When you believe something, facts become inconvenient obstacles

Short BRL - charts only

As we approach Brazilian Presidential elections, it is probably an opportune time to illustrate the case for going short the BRL - timing wise, initiating a small position now could make sense (EURUSD 2.90 as of today), but the big move should happen after Brazilians goes to the polls. Whoever win, the BRL should start a sharp decent to last decade lows against major currencies as the Brazilian economy craters.

After 3 terms, the BR socialist party is leaving the economic landscape in total disarray – The socialist government essentially ran the country during 12 years as would do a sub-Saharan dictator.

 Brazil economy now presents most of the basic elements for a fully blown financial crisis:

- historical high current account deficit (one of the world largest vs GDP)

- historical high private sector external debt in foreign currencies

- high private sector debt level

- high inflation levels + high inflation expectation levels

- short term rate (SELIC) management broken as a tool for monetary/fiscal policy – Less and less effect of the SELIC rate (short term rate) on inflation level as the BNDES is lending money at subsidized rates (5.5%). BNDES is now the largest loan originator in Brazil.

 - the daily manipulation of USDBRL to maintain the currency (via swap) in a tight band before election (in order for the inflation not to run up further before the poll) – is reducing external reserves: the swaps are exhausting foreign fx reserves on a net basis as the central bank is taking huge hit on its short USD exposure created with the fx swaps

- historical low industrial production level and deteriorating

- historical low private sector confidence

A currency devaluation would increase competitiveness + in parallel leveraging up the government debt (which would put additional pressure on the FX)  to invest in huge projects would help fight inflation on a structural basis and provide jobs while the economy digest the short term hangover of the devaluation. Brazil gov probably will need to invest at least 10% of GDP as a one time fiscal stimulus (approx USD 250bn at current rates)-

I expect a 40-60% devaluation for the BRL over the next 24 months. It could unravel much quicker as net currency exposures of the Brazilian sector could trigger a snow ball effect.

I copy/paste below few charts that illustrate the case - charts Sources: GS, TradeEconomics, BNDES BSI

Output Gap, Nominal Rates, Inflation Expectations after banking crisis : 10 years to normalize...on average

An interesting research produced by GS that analyzed the data of banking crisis in 19 countries back to 1800's.  Most macro indicators on average normalized after 8-10 years  - but if we takes an average of output gap estimates in the US (currently around 4%), we have then more of 3 SD scenario and 10 year yields then could take this time 15 years to normalize! Short bonds anyone ?...;)

Small in the news but BIG in potential impact

France and Italy to propose changes to the Stability Pact. 

The French and Italian government plan to present changes to the Stability Pact, which defines fiscal rules for Euro area countries, at the upcoming EU summit end of next week. The proposal foresees that government investment to support growth and employment should not be counted anymore for the budget deficit. In return, countries need to make binding promises for structural reforms. While the SPD parts of the German government seem to be in favour of such a change, Chancellor Merkel and finance minister Schäuble are unlikely to approve this proposal. Deputy finance minister Kampeter (CDU), for example, said that the current rules already provided a sufficient degree of flexibility.

This is a very very welcomed and surprising proposal from France and Italy. This is a critical step to reduce Europe s grip on members monetary/fiscal sovereignty which will ultimately allow for more budget deficit needed to kickstart economic growth (pls see article of 2012 for detailed explanations). Someone need to spend!

What the ECB should do tomorrow - Key data to follow to trade EU assets

Tomorrow Draghi will speak at the monthly ECB press conference. He promised that he shall use all possible tools to try to defeat deflation in the Eurozone. While there is rumors of negative interest rate and sovereign bonds buying we think that the silver bullet should be something much larger.
Indeed, deflation forces are increasing across the board in the Eurozone :

 

Lending is anemic at best in the core of Eurozone while negative in the periphery :

To my view, the obvious first medication in the current structural and very large problem is:

Very large quantitative easing with large monthly buying of at least EUR 50bn/month of PRIVATE SECTORS LOANS = corporates loans and asset backed loans. It will restore some velocity in private sector loans, reduce banks balance sheet and reduce yield for loans in the periphery and finally initiate some inflation despite the lack of spending (both on the private sector and government side). While this might appears  a"big move" philosophically for the ECB, it will be a small move relative to the deflation/lack of spending in the Eurozone - this is the least the ECB could..

If nothing is done on that front tomorrow, EU markets might not like it and Drgahi might loose some credibility, so it is expected at least some indication of something.
Inflation in the Eurozone is becoming quickly the key risk datapoint to watch for the second part of the year as it will - at one point - be the trigger for QE. It is only a question of time.

Obviously, if tomorrow Draghi offer us a large QE (set up ideally to last until inflation reach a certain level) it will be extremely bullish for equity markets globally.

May 26th : raising the probability of a "political bank run"

May 26th European elections saw a strong rise of radical/populist/anti EU parties across the Eurozone which control now approximately 1/3 of the EU parliament. This is a well expected consequence of the static stance of EU political elite in front of raising structural unemployment.
EU parliament seats breakdown. Source: The Economist.

So far, peripheral EU has been impressionably tolerant of historical high unemployment level and economic distress. However, time is playing an increasingly important role in the capacity of the public to digest unemployment and economic hardship. At one point, opposition to EU - which is labeled as the cause of all economic and social illness - may become an evident way to gain broad political ground. We could see Eurosceptisim shifting from radical/populist parties toward a broader part of the Eurozone electoral landscape.

The May 26th vote might have provided us with an open window on the next chapter in the EU crisis. As the Eurogroup is refusing any flexibility into the Maastricht treaty (namely budget deficit and gov debt level)  - which could have been implemented for a short period of time and/or adjusted to specific country in financial distress (Greece, Portugal et..) and/or refuse so far to consider Eurobonds - it slowly force Europeans to choose between an Europe with structural unemployment/decimated private sector spending or ultimately a break-up of the Eurozone.

This is quite a risky bet : as time goes by and unemployment stay high, the social forces at play will intensify and at one point it will trigger a snow ball effect: when the Eurosceptisim will be felt as broad enough in term of potential electoral support, it will accelerate significantly as it will resonate into larger political parties = the Political "Bank Run".

The passiveness of the EU political elite in front of the largest eco-social disaster since WWII, might remember to some the passiveness of EU as Hitler was annexing part of east Europe during the Anschluss - we all know how its ended..

Moreover, in a not so distant future as China will continue to rebalance its economy toward domestic consumption, it will be a growing source of demand/import and Germany exports will probably find a new heaven (currently >70% of Germany exports are intra EU) and Eurozone demand will as a result be less strategic for Germany. Therefore, the Eurozone will be significantly less economically attractive even for the most pro-Eurozone member...


% of Populist parties (source: The Economist)

May Trading Performance

North of +10% - decided that posting performance does not add any value to this blog other than helping me tracking my past performance. So from now on I ll not any more post trading results.
I ll write this we a small piece on May 26th EU election results and its long term potential impact on EU - notably the potential for trigger of a "political" bank run

Why the decreasing US labor "participation rate" is not an issue and why unemployment will grow even as job growth is positive in 5 charts

Source: GSGIR

April Trading Performance +25.2%

Significant volatilty between 10th and 22nd of the month helped trading in FTSE MIB Future - Did not trade any silver this month.

Wages and Inflation Divergences in EU - The Challenging Puzzle of EU eco integration..

Shuman Foundation put together a "breakdown per country of the development of unit labour costs since 1999 between the contribution made by inflation (GDP deflator), the real average compensation and productivity. Unit labour costs are defined as the ratio between the real average compensation and productivity. The ratio between real unit labour costs (RULC) and nominal unit labour costs (NULC) is naturally inflation (GDP deflator). Hence we see the decisive importance of divergences in inflation (see graphs page 9).

The example of Italy is striking. The wage share (or the real unit labour costs) has barely risen over this period. Above all the development of nominal unit labour costs therefore reflects that of prices. Real unit labour costs have stagnated, for the simple reason that wages and productivity have followed a common trend of stagnation. Productivity gains have been zero, slightly negative even, likewise the average salary. The lack of productivity gains is a major economic problem but which must not be confused with a wage drift. These two problems are different and call for different solutions. Wage reductions whatever the cost, mass unemployment and more generally the economic confusion that goes together with a recession and a credit crunch only worsen the dynamics of productivity. This is what we could see in Portugal.

In Germany the decrease in real unit labour costs resulted (until 2008) from the productivity gains which were not felt in the average real wage (which only rose slightly over this period). These productivity gains were quite moderate, barely more than a total of 10% over nine years. France actually experienced a similar development in its productivity but over the same period the real average wage developed in line with productivity, which implies stable real unit labour costs. In Spain the real wage decreased over that period with stagnating productivity, resulting in a sharp drop in real unit labour costs. However the cumulative inflation of over 40% drove the nominal unit labours cost upwards. A healthy situation would comprise significant productivity gains, similar wage increases and an almost homogeneous inflation rate between the various countries of the euro zone."

Source: Foundation Robert Shuman - eu