Month: April 2016

Submitted by Ian Armstrong via GlobalRiskInsights.com,

The recent failure of North Korea’s missile tests reaffirms the deficiencies of its ballistic and nuclear programs. Perversely, it also increases the risk of an imminent greater destabilizing behavior.

On April 15th, Pyongyang attempted and failed a test launch of a land-based ballistic missile that, if properly deployed, is capable of hitting a target 2,400 to 3,200 miles away.

One week later, leader Kim Jong Un conducted a second missile test via submarine. While the follow-up was more successful than the first (which exploded within seconds of lift-off), it only traveled for a mere 30 km — shy of the standard 300 km needed for a ballistic missile launch to be considered successful.

Outwardly, these two failures appear to demonstrate that Pyongyang’s ballistic missile and nuclear programs are still relatively unsophisticated and incomplete. These conclusions, however, are superficial. In reality, both launches have revealed the increasing capability and ambition of North Korea’s atomic efforts.

They have also — through their publicly lackluster outcomes — elevated the short-term risk of further sporadic, destabilizing military actions from the Kim regime, with damaging implications for international security and finance.

Hastened progress on DPRK nuclear program

The April 15th and April 23rd missile tests are a clear continuation of the increasingly frequent antagonistic efforts undertaken by North Korea, otherwise known as the Democratic People’s Republic of Korea (DPRK). As a result of various nuclear and missile technology tests conducted by the rogue regime earlier in 2016, Pyongyang’s nuclear capacity has been increasing at an accelerated rate.

Although both tests were, at least from a definitional standpoint, unsuccessful, they serve to compound this accelerated trend of technological progression — and therefore geopolitical instability.

First and foremost, North Korea gains a significant amount of technological know-how from missile tests regardless of the degree to which they succeed. The lessons learned from the April tests, in spite of their failures, will be applied to future missile iterations and ultimately hasten the pace at which the DPRK develops vehicles for delivering nuclear payloads. In short, the rate at which tests occur is a strong indicator for the speed of program development.

Furthermore, while both tests failed by large margins in achieving the full-flight of a non-tactical ballistic missile, to label the second attempt as a complete “failure” is a misnomer. For one, the launch represented clear improvement from North Korea’s previous submarine-launched missile test in December, which failed at ignition.

It also utilized a more energetic and sophisticated fuel source that was not previously recognized as a functioning component North Korea’s missile repertoire. In achieving at least 30 km of missile flight, the DPRK has thus demonstrated a faster than expected growth in WMD-related abilities.

Greater likelihood of provocations

On its own, North Korea’s growing missile capacity has thus far done little to stoke the kind of geopolitical tension that steadily contributes to volatility in financial markets. The one exception appears to be the short-term volatility that follows full-scale North Korean nuclear tests.

Prior to the April missile tests, South Korean intelligence agencies had already concluded that a fifth DPRK nuclear test would occur in 2016, specifically pointing to satellite imagery showing the resumption plutonium production and increased activity at known nuclear test zones.

Unfortunately, the fact that these two particular launches performed below the standards of successful ballistic missile tests increases the chance that another North Korean nuclear test is imminent within next 1-3 months. In May, Kim Jong Un will oversee the 7th Congress of the Workers’ Party of Korea, an extremely rare meeting of North Korea’s highest political body that last occurred in 1980.

Timeline of Previous North Korean Nuclear Tests

At the Congress, it will be in the interest of the Kim regime to underscore his contributions to the progress of North Korea’s military, the core of which is its rogue nuclear program. As such, it is likely that Kim will utilize a powerful nuclear test to erase any notion of failure brought about by the lackluster tests in April.

North Korea’s nuclear tests may not have demonstrated the full-flight capacity that world powers have sought to prevent for decades, but they do impose a greater short-term risk of a nuclear test to compensate. Such a risk entails both heightened geopolitical tensions and brief financial volatility, particularly in the Japanese and South Korean markets, where the threat from North Korea is most acute.

Perhaps acknowledging the greater likelihood of a nuclear trial, North Korea offered world powers a diplomatic solution on Sunday: Cease U.S.-South Korea military exercises, and DPRK nuclear tests will halt. Knowing the hollowness of Pyongyang’s word, both countries declined. If diplomatic history is any indicator, there is little that world powers can or will do to prevent North Korea’s looming nuclear test.

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“Forgive the macros – they know not what they do.”

That is how Morgan Stanley’s Adam Longson begins his note explaining why while risks for oil continue to rise, the “macro rally can persist.” Specifically he says that while “oil continues to rise on the back of macro funds, CTAs, index/ETF flows and investors fearful of missing out” the fundamentals remain bearish and are set to deteriorate further, “esp if prices move higher. Non-fundamental rallies can last for several months and near-term catalysts may be lacking, but a macro unwind could cause severe selling given positioning and the nature of the players in this rally.”

In justifying the relentless “macro” driven buying, Longson writes that “close your eyes and buy seems to be the mantra for now.”

Here a curious question emerges: will the algo buying push oil back to the $60/bbl level we saw last summer. This is his answer.

While fundamentals don’t justify a cyclical recovery in oil yet, the market continues to move higher. The primary driving force has been macro funds, index money and CTAs. Technicals and momentum have only added to it, and there is a sense from some of investors that they need to buy for fear of missing out. Also similar to 2015, we see a confirmation bias where any bullish data point is embraced (e.g. supply outages, weekly US production, etc) and bearish data points are dismissed or spun as a buying opportunity (i.e. the worse is behind us).

 

Non-fundamental rallies can last for several months before the physical market pushes back. In 2015, the rally to $60 WTI lasted for over 2 months.

 

 

Yet, unlike other assets, there is a physical market behind commodities. If prices move too early, there are real world implications, even if those facts are slow to play out. It’s one reason why expectations investing is less effective in commodities. Nothing happens until it happens. Fundamentals are poor and set to deteriorate. The macro/CTA players are mostly generalists and quants expressing a macro view. Yet, the market impact underscores how macro and technical oil trading is at the moment. The problem is that prices are approaching important fundamental levels, and the fundamental trends look worse.

Meanwhile, the fundamentals are set to deteriorate:

Fundamentals are poor and set to deteriorate. The macro/CTA players are mostly generalists and quants expressing a macro view. Yet, the market impact underscores how macro and technical oil trading is at the moment. The problem is that prices are approaching important fundamental levels, and the fundamental trends look worse.

 

A significant number of supply outages are set to resolve in the coming weeks/months.

• OPEC production could rise nearly 1 mmb/d from Mar – June, and Doha’s failure could setup a market share war with many producers now calling for growth.
• Prices above $45 WTI will start to impact the rate of decline in US supply and should attract much more producer hedging. We are also already seeing increased appetite for energy lending after this move – a reversal from Jan, which excited the market.
• Gasoline trends in Asia look quite poor with tankers of product floating off Asia. EM ex. China oil demand has also been underwhelming, which is the key area of growth.

Near-term catalysts may be lacking, but a macro unwind could cause severe selling pressure. The extreme long spec positions from many of these funds could prove problematic. Realization of the MS economics and FX views could setup for an unwind in 2H16 given their sensitivity to macro trends.

Note that as we pointed out over the weekend, net spec positions recently shifted from record short to record long. This may be just the positional unwind catalyst that leads to Longson’s “severe selling pressure.” That and the realization that Mid-east is now skewed bearish.

The Middle East is skewed bearish, in contrast to the optimism surrounding energy in the US and Europe. We spent several days in the Middle East last week with corporate clients and investors. While US investors are increasingly bullish based on US trends, the tone in the Middle East was much more bearish, particularly near term. Several investors stated they would be sellers if oil reached $50. While every region can be biased by local life, we find this sentiment interesting given the importance of the debate around OPEC supply and Middle East demand.

 

Several key ideas and concerns were reiterated:

 

1. A view that OPEC production is likely going higher, not lower. The view was that hoping for OPEC intervention is and has been misguided. Perhaps this investor base is too close to tensions in the region, but most investors expect OPEC and potentially Russian production to rise post-Doha. Conversely, macro funds and CTAs are driving the front higher, and now there are renewed hopes on the tape of another production freeze meeting or positive trends at the OPEC meeting.

 

In our base case, we see OPEC production rising nearly 1 mmb/d by June from Mar-16’s 32.5 mmb/d. Much of the increase is simply a seasonal ramp from Saudi Arabia, Iran’s ramp, and outages resolving. With more aggressive efforts from Saudi Arabia, Iran and Kuwait, production could rise above 34 in short order, which would offset both our estimated global crude demand growth and US declines for 2016. 35.5 mmb/d is possible with Libya, more Iran success and Saudi Arabia at 11.5.

 

2. Opinions on EM demand and GDP were not optimistic. We heard concern about the impact of reform and oil subsidy removal on local GDP and oil demand, inline with our view. We find this particularly interesting from an investor base able to view these changes in real time. We also heard concerns about the sustainability of the EM rally and China stimulus.

 

3. There is a concern that US supply might respond if oil moves higher too quickly. Most investors expressed that oversupply still exists and that shale has permanently changed the dynamic of the oil market.

 

Finally, MS touches on a topic we discussed a month ago when we explained that the collapsing prompt contango is about to shift into backwardation making offshore storage unprofitable. Here is MS:

Brent backwardation reflects regional supply issues, not an improving balance. As of mid-April, the Brent 1-2 time spread became backwardated (a situation where the front month oil futures contract trades at a premium to the second month futures contract). As we’ve long noted, there is a strong link between regional storage and prompt month structure, and such a situation typically indicates physical supply tightness for the contract time frames. The same is true here, as front-month Brent is trading June 2016 delivery, which coincides with higher North Sea field maintenance and seasonally strong refinery demand.

 

We continue to stress this is a temporary regional dynamic, that has occurred many times in the past, not a bullish global signal. Given the very limited streams and production supporting the BFOE market, lost cargoes and incremental buyers can move the market significantly. This was particularly pronounced during 2012/13 when a Korea tax arbitrage drove incremental buying of Forties and periods of sudden steep backwardation. Upcoming North Sea field maintenance also has a history of lifting prompt month Brent spreads, which then typically fade as supply returns. Global outages in the Atlantic Basin have only reinforced the near term impact. However, we’ve already seen the magnitude of backwardation begin to fade heading towards expiry even as flat price rises.

 

Backwardation likely attracted additional inflows from passive investors. Passive commodity investment tends to follow commodities that are in backwardation as they not only provide a venue for profiting from overall price appreciation but also provide positive roll yield. As Brent flipped into backwardation, it likely attracted more inflows from index strategies.

 

Brent’s upcoming roll could be a negative catalyst: backwardation is not present beyond the prompt month. As a result, we would expect that when the backwardation dissipates (i.e., when the June Brent contract expires at month-end and the market is no longer pricing forward outages/maintenance), this  incremental passive investing could slow or exit the market, adding downside pressure to front-month pricing.

 

So does all that matter? Judging by today’s spike in oil, which just pushed above $44, and is now above key resistance levels, the CTA and other “macros” remain firmly in control as fundamentals continue to be completely ignored. For how much longer this can continue is anyone’s guess.

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Everything is going wrong for the GOP establishment. Yesterday, 'the alliance' broke down within hours of being conjured into life, and today the anti-Trump-ers face disaster as a new NBC poll shows Donald Trump has reached 50 percent support from Republicans and Republican-leaners nationally for the first time since the campaign began.

This milestone is significant as the 2016 primary heads into its final few weeks of contests, as there has been intense speculation that Trump's support has a ceiling. Though his support has hovered in the high 40s since mid-March, the front-runner had yet to secure half of Republican voters.

Overall, this week's 6-point swing – Trump up 4 points, Cruz and Kasich down 2 points – is the biggest weekly shift in the poll so far. Combined with his significant win in New York, Trump's rise nationally could be an early sign of consolidation within the Republican Party.

As Goldman notes, after a brief period of uncertainty following the Wisconsin primary earlier this month, the Republican nomination once again looks like it is Mr. Trump’s to lose, while Sec. Clinton appears to have a tight grip on her party’s nomination and could clinch it outright (including “superdelegates” in the total) before the last of the contests in June.

The outcome of the Republican nomination looks unlikely to become clear until the convention.

If Trump fails to win 1237 delegates in the contests through June 7, his remaining option to secure the nomination would be to win the support of unbound delegates before or even during the convention, which starts July 18. Under the hypothetical delegate scenario illustrated above where Trump wins around 1200 of the delegates but falls short of a majority, he would need to work to gain the support of another 37 or more unbound delegates, out of around 150 total. However, a number of these delegates have already announced their support for other candidates (e.g., Sen. Cruz), leaving a smaller pool for Trump to draw from. The April 26 primary results in Pennsylvania could shed some light on this question; Pennsylvania will send 54 unbound delegates to the convention—the largest amount from any single state—and some Pennsylvania delegates have suggested they might feel obliged to support their state’s winner (though others have already announced support for a candidate regardless of the results). We would expect to see additional scrutiny of these delegates’ intentions in coming days.
 

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If there was some confusion why the Atlanta Fed recently revised its GDP Nowcast higher following the recent retail sales miss, that confusion will be even more acute today when moments ago the Atlanta Fed plugged today’s weaker than expected durable goods print (and downward revision to past month’s data), and ended up with… a GDP forecast that was higher than previously, or an increase from 0.3% to 0.4%.

From the Atlanta Fed’s Nowcast:

The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 is 0.4 percent on April 26, up from 0.3 percent on April 19. After last Wednesday’s existing-home sales release from the National Association of Realtors, the forecast for first-quarter real residential investment growth increased from 8.5 percent to 10.8 percent. After this morning’s advance report on durable manufacturing from the U.S. Census Bureau, the forecast for real equipment investment growth declined slightly while the forecast for real inventory investment increased slightly.

 

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Exxon Mobil has been rate AAA by S&P since 1930 according to Bloomberg. Today that ended as the global crude explorer with sales that dwarf the economies of most nations was cut to AA+ (Outlook stable). Having been put on notice in February (negative watch), citing concern that credit measures would remain weak through 2018.

Credit measures will be weak for a AAA rating due, in part, to low commodity prices, high reinvestment requirements and large dividend payments, S&P says.

 

Maintaining production and replacing reserves will eventually require higher spending, S&P says.

 

Greatest business challenge is replacing co.’s ongoing production, S&P says.

XOM stock is sliding and weighing on The Dow (back below 18,000).

As Bloomberg reports,

The oil-market crash that began in late 2014 has choked crude-producing nations like Nigeria and Venezuela of cash, thrown hundreds of thousands of employees out of work, stalled drilling and pipeline investments around the world and even reverberated into ancillary industries such as steel-making and railroads. Exxon was one of the last holdouts against the wave of credit downgrades that engulfed oil drillers with diminishing prospects of paying debts, dividends and rig fees.

 

The downgrade will not only raise Exxon’s cost to borrow money but may also erode its status among oil-rich governments as a premier partner with which to do business.

 

As Exxon Vice President of Investor Relations Jeffrey Woodbury said in February, the company’s AAA rating has been a key selling point when competing for drilling licenses.

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Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Japan has proven that decay can be stretched into decades, but it has yet to prove that gravity can be revoked by central bank monetary games.

Japan's fiscal and monetary extremes are in the news again: this time it's the Bank of Japan's extraordinarily large ownership of Japanese stocks, a policy intended to boost "investor sentiment" and prop up sagging equity valuations:

The Tokyo Whale Is Quietly Buying Up Huge Stakes in Japan Inc.

The core failure of Japan's central bank and state is they have attempted to substitute monetary games for desperately needed social, political and economic reforms. This is the Keynesian ideology and project in a single sentence:

Keynesian policy holds that expansionary monetary and fiscal policy can be substituted for structural social, political and economic reforms, enabling the status quo to retain its power and privileges without disruption.

In effect, Japan has pursued a vast monetization campaign for 26 years. The Bank of Japan creates money out of thin air and uses the free money to buy government bonds, funding the state's enormous fiscal deficits (also known as monetizing government debt). The BoJ has extended this monetization to corporate bonds and the stock market– effectively propping up government debt, corporate debt and the stock market with newly created money.

That these were once private-sector markets has been set aside, as the only thing that matters now is keeping them propped up, regardless of the cost. As I note in my new book Why Our Status Quo Failed and Is Beyond Reform, when emergency measures become permanent policies, you know the status quo is on life support.

Longtime readers know I have a long history of studying Japan, starting with language and cultural studies in university (mid 1970s) and continuing into the 2000s with economic, financial and social analyses. We have many friends in Japan (representing all age groups), and maintain an on-the-ground situational awareness of cultural/social trends.

If you seek a data-based grasp of Japan's fiscal and financial decay, I recommend the following documents: the first is an easy-to-digest series of slides from an OECD study, the next two are detailed official Ministry of Finance reports in English, and the fourth one is an article describing the political resistance of the status quo in Japan to any real, systemic reform:

OECD Revitalizing Japan 2015 (Slideshare)

Japanese Public Finance Fact Sheet

Japan's Fiscal Condition

Japan’s powerful prime minister still can’t get the economy going

The key takeaway here is that decay can last for decades, enabling the status quo of the state and media to maintain the illusion that superficially all is well. As visitors and paid pundits never tire of exclaiming, Japan remains a wealthy nation where everything works wonderfully well–public transport, etc.–and the average lifestyle is enviable: long lives, good health, an abundance of consumer goodies, etc.

But this well-being has been maintained at a high cost. Social cohesion is fraying (beneath the surface, of course), birthrates continue to decline (and what does that say about a culture, that young women no longer want children?) and the signs of economic stagnation are visible to anyone who peeks beneath the hood.

The Keynesian fantasy that Japan has embraced holds that every problem can be solved by printing more money. The Keynesian faithful (a.k.a. the Keynesian Cargo Cult of Paul Krugman et al.) hold that there is no problem that can't be solved by printing more money and issuing more credit.

Not only are some problems immune to printing/borrowing more money, the reliance on printing/borrowing vast sums of money year after year creates a new set of intractable problems. Just to give one example of many: over 80% of Japan's farmers are over 60 years of age and are poised to retire in the next decade. Printing money hasn't printed new young eager farmers, nor has it changed the perverse incentives and political imbalances that are exacerbating the problem.

Decades of borrowing money in a futile attempt to avoid structural reforms has crippled Japan's fiscal future. Even at effectively zero rates of bond yields, Japan now spends roughly a quarter of its government budget on debt service–and servicing of existing debt now consumes 41% of all tax revenues.

Tax revenues only cover 64% of spending; 35.6% of the government's spending is borrowed.

These are staggeringly unsustainable policies, yet the status quo's refusal to accept fundamental structural changes dooms Japan to the TINA Trap: there is no alternative to endless monetary expansion and central-planning control of markets.

Meanwhile, the fiscal realities become more unsustainable every year. While tax revenues increased 14.7% from 51 trillion yen (TY) at the peak of the property and stock bubble in 1989 to 57.6 TY today, social security spending has tripled from 10 TY to 32 TY.

While tax revenues rose a modest 15% in 26 years, total government spending soared from 60 TY to 96.7 TY–an enormous 60% gain.

Even as the BoJ repressed interest rates paid on government bonds to near-zero, national debt service more than doubled, from 11.6 TY to 23.6 TY.

Cutting income taxes–another Keynesian staple–failed to accomplish anything but further weaken the fiscal outlook. The percentage of personal income taxes as a share of all tax revenue has plummeted, to no avail: all the conventional measures of economic vitality have continued their downward trend.

Every status quo and every nation has pursued the same fantasy: that playing monetary games such as quantitative easing and buying stocks and bonds to prop up over-valued markets can be substituted for painful structural reforms in the core fiscal, social and financial sectors.

Japan has proven that decay can be stretched into decades, but it has yet to prove that gravity can be revoked by central bank monetary games.

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