in the value of the dollar results in disinflatinary pressures elsewhere (e.g. Europe) to the extent that oil and other commodities are traded in dollar denominated values. This is clearly true, since, for example, Europe would need fewer Euros to purchase the oil which is priced in dollar terms. However, it is only true to the extent that oil prices themselves do not change as a result of the reduction in the value of the dollar.
So my question is, "How much of an effect do you believe the falling dollar has on nominal oil prices?"
Since the drop in interest rates in the US, the dollar has fallen and oil prices have risen, but I've seen no one comment on the connection between them.
It seems to me that because oil is traded primarily in dollar denominated prices, it is predictable that oil prices would rise (all else being equal) as the value of the dollar falls, for two reasons: (1) supply and (2) demand.
Supply -- Non-US oil producers have an incentive to raise prices when the dollar falls, so that the purchasing power of the money they receive from the sale of their oil doesn't go down.
Demand -- Non-US oil consumers are more willing to pay at least somewhat higher prices (all else being equal), since it will still cost them less (in their currency) than prior to the fall in the value of the dollar.
In times like these, when oil prices are relatively high, and when there is neither a huge glut of oil nor horrible shortages, it seems to me that the drop in the fall of the dollar may be (at least partially) to blame for the rise in the price of oil.
If this is true, then it reduces (in part) the deflationary pressures in Europe and increases (even more than otherwise) the inflationary pressures in the US.
I may be all wet, but I'd like those who have more expertise in economics than I do to comment on this theory.
"I wonder what sort of tale we've fallen into."
But I'll take a shot at your questions anyway.
To the best of my knowledge, oil prices are currently running ahead of supply/demand factors. Well ahead of them, in fact, to the point that there is significant price risk in oil assets (in short, they're overbought right now).
Why? What I've heard is that people are discounting the stimulative effect of Fed rate cuts on the economy. Meaning, they're expecting higher demand in the future.
If this is all true, then there is a linkage between rate cuts and higher oil prices, but it still puts the US at a relative disadvantage because we have to pay more for oil in weaker dollars. But for the rest of the world the impact of higher oil prices is muted by the dollar weakness.
Here's the weird thing about OPEC producers raising prices to counter the revenue effects of dollar weakness: many of them operate their currencies on dollar pegs. This includes Saudi, the Emirates, and even (though they would never admit it) Venezuela.
All of these countries are now running raging inflation because they're making too much money. (Just like China, but for different reasons.) And the rate-cut dollar weakness makes this problem far worse for them. Wild, huh? I'd expect Saudi, for instance, to try pumping more oil rather than less.
Now here's something I'm having some trouble with: have you seen the stock prices of Chinese oil companies? They are positively exploding. CNOOC stock has almost doubled from its lows of five weeks ago, and has risen far above its pre-crisis highs. PetroChina has done nearly as well. It's almost as if XOM, which was trading at $80 or so last month, were at $160 instead of its recent $92!
I've heard that these Hong Kong-listed stocks will soon be cross-listed in Shanghai (which means that Chinese nationals will be able to buy then), and this may account for their recent price action. But what a wild ride it's been, just the same.
Your anaysis on financial issues is always inciteful. Given the fact that many Chinese stocks are way overpriced, I think your guess as to why Chinese oil companies have gone up so quickly makes sense.
"I wonder what sort of tale we've fallen into."
His "inciteful" comments have caused riots in the streets, not to mention broker swan dives from skyscrapers...oh wait, the dateline on that story was 1929.
but I suspect that a few may have had to put extra chlorine in the jacuzzis after reading some of the stuff he's been reporting.
just my opinion :>)
I just said they've been going up like a rocket :-). And if they are overpriced, there's no particular reason they can't become more overpriced. If you have insights on their valuation, I'm all ears!
I do think that the recent rise in oil prices and the prices of related assets has been overdone, but that's a near-term technical event. While the oil markets have concentrated on demand in recent days, supply factors still matter a great deal and may come back to the fore.
The Shanghai stock market (which is closed to foreigners) is more like a casino than a stock market. In the past year or so, it's served as a pressure valve for the huge inflation in China. What happens is that, rather than stuff their yuan into their mattresses and see them lose value, ordinary Chinese buy stocks in Shanghai.
There is a smaller stock market in Hong Kong that trades the relatively few shares which China allows foreigners to own, typically well-established larger companies including PTR and CEO. Volatility and the ratio of daily volume to total value in Hong Market are much closer to what you might recognize as "normal" than they are in Shanghai.
Industrial commodities in general have been extremely hot for at least a year, as China's growth sucks them out of every corner of the earth.
because if you tell someone to buy, they better know why they are buying right now and know when and why to sell. However,
"To the best of my knowledge, oil prices are currently running ahead of supply/demand factors. Well ahead of them, in fact, to the point that there is significant price risk in oil assets (in short, they're overbought right now).Molon Labe!"
oil prices "may" be running "ahead of of supply/demand" right now, but only a fool would short oil now. Although the weakening dollar is an issue, inherent demand from BRIC (brazil, russia, india, china) countries, along with Aisra, Latin America, Africa, etc, will continue for some time. It really does not matter if oil prices are "ahead of supply and demand", the key is whether oil prices are likely to rise of fall. If you think oil will hit $60 before $100, you are making a mistake at this juncture. One nice thing about oil is that it trades on supply/demand as well as "event risk". The reality is there will be for some time weather events, terror events, embargo events, war events, and dollar events.
Some of us have made a lot of money investing in oil, Europe, and American exporters to the BRIC countries. I offer no insight, this is what I do for a living. I can't tell you to buy Schlumberger six months ago or to sell Citigroup six months ago. What I can say is I doubt an economic meltdown in the short future based on inflation.
Why would anyone invest in the US domestic economy now? Europe, France is particular, is poised to reduce government pressures on commerce, while the US, is at least 60-40 to increase them. Chinese oil companies are not going to catch hell from their own government, but can you say the same about Halliburton? The Europeans, for all their ills, are planning to reduce taxes, but are we likely to do that anytime soon?
Don't get me wrong, I am signifigantly overweight American stocks, just not companies that make most of their case here. The falling dollar is a boon to US exporters, that is why Sarkozy is so angry. However, you can look at a mulititude of European/UK companies, such as Diageo (ticker DEO) and see they still thrive with a strong currency. There are actually some great companies over there that will make money even with a high priced currency. Then again, with a better than 50-50 chance of left wing socialism here, it is not surprising our domestic stocks suffer.
my main point, the world economic boom is real, and if you short oil/energy, you will be sorry. You may have missed the boat, but that all depends on your time horizon. If oil is less than present price in 5 years, I will eat my hat. Again, I repeat, do not take investment advice from the internet, I make several hundred trades a year, crud happens.
As I've said many times, I don't give investment advice (not for free, anyway, and most certainly not in this forum).
The question in regard to oil prices was whether the dollar weakness induced by the Sept 18 rate cut was putting upward pressure on oil prices, thus muting the disinflationary effect felt by the Europeans.
My answer was that, in my view, people have bid up oil recently because they think the rate cuts will stimulate economic activity in the US and thus increase demand for oil. There's no direct linkage with the forex value of the dollar.
It's no secret to anyone that oil prices are extremely volatile, easily and often swinging 10% or more in just days.
Your points about political risks in the various regions are very well taken. The US is an unattractive place to invest now for cyclical reasons, but I completely agree that the political factors make everything worse for us.
We seem to be among the very few countries (along with Venezuela and Iran) that are turning toward socialism rather than away from it.
look at Europe. Right wingers win in France, Germany, and many others. So called leftists in the UK and Spain are doing little to curtail economic expansion. Your comment on Ireland was well taken, something that has been going on for over a decade with little or no mention in the main stream media.
AS you know, it does not matter if we are "better" than Europe, the prices are stable, what matters is who will change now, and in which direction.
My only quibble was with your oil prediction, I realize why you said it, heck, I am not sure what the price will do in the short term, really no one is that sure other than a sheik who might cut the spigot or a terrorist who might attack a riq in Africa. My point was oil is very volatile and for a trader, there are always "events" that allow a good selling price. Furthermore, I am a contrarian, the more I read about alternative energy, the more oil stock I buy. So far it has worked well, but I prefer oil services and shipping to integrateds.
Molon Labe!
It's been kind of hard to miss their participation in the last two years or so. I think they're the proximate cause of all the hyper-volatility because they pile onto and exaggerate any move in either direction.
There's been some evidence of heavy buying by financial players in the last 10 days, which is why I made my remark about the upside move being overdone. As you correctly pointed out, that's no reason to suppose it can't be even more overdone.
they make this game much harder. As you say, the extremes are made more extreme by the hedge funds. And the last few days we have mutual funds with their end of quarter window dressing. Can you say, hold RIMM and AAPL? he he. but that could change quickly come oct 1
Molon Labe!
propelled by hedge funds trading on a weather analysis trend report that said 2006 MIGHT be an active hurricane year. So prices went up in anticipation of a bad hurricane season that hadn't started yet.
And of course 2006 was a MILD season. That never deters hedge funds- they have no shame!
The Fed's recetn rate cut weakened the dollar further. In fact we're just about in a free fall and no one around here seems to notice as Wall Street rallies. But there's a huge storm looming on our horizon. Sausi Arabia has refused to cut interest rates in concert with the U.S. Fed for the first time ever. I've rade sources suggesting that they are preparing to break the dollar currency peg for oil. If this happens, its the beginning of the end for the dollar and subsequently U.S. economic domination with the world holding our $9 trillion debt.
This is not the "first time ever" that the Saudi's didn't mirror moves by the Fed.
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Underlying most arguments against the free market is a lack of belief in freedom itself. - Milton Friedman
...then I won't try to change your mind. I would, however, like to know what you're investing in these days, so I can consider doing the opposite.
If you're a Paulite as zuiko suggests, then I imagine you're buying gold and commodities. Those have been good calls recently, so congrats on that.
The USA is still the largest consumer. Dollars are floating around the world because we bought goods and gave them dollars. If the dollar falls more, it will only hurt those that took them for their goods. If those countries do not invest those dollars, buy buying American goods and assets, then they just go screwed. The dollar will NEVER collapse as long as our creditors want to keep their money worth something.
Molon Labe!
I would tear my hair out trying to read that data. Nice to have someone I can trust making it clear.