2015 Second Half Outlook: Quadrophobia
             



Summary
  • The second half of 2015 promises to deliver an interesting ride for investors.
  • After what was a relatively quiet first half, the capital markets are being confronted with a mounting set of challenges as we enter the back half of the year.
  • At least four critically important issues have risen to the forefront for global investors to navigate as we progress through the remainder of the year.
The second half of 2015 promises to deliver an interesting ride for investors. After what was a relatively quiet first half, the capital markets are being confronted with a mounting set of challenges as we enter the back half of the year. While the list is bound to grow and evolve in the coming months, at least four critically important issues have risen to the forefront for global investors to navigate as we progress through the remainder of the year.

Greece And The Eurozone

The second half of the year is getting underway with a livewire of a problem in Greece and its standoff with European creditors. Given that the unfolding dilemma in Greece has been well documented in a variety of sources, including several of my own recent articles, I will instead focus on the longer-term implications of the currently unfolding situation after a brief summary. Basically, Greece has the unsustainable problem of too much debt and insufficient growth to overcome these high and rising debt levels. The country has been reliant on support from European creditors in the eurozone to avoid default, but its new Syriza leadership has balked on accepting further austerity in order to receive more bailout funds. As a result, default and a potential departure from the eurozone are now presenting themselves as real possibilities for Greece.

The Greece situation alone leads to a quadruple dilemma for investors as we enter the second half of the year. The first is that negotiations remain ongoing. It is still very possible that Greece and its European creditors could end up striking a deal in the coming days, even though it appears that the clock is already striking midnight. The next critical date is July 5, when the Greece citizens vote on a referendum whether to accept or reject the austerity measures proposed by its European creditors. But even if Greek voters accept the deal and reject their Syriza leadership in the process, this does not mean that the Greece problem is solved and all is well. The country is sinking fast under the weight of its own debt. And while a deal may put the problem off until another day, the problem is only likely to be worse and more complex once that day finally arrives.

But suppose Greek voters reject austerity. This leads to the second dilemma for investors. Yes, European policymakers have been preparing for the last several years for the day when Greece finally defaults. And while policymakers may think that they have isolated the Greece problem and have constructed adequate firewalls around other at-risk eurozone members, we will not know what the true fallout effects will be once the event finally happens. For it is typically the unanticipated surprises that can shock capital markets into a correction. Such will be the persistent risk for investors for weeks and months after the fact.

The third dilemma for investors is that with Greece gone, the focus of the problem will naturally move up the line to the next at-risk segments. Portugal stands as the next logical target in line, but the much larger eurozone members in Italy and Spain are also in queue. These countries are not so neatly quarantined as Greece is today. And in the case of Italy and Spain, these are much larger economies with considerably larger debt burdens that will be far more difficult to contain if the situation begins to unravel. Thus, the risk monitoring process promises to become far more complex in the months ahead, regardless of how the situation in Greece plays out.

Lastly, what will be the potential allure for these at-risk nations to follow Greece and bolt from the eurozone at the end of the day? As of today, they all proclaim to varying degrees that they still want to be a part of the euro currency experiment. But what has been increasingly notable over the last several years is the drift toward separation across the region. This has included the rise of Podemos in Spain and other more fringe-oriented political parties across the European Union. It has also included referenda in the United Kingdom for Scotland's independence and ongoing British membership in the European Union. Such separatist inclinations are particularly problematic, for an economic and currency union requires a shift toward unity, not separation. With this in mind, suppose Greece decides to go its own way and leave the eurozone. And what if Greece's economic experience is better than expected? With the precedent now set for a country to leave the currency union, which country might next be inclined to follow?

These varying and complex issues are likely to unfold at different times and speeds as we progress through the second half of 2015 and into 2016. But these are problems that are not likely to go away, and instead, are likely to build.

The investment implications of the unfolding situation in Europe is the following. It is supportive of a stronger U.S. dollar (NYSEARCA:UUP) and a weaker euro (NYSEARCA:FXE), particularly as European policymakers unleash additional liquidity into the financial system. From an equity perspective, it should cause U.S. investors to bias more toward domestically-oriented firms in their stock (NYSEARCA:SPY) portfolios. It should also lead to gradually increasing risk aversion on the fixed-income side away from segments such as high yield (NYSEARCA:HYG) and senior loans (NYSEARCA:BKLN), and an inclination toward higher-quality safe-haven credits such as U.S. Treasuries (NYSEARCA:TLT). Precious metals such as gold (NYSEARCA:GLD) may also finally start to have their day under such a scenario, but liquidation pressures may weigh on the metal in the near term. Moreover, other factors must be considered before considering a long-term allocation to gold, including the direction of the dollar and other factors that have been recently unique to the precious metals market.

The China Bubble

While the word "bubble" gets thrown around way too much in the financial media nowadays, the Chinese stock market (NYSEARCA:GXC) is currently in what can truly be described as a bubble. A look at a chart of the Shanghai Stock Exchange Composite shows why.

(click to enlarge)


China was a stock market that was adrift in a sideways pattern for several years. But suddenly last summer, it began erupting to the upside. And over the past year, it increased by over +150% in value, before recently falling back by more than -20% in recent days. China stocks have made this remarkable advance not because their economy has been performing so well, but instead, it has taken place despite the fact that the country's economy continues to slow. For in a story that is all too familiar to first United States then Japanese and now European investors, Chinese policymakers - including the People's Bank of China - have created financial market conditions that have been conducive to artificially inflating asset prices, including stocks, beyond all reasonable recognition.

The only difference here is that China has done so far more aggressively over the last year, and unlike beleaguered investors across much of the rest of the globe who are still licking their wounds from other major bear markets that have taken place in recent years, many Chinese investors are relatively new to the stock market game. As a result, the rise in Chinese stocks has been accompanied by many of the classic signs of bubble behavior, including inexperienced retail investors borrowing money they do not have to get leveraged to the hilt in stocks and corporations shutting down more productive activities so that they can divert capital into the stock market. Such bubble-like conditions never end well, and China, more than the rest of the world, is currently caught up in such a mania.

Thus, the fate of the Chinese stock market also warrants close attention as we progress through the second half of 2015. Indeed, the opening of the mainland China market to foreign investors may ultimately justify the recent rise in Chinese stock prices, but given that the market has come so far so quickly in so many unhealthy ways, some extended periods of extreme volatility and pain should now be expected going forward.

As for the references that Chinese stocks have now entered a bear market, this may be technically true, given that the market is now down -20% from its recent highs. However, what makes a bear market a true bear market is not only the magnitude of the decline, but also the duration. If a stock market drops by -20% over the course of a few weeks and quickly recovers this decline, this is not really a true bear market, because investors did not feel any prolonged pain (for example, if it's something that you could have missed while on vacation, it's not a bear market). But if it's something that drags on seemingly relentlessly over time, then that is a bear market in the truest sense.

But what are the implications of a Chinese stock market bubble bursting for investors in other parts of the world, including the United States? First, global investment markets are now highly interconnected. Thus, a major liquidation of assets in one part of the world will almost certainly have spillover effects on the rest of the globe that have the potential to play out over time and in potentially unpredictable ways.

To highlight this point, it is worthwhile to reflect on the so-called "taper tantrum" of May and June 2013. While the market sell-off at the time was largely attributed to the U.S. Federal Reserve beginning the conversation about scaling back on QE3 asset purchases, another more destabilizing and destructive force was playing out underneath the market surface at the same time that few in the media chose to recollect or even remember today. For at the same time that then Fed Chairman Ben Bernanke was taking to the podium to talk about scaling back asset purchases in May and June 2013, Chinese policymakers, including the People's Bank of China, were cracking down on activities in their shadow banking system. This caused liquidity across the Chinese financial system to dry up, as reflected by a dramatic spike in the seven-day Shanghai intrabank offered rate (SHIBOR) to over 12% (by comparison, it is currently below 3% today). In short, financial institutions across China did not have access to necessary daily liquidity at the time (remember the post-Lehman Brothers period in the U.S.) and were forced to fire-sell assets to raise cash to fund operations (once again, remember the post-Lehman Brothers period in the U.S.). What were these Chinese financial institutions selling at the time?

Among other things, the holdings that were most liquid, which included U.S. stocks, U.S. Treasuries and gold. Thus, if a bursting of the Chinese stock bubble causes liquidity conditions to seize, do not be surprised if assets across the board in the United States find themselves coming under pressure.

The investment implications of what is taking place in China are the following. First, any direct investments in China (NYSEARCA:FXI) or closely related markets such as Hong Kong (NYSEARCA:EWH) may best be avoided, or at a minimum, should be undertaken with great care by those with the experience to navigate these markets. As regards those not directly exposed to China, they can ill afford to ignore how events are unfolding. For if market conditions begin to accelerate more sustainably to the downside, liquidation pressures are likely to eventually find their way to U.S. shores across all asset classes, including stocks, bonds and precious metals. Liquidation episodes are often followed by attractive buying opportunities, but they can bring second and third derivative spillover effects that must also be evaluated. Lastly, if a market correction in China starts to measurably erode business activity in the country, this has the potential to have adverse effects on the many companies in the United States that rely on China as a low-cost supplier of inputs for production.

In short, keep a close eye on China, and be ready to adjust portfolio allocations as necessary if conditions look like they are starting to unravel in a more meaningful way.

Deteriorating Corporate Earnings

The growth of corporate earnings is the lifeblood for stocks in a fundamentally driven market environment. And throughout the post-crisis period, a key tailwind for stocks has been the fact that corporate earnings have been steadily rising both on a quarter-over-quarter and year-over-year basis since the 2009 lows. But as we continue into the second half of 2015, investors will increasingly be seeing a market where the growth in corporate earnings, in many cases, will instead be falling on both of these measures.

Such was not supposed to be the case heading into 2015. At the end of last year, corporate earnings were projected to rise each quarter at a healthy double-digit pace on a year-over-year basis between 15% and 25%. Knowing that stock prices are predictive mechanisms that derive their value in part from expectations about future earnings, this optimistic forecast would presumably help explain the positive returns for stocks in 2014.

(click to enlarge)

But what has actually taken place so far in the first half of 2015 has been anything but robust.

In fact, it has been fairly ugly. Corporate earnings growth was not double-digit positive on a year-over-year basis in the first quarter of 2015. In fact, it was not positive at all. Instead, earnings declined by more than -1%. And for the second-quarter earnings season that is soon to get underway, earnings are now projected to fall by nearly -5% on a year-over-year basis. Even if they come in "better than expected", as they always do, they will still be a far cry from the +20% earnings growth predicted only a few months ago. And earnings growth is only expected to get worse in the third quarter before they are somehow supposed to start improving in the fourth quarter (let's see where this number stands in a month or two, as it was close to 10% only a couple of months ago).

(click to enlarge)

Now some rightfully point out that a good portion of the drag on corporate earnings is being sourced from the energy sector (NYSEARCA:XLE) that was badly bruised by the roughly 60% drop in oil prices since last July. But this overlooks the fact that the economically sensitive industrial sector (NYSEARCA:XLI) is also seeing earnings slip by double-digits on a year-over-year basis, undoubtedly in part due to the challenges from the energy sector. Earnings in the materials sector (NYSEARCA:XLB) are also flattening, while consumer staples (NYSEARCA:XLP) have been edging lower for several quarters. And the temporary boost to the overall earnings number from the telecom services sector (NYSEARCA:IYZ) that occurred from 2013 Q4 to 2014 Q3 is also now fading away.

So putting this all together, what we have here is a market that moved solidly higher in 2013 and 2014, based in part on strong earnings growth expectations that never fully materialized in 2015. Yes, certain sectors are still holding up well, but not so for the market in aggregate. Under normal market conditions, such would be the conditions for a measurable correction, particularly given that stock valuations are currently at the high end of historical ranges, both on an as-reported trailing 12-month and a 10-year cyclically adjusted price-to-earnings ratio basis.

Thus, the investment implications in a normal market environment would be to look to lighten up on stock allocations. But stocks can defy rational expectations in an environment of perpetually easy monetary policy, where interest rates are locked effectively at 0% by central banks such as the U.S. Federal Reserve. This leads us to our next critically important issue for investors to consider in the second half of 2015.

A Fed Determined To Raise Interest Rates

Since the outbreak of the financial crisis in 2007, the U.S. Federal Reserve has known only one policy stance. It was first to cut interest rates. But once interest rates had been lowered effectively to 0%, the next step was to engage in large-scale asset purchases as part of its quantitative easing programs (QE) to provide even more stimulus to the economy and financial markets. But after so many years of zero interest rate policy (ZIRP), the Federal Reserve is determined to raise interest rates, if at all possible, before the year is out. This represents a major shift not only from a policy perspective, but also as it relates to the financial markets.

While it can be clearly argued that monetary policy has actually been getting tighter since not long after the Fed began tapering QE3 well over a year ago, the financial markets have not had to deal with monetary tightening that included a Fed funds rate that was higher than the zero bound for many years. Although it seems like a small move to raise interest rates from essentially 0% to 0.25% or 0.50%, it is a major shift from a statistical and modeling perspective.

Investors should be prepared for increased stock market volatility the closer we get to the next phase of the Fed tightening cycle. Long gone are the days when the Federal Reserve would show up with its daily liquidity injections into financial markets totaling billions of dollars in the form of U.S. Treasury purchases. This helps explain why the stock market is not that much higher today than it was back in November 2014, when the Fed finished its QE3 stimulus program. But at least money from the Fed was still effectively free from an interest rate cost standpoint. But this will also soon change, assuming the Fed is able to follow through with its planned interest rate increases in the coming months.

Investors should be prepared not only for greater stock market volatility, but also for more sustained movement to the downside. This is because interest rates are expected to rise, and because of the conditions under which the Fed is seeking to raise interest rates. For under normal conditions, the Fed would be raising rates because of the economy, with the intent of slowing it down. But today, the Fed is raising rates despite the economy and the fact that it remains sluggish so many years into the recovery. So why then is the Fed looking to raise interest rates? At least in part because they want the policy flexibility to be able to lower interest rates by the time the next recession rolls around. And given that they are seeking to do so with valuations at historical highs and corporate earnings already trending lower suggests that stocks could come under increasing downside pressure as we move through the second half of the year.

So exactly when should we expect the Fed to begin raising interest rates? September is the period most widely discussed by Fed members in recent dialog, but whether this comes to pass will be both data and market dependent. After all, these same policy members once talked about June as a possibility, and that did not come to pass. But if the Fed were to raise rates in September, the next logical step would be a potential second-quarter point rate hike in December. But a good deal of time exists between now and then.

The investment implications of higher interest rates from the U.S. Federal Reserve are the following. The third-longest stock bull market in history remains ongoing to-date, but it may soon start to come to an end in the coming months. As a result, investors should seek to be more selective and defensive in their equity allocations than they may have been in the past. The time may finally arrive in the second half of the year to selectively and carefully consider selected inverse strategies that are designed to perform well during periods when the stock market is falling. This could be as simple and conservative as an allocation to intermediate-term U.S. Treasuries (NYSEARCA:IEF), or many other options that are more assertive in this regard.

Holding an increased allocation to cash (NYSEARCA:BIL) is also a prudent approach in such an environment. For whenever one wishes to go shopping, it is always beneficial to wait for the items you wish to buy to go on sale to help get the most out of your dollar.

Bottom Line

It promises to be an exciting and eventful second half of 2015. Four critical market events have been explored here, and this list does not even include the unfolding debt crisis in Puerto Rico or the ongoing geopolitical threat that also loom as potential risks for the markets in the months ahead. And when considering the convergence of these various forces mentioned above, we could be entering a stretch in time for capital markets where virtually any major asset class could come under sustained pressure for a measurable period of time. But in aggregate, stocks are at the greatest risk of a sustained downside correction, given the various forces at work.

Right now, the uptrend in stocks remains intact, and it should be respected. But this could change at any time at this point. As a result, investors should be ready to act accordingly to protect their portfolio value if and when conditions warrant.

More than ever before, the coming months will not be a time for investor complacency. It will be important to maintain a close watch on capital markets and to have an action plan at the ready not only navigate the downside risks, but also to capitalize when the time is right for meaningful upside opportunities will also present themselves along the way and will be there for the taking for those that are prepared and at the ready.

Europe’s Attack on Greek Democracy

Joseph E. Stiglitz

JUN 29, 2015



NEW YORK – The rising crescendo of bickering and acrimony within Europe might seem to outsiders to be the inevitable result of the bitter endgame playing out between Greece and its creditors. In fact, European leaders are finally beginning to reveal the true nature of the ongoing debt dispute, and the answer is not pleasant: it is about power and democracy much more than money and economics.
 
Of course, the economics behind the program that the “troika” (the European Commission, the European Central Bank, and the International Monetary Fund) foisted on Greece five years ago has been abysmal, resulting in a 25% decline in the country’s GDP. I can think of no depression, ever, that has been so deliberate and had such catastrophic consequences: Greece’s rate of youth unemployment, for example, now exceeds 60%.
 
It is startling that the troika has refused to accept responsibility for any of this or admit how bad its forecasts and models have been. But what is even more surprising is that Europe’s leaders have not even learned. The troika is still demanding that Greece achieve a primary budget surplus (excluding interest payments) of 3.5% of GDP by 2018.
 
Economists around the world have condemned that target as punitive, because aiming for it will inevitably result in a deeper downturn. Indeed, even if Greece’s debt is restructured beyond anything imaginable, the country will remain in depression if voters there commit to the troika’s target in the snap referendum to be held this weekend.
 
In terms of transforming a large primary deficit into a surplus, few countries have accomplished anything like what the Greeks have achieved in the last five years. And, though the cost in terms of human suffering has been extremely high, the Greek government’s recent proposals went a long way toward meeting its creditors’ demands.
 
We should be clear: almost none of the huge amount of money loaned to Greece has actually gone there. It has gone to pay out private-sector creditors – including German and French banks. Greece has gotten but a pittance, but it has paid a high price to preserve these countries’ banking systems.
 
The IMF and the other “official” creditors do not need the money that is being demanded. Under a business-as-usual scenario, the money received would most likely just be lent out again to Greece.
 
But, again, it’s not about the money. It’s about using “deadlines” to force Greece to knuckle under, and to accept the unacceptable – not only austerity measures, but other regressive and punitive policies.
 
But why would Europe do this? Why are European Union leaders resisting the referendum and refusing even to extend by a few days the June 30 deadline for Greece’s next payment to the IMF? Isn’t Europe all about democracy?
 
In January, Greece’s citizens voted for a government committed to ending austerity. If the government were simply fulfilling its campaign promises, it would already have rejected the proposal. But it wanted to give Greeks a chance to weigh in on this issue, so critical for their country’s future wellbeing.
 
That concern for popular legitimacy is incompatible with the politics of the eurozone, which was never a very democratic project. Most of its members’ governments did not seek their people’s approval to turn over their monetary sovereignty to the ECB. When Sweden’s did, Swedes said no.
 
They understood that unemployment would rise if the country’s monetary policy were set by a central bank that focused single-mindedly on inflation (and also that there would be insufficient attention to financial stability). The economy would suffer, because the economic model underlying the eurozone was predicated on power relationships that disadvantaged workers.
 
And, sure enough, what we are seeing now, 16 years after the eurozone institutionalized those relationships, is the antithesis of democracy: Many European leaders want to see the end of Prime Minister Alexis Tsipras’s leftist government. After all, it is extremely inconvenient to have in Greece a government that is so opposed to the types of policies that have done so much to increase inequality in so many advanced countries, and that is so committed to curbing the unbridled power of wealth.
 
They seem to believe that they can eventually bring down the Greek government by bullying it into accepting an agreement that contravenes its mandate.
 
It is hard to advise Greeks how to vote on July 5. Neither alternative – approval or rejection of the troika’s terms – will be easy, and both carry huge risks. A yes vote would mean depression almost without end. Perhaps a depleted country – one that has sold off all of its assets, and whose bright young people have emigrated – might finally get debt forgiveness; perhaps, having shriveled into a middle-income economy, Greece might finally be able to get assistance from the World Bank. All of this might happen in the next decade, or perhaps in the decade after that.
 
By contrast, a no vote would at least open the possibility that Greece, with its strong democratic tradition, might grasp its destiny in its own hands. Greeks might gain the opportunity to shape a future that, though perhaps not as prosperous as the past, is far more hopeful than the unconscionable torture of the present.
 
I know how I would vote.
 


Markets Insight

June 29, 2015 5:11 am
 
Do not bank on China QE to refuel stocks
 
 
Beijing’s local government debt swap does not create new money
 
 
There are several reasons not to write off Chinese equities just yet, despite this month’s sharp correction and a structural economic downturn. But banking on Beijing’s Rmb2tn local government debt swap to work monetary magic is not one of them.
 
The swap is a sensible piece of financial engineering. By transforming expensive short-term loans into cheaper bonds with longer maturities, China is reducing the threat that its rapid accumulation of debt poses to financial stability and the economy. By Lombard Street Research estimates, China’s non-financial debt had jumped to 240 per cent of GDP by 2014 from around 150 per cent in 2008.
 
But the idea in some quarters that the operation is akin to the quantitative easing programmes pursued by other central banks is wide of the mark. Anyone lured by the talk of QE into expecting the debt restructuring to provide a fillip to growth will be sorely disappointed.
 
This is far from a monetary policy boost. QE is money creation by the state, be it the government or central bank, when it buys assets from banks or non-banks. But swapping loans to local governments for bonds simply changes the composition of the asset side of the banks’ balance sheet. It does not entail asset purchases and so does not create new money.

True, the debt swaps do have second-round monetary effects. Because the bonds carry a lower risk weighting than the loans they replace, the swap frees up capital so, in theory, banks can lend more. In practice, Chinese banks are wallowing in bad loans and may well be reluctant to lend, especially to smaller, privately owned firms. In addition, the corporate sector is already overextended, its debts estimated at 150 per cent of GDP due to the credit-fuelled investment binge ordered by Beijing to prop up the economy after the 2008 financial crisis.

The local government debt restructuring is just one part of a broader shake-up of the Chinese financial system that promises to be neutral to negative for overall monetary conditions. And remember that money growth is already extraordinarily weak. The growth of the broad money supply (as measured by M2) plumbed a record low of 10.1 per cent in the year to April (before rebounding modestly in May) even though, by our estimates, the economy last winter was nearly as weak as in 2008-09. We calculate that Chinese GDP shrank between the fourth quarter of 2014 and the first quarter of 2015 as domestic demand plunged.

Chart

Although Chinese banks have issued large volumes of preference shares and subordinated debt, they need fresh equity capital. As Basel III rules governing bank capital requirements come into effect and deposit rates are fully liberalised, it will be difficult for banks to replenish capital through profit growth alone.
 
Not many realise that recapitalising the banks could exacerbate the weakness of broad money. If Beijing sells shares to the domestic non-bank private sector, money growth will fall as deposits are drained to settle the transactions.

This background of a swooning economy and a weak monetary response is seemingly enough to explain the fall in Chinese stocks over the past two weeks. But it is important not to lose sight of some of the factors that fuelled the explosive rally in the first place.
 
Crucially, the cuts to interest rates and the required reserves ratio for banks this weekend confirm that the rally has had the blessing of the ruling Communist party. Of course, the authorities do not want a re-run of the market’s collapse in 2008 — hence the recent crackdown on margin trading. But they would rather see money pouring into shares than inflating a new property bubble that could burst with potentially more severe social consequences. Moreover, by making it easier to issue fresh equity, a rising market promotes China’s strategic shift away from an over-reliance on debt. And, not to be forgotten, it makes it cheaper to recapitalise the banks.
 
But lastly and most importantly, investors should remember that the market is not being propelled by an excessive injection of money into the economy, as happened after the financial crisis. Rather, this year’s rally has been driven by increased liquidity, or in other words, a decrease in the demand for money due to a greater appetite for risk-taking. This makes this bubbly market upswing more vulnerable to a change in investor sentiment, but resisting Beijing’s wishes can be a costly game.


Diana Choyleva is chief economist and head of research at Lombard Street Research

George Osborne spearheads assault to stop Greece 'suicide’

Athens told that a vote in this weekend’s referendum to refuse austerity would catapult the country out of Europe

By Matthew Holehouse, Brussels, Ambrose Evans-Pritchard, Justin Huggler, Berlin and Steven Swinford

10:49PM BST 29 Jun 2015

A supporter of the NO vote in the upcoming referendum wears a sign reading 'No

A supporter of the NO vote in the upcoming referendum wears a sign reading 'No" in Greek, German and English in Athens Photo: AP
 
George Osborne on Monday led attempts to strong-arm Greece into voting for a bail-out package as he warned that a Greek exit would threaten Britain’s financial stability.

Britain joined Germany, France, Italy and the European Commission in telling the Greek people that refusing austerity measures in next Sunday’s referendum would catapult them “from the eurozone and from Europe”.
 
Jean-Claude Juncker, the European Commission president, warned the Greeks – who are on Tuesday night expected to default on a €1.5 billion (£1.1 billion) loan from the International Monetary Fund (IMF) – not to “commit suicide” by rejecting the proposed €12 billion loans-for-reforms package. The threat comes despite voters being asked only whether they support the bail-out.
 
Some £36 billion was wiped off the value of major British companies on the FTSE 100 as markets slid around the world, while Greeks queued in their thousands at cash machines, petrol stations and supermarkets for a third day.
.
Pensioners line-up outside a branch of the National Bank of Greece hoping to get their pensions, in Athens (Reuters)

It emerged on Monday night that British taxpayers could be tapped for hundreds of millions of pounds to support Greece if it leaves the currency, under emergency plans prepared by the EU.

Treasury sources conceded that Greece could request help from a balance of payments support system available to all 28 EU members to relieve its public finances. Britain pays into the scheme, which has previously been used by Hungary, Latvia and Romania.

The cash-strapped Greek government will also be hit today with a €1.9 billion bill for public salaries and pensions.

 






























A group of pensioners queue outside a branch of the National Bank of Greece in the hope that it might open (Bloomberg)

On July 13, another €465 million is due to the IMF. Most crucially, on July 20 it must find €3.5 billion to pay the European Central Bank. Failure to do so would be likely to result in €88 billion of emergency loans to Greek banks being withdrawn, resulting in collapse and 'Grexit', the exit of Greece from the euro.

Greece on Monday published the ballot paper for Sunday’s vote, with No, or Oxi, at the top. The word carries powerful resonance in Greece from the day in October 1940 when it refused Mussolini’s ultimatum.

Mr Osborne told the Commons: “I don’t think anyone should underestimate the impact a Greek exit from the euro would have on the European economy and the knock-on effects on us.

“The eurozone authorities have made clear that they stand ready to do whatever is necessary to ensure financial stability of the euro area and we welcome that commitment to the currency.

“Equally the British Government and the Bank of England stand ready to ensure our financial stability in the UK,” the Chancellor said.

Mr Juncker said: “I will say to the Greeks, who I love deeply, you mustn’t commit suicide because you are afraid of death.”

“You must vote 'yes’, independently of the question asked. The whole planet would consider a Greek 'no’ to the question posed as meaning that Greece wants to distance itself from the eurozone and from Europe.”

In a rambling and self-pitying address in Brussels, Mr Juncker railed against Mr Tsipras’s “betrayal” and accused the “egotist, populist” of jeopardising “my major life’s work”.

Alexis Tsipras, prepares for a TV interview at the State Television (ERT) studios in Athens (AP)

“I will never let the Greek people go down, never, and I know that the Greek people don’t want to let down the European Union,” he said. “I have done everything, and we don’t deserve all the criticism being heaped upon us.”
 
Mr Juncker, who in a previous crisis said, “When the going gets tough, you have to lie” – was accused of a “preposterous lie” after claiming that the proposed bail-out contained no pension cuts.

Angela Merkel, who is under intense pressure from German taxpayers infuriated by bail-outs, said she could not soften the “generous offer” made to Greece.

“If the euro fails, Europe will fail,” she said. “That’s why we have to fight for these principles.

We could maybe say we’ll just give in. But I say: in the medium and long term, we will suffer damage that way.”

François Hollande, the French president, said France had “nothing to fear” from Grexit, while Matteo Renzi, the Italian premier, wrote on Twitter: “Euro vs drachma. This is the choice.”
 
Angela Merkel and and German economy minister Sigmar Gabriel (AFP)

Greece said the ultimatum was illegal because the European treaties contain no mechanism for a euro exit. “We are taking advice and will certainly consider an injunction at the European Court of Justice.

Our membership is not negotiable,” Yanis Varoufakis, the finance minister, told The Telegraph.

The Kremlin, which offered Mr Tsipras a hero’s welcome a fortnight ago and is a potential new lender, said it was “watching developments very closely”.

“We are concerned about the possible negative consequences for the whole of the EU,” a spokesman said.


Emerging Markets After the Fed Hikes Rates

Nouriel Roubini

JUN 29, 2015

 Fed chair Janet Yellen 

NEW YORK – The prospect that the US Federal Reserve will start exiting zero policy rates later this year has fueled growing fear of renewed volatility in emerging economies’ currency, bond, and stock markets. The concern is understandable: When the Fed signaled in 2013 that the end of its quantitative-easing (QE) policy was forthcoming, the resulting “taper tantrum” sent shock waves through many emerging countries’ financial markets and economies.
 
Indeed, rising interest rates in the United States and the ensuing likely rise in the value of the dollar could, it is feared, wreak havoc among emerging markets’ governments, financial institutions, corporations, and even households. Because all have borrowed trillions of dollars in the last few years, they will now face an increase in the real local-currency value of these debts, while rising US rates will push emerging markets’ domestic interest rates higher, thus increasing debt-service costs further.
 
But, although the prospect of the Fed raising interest rates is likely to create significant turbulence in emerging countries’ financial markets, the risk of outright crises and distress is more limited. For starters, whereas the 2013 taper tantrum caught markets by surprise, the Fed’s intention to hike rates this year, clearly stated over many months, will not. Moreover, the Fed is likely to start raising rates later and more slowly than in previous cycles, responding gradually to signs that US economic growth is robust enough to sustain higher borrowing costs.

This stronger growth will benefit emerging markets that export goods and services to the US.
 
Another reason not to panic is that, compared to 2013, when policy rates were low in many fragile emerging economies, central banks already have tightened their monetary policy significantly. With policy rates at or close to double-digit levels in many of those economies, the authorities are not behind the curve the way they were in 2013. Loose fiscal and credit policies have been tightened as well, reducing large current-account and fiscal deficits. And, compared to 2013, when currencies, equities, commodity, and bond prices were too high, a correction has already occurred in most emerging markets, limiting the need for further major adjustment when the Fed moves.
 
Above all, most emerging markets are financially more sound today than they were a decade or two ago, when financial fragilities led to currency, banking, and sovereign-debt crises. Most now have flexible exchange rates, which leave them less vulnerable to a disruptive collapse of currency pegs, as well as ample reserves to shield them against a run on their currencies, government debt, and bank deposits. Most also have a relatively smaller share of dollar debt relative to local-currency debt than they did a decade ago, which will limit the increase in their debt burden when the currency depreciates. Their financial systems are typically more sound as well, with more capital and liquidity than when they experienced banking crises. And, with a few exceptions, most do not suffer from solvency problems; although private and public debts have been rising rapidly in recent years, they have done so from relatively low levels.
 
In fact, serious financial problems in several emerging economies – particularly oil and commodity producers exposed to the slowdown in China – are unrelated to what the Fed does.

Brazil, which will experience recession and high inflation this year, complained when the Fed launched QE and then when it stopped QE. Its problems are mostly self-inflicted – the result of loose monetary, fiscal, and credit policies, all of which must now be tightened, during President Dilma Roussef’s first administration.
 
Russia’s troubles, too, do not reflect the impact of Fed policies. Its economy is suffering as a result of the fall in oil prices and international sanctions imposed following its invasion of Ukraine – a war that will now force Ukraine to restructure its foreign debt, which the war, severe recession, and currency depreciation have rendered unsustainable.
 
Likewise, Venezuela was running large fiscal deficits and tolerating high inflation even when oil prices were above $100 a barrel; at current prices, it may have to default on its public debt, unless China decides to bail out the country. Similarly, some of the economic and financial stresses faced by South Africa, Argentina, and Turkey are the result of poor policies and domestic political uncertainties, not Fed action.
 
In short, the Fed’s exit from zero policy rates will cause serious problems for those emerging market economies that have large internal and external borrowing needs, large stocks of dollar-denominated debt, and macroeconomic and policy fragilities. China’s economic slowdown, together with the end of the commodity super-cycle, will create additional headwinds for emerging economies, most of which have not implemented the structural reforms needed to boost their potential growth.
 
But, again, these problems are self-inflicted, and many emerging economies do have stronger macro and structural fundamentals, which will give them greater resilience when the Fed starts hiking rates.
 
When it does, some will suffer more than others; but, with a few exceptions lacking systemic importance, widespread distress and crises need not occur.
 
 
Read more at http://www.project-syndicate.org/commentary/fed-interest-rate-rise-emerging-markets-by-nouriel-roubini-2015-06#zyDOS2mlcXC4xcJM.99

Op-Ed Columnist

Greece Over the Brink

Paul Krugman

JUNE 29, 2015

 
Leaving a currency union is, however, a much harder and more frightening decision than never entering in the first place, and until now even the Continent’s most troubled economies have repeatedly stepped back from the brink. Again and again, governments have submitted to creditors’ demands for harsh austerity, while the European Central Bank has managed to contain market panic.

But the situation in Greece has now reached what looks like a point of no return. Banks are temporarily closed and the government has imposed capital controls — limits on the movement of funds out of the country. It seems highly likely that the government will soon have to start paying pensions and wages in scrip, in effect creating a parallel currency. And next week the country will hold a referendum on whether to accept the demands of the “troika” — the institutions representing creditor interests — for yet more austerity.
 
Greece should vote “no,” and the Greek government should be ready, if necessary, to leave the euro.
 
To understand why I say this, you need to realize that most — not all, but most — of what you’ve heard about Greek profligacy and irresponsibility is false. Yes, the Greek government was spending beyond its means in the late 2000s. But since then it has repeatedly slashed spending and raised taxes.
 
Government employment has fallen more than 25 percent, and pensions (which were indeed much too generous) have been cut sharply. If you add up all the austerity measures, they have been more than enough to eliminate the original deficit and turn it into a large surplus.

So why didn’t this happen? Because the Greek economy collapsed, largely as a result of those very austerity measures, dragging revenues down with it.
 
And this collapse, in turn, had a lot to do with the euro, which trapped Greece in an economic straitjacket. Cases of successful austerity, in which countries rein in deficits without bringing on a depression, typically involve large currency devaluations that make their exports more competitive. This is what happened, for example, in Canada in the 1990s, and to an important extent it’s what happened in Iceland more recently. But Greece, without its own currency, didn’t have that option.

So have I just made the case for “Grexit” — Greek exit from the euro? Not necessarily. The problem with Grexit has always been the risk of financial chaos, of a banking system disrupted by panicked withdrawals and of business hobbled both by banking troubles and by uncertainty over the legal status of debts. That’s why successive Greek governments have acceded to austerity demands, and why even Syriza, the ruling leftist coalition, was willing to accept the austerity that has already been imposed. All it asked for was, in effect, a standstill on further austerity.
But the troika was having none of it. It’s easy to get lost in the details, but the essential point now is that Greece has been presented with a take-it-or-leave-it offer that is effectively indistinguishable from the policies of the past five years.
 
This is, and presumably was intended to be, an offer Alexis Tsipras, the Greek prime minister, can’t accept, because it would destroy his political reason for being. The purpose must therefore be to drive him from office, which will probably happen if Greek voters fear confrontation with the troika enough to vote yes next week.
 
But they shouldn’t, for three reasons. First, we now know that ever-harsher austerity is a dead end: after five years Greece is in worse shape than ever. Second, much and perhaps most of the feared chaos from Grexit has already happened. With banks closed and capital controls imposed, there’s not that much more damage to be done.
 
Finally, acceding to the troika’s ultimatum would represent the final abandonment of any pretense of Greek independence. Don’t be taken in by claims that troika officials are just technocrats explaining to the ignorant Greeks what must be done. These supposed technocrats are in fact fantasists who have disregarded everything we know about macroeconomics, and have been wrong every step of the way. This isn’t about analysis, it’s about power — the power of the creditors to pull the plug on the Greek economy, which persists as long as euro exit is considered unthinkable.
 
So it’s time to put an end to this unthinkability. Otherwise Greece will face endless austerity, and a depression with no hint of an end.


Review & Outlook

China’s Debt Bomb

Stock volatility is the latest sign of the economy’s excessive leverage.

June 28, 2015 5:07 p.m. ET

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An investor observes stock market at a stock exchange hall on June 26 in Fuyang, Anhui province of China.An investor observes stock market at a stock exchange hall on June 26 in Fuyang, Anhui province of China. Photo: ChinaFotoPress/Getty Images
 
 
The spectacular volatility in Chinese stocks the past two weeks is a reminder that, for all its size, China remains a developing economy with an immature financial system. As stock prices soared more than 100% in the past year, so did margin lending, estimated at $238.5 billion last week. That debt probably added to the price swings, with the Shanghai Composite Index down 19% since June 12 and 7.4% on Friday.

Property developers, local governments and state-owned enterprises are also broadly overleveraged.

Despite Beijing’s attempts to rebalance the economy from investment to consumption, inefficient borrowing continues to expand. So how concerned should the world be about Chinese debt?

A recent McKinsey Global Institute report put total borrowing—by individuals, companies and government—at 282% of GDP in 2014. That’s extraordinarily high for a developing economy, and up from 158% of GDP as recently as 2007. After the 2008 financial crisis, Beijing encouraged Chinese banks to lend to local governments and state-owned companies.

The cheap credit with few controls often financed projects with a low or negative rate of return.

The wasteful investment is reflected in China’s falling incremental capital output ratio, one measure of how efficiently borrowing translates into economic activity. In the five years before the 2008 panic, it took an increase of less than 3% in investment to add 1% of GDP. By 2012 it took 4.9%. China’s debt figures are reminiscent of Korea, Indonesia and Thailand in the runup to the 1997 Asian financial crisis.

Beijing is trying to defuse the problem, though some of its steps may make it worse in the long-term. The People’s Bank of China (PBOC) is bailing out local governments responsible for bridges to nowhere and palatial buildings. Provincial governments will retire bank debt by issuing $419 billion in bonds to be bought by state banks, which will swap them with the central bank for reserves to lend.

This repeats the bank recapitalization of the late 1990s, when bad loans were warehoused and largely forgotten. By failing to liquidate bankrupt borrowers, the government creates a moral hazard in which neither loan officers nor local officials face the consequences of bad decisions.

Meanwhile, Beijing has encouraged the rising stock market as a way to boost the slowing economy.

This allows new companies to list shares and brings down business leverage. But some managers have taken the opportunity to borrow more on the back of their higher market value.


Combine that with margin lending to speculators, and the bull market may have increased systemic risk.

If there’s a bright spot, it’s the PBOC’s moderate monetary policy. It has cut rates and freed up some liquidity, but the central bank has not reopened the money taps as it did in 2009, when real deposit rates were negative and real lending rates were near-zero.

The GDP deflator fell 1.2% in the first quarter, only the second time this has happened. The interest rates most companies pay on loans are higher than the nominal GDP growth rate of 5.8% in the first quarter, and real rates are even higher. The PBOC has room to ease further, but it’s positive for China in the long run that borrowers need to find investments with a healthy rate of return to service debts.

As long as Beijing resists calls for too aggressive monetary stimulus and gets tough on bankrupt borrowers, it still has the capacity to defuse the debt bomb. Bad habits are always hard to break, but that’s all the more reason to introduce market discipline now.

Americans Can't Sell Stocks Fast Enough as Rally Tops Flows

 
 

As hard as investors try to wean themselves off stocks, the habit is proving impossible to kick.
 
In a year when fund clients pulled about $60 billion from equities, the value of shares has climbed by $527 billion, pushing the total owned by households to $20 trillion, data compiled by Bloomberg and Ned Davis Research Inc. show. Today, Americans have 41 percent of their financial assets in stocks, matching the high in 2007 and trailing only the Internet bubble.
 
It’s testament to the power of a six-year bull market that even as investors were busy cashing in shares and snapping up every bond in sight, the market’s unrelenting appreciation kept swelling their equity holdings. Now, with so much money parked there, some analysts struggle to see where buying will come from to extend an advance already showing signs of fatigue.
 
“You’ve saturated demand,” said Dan Oshinskie, who helps oversee about $6 billion as chief investment officer at Rothschild Asset Management Inc. in New York. “It doesn’t mean equities can’t continue to rise. What it says is your valuation multiples will have a tough time.”
 
One lesson of the rally that began in 2009 is that stock prices can go up while individuals are bearish, and that could continue. Scarred by two crashes in less than a decade, investors withdrew almost $50 billion from stock mutual and exchange-traded funds over the last six years, according to data compiled by Bloomberg and the Investment Company Institute.
 
The withdrawals coincided with one of the biggest bull markets on record, in which $17 trillion of equity value was created as S&P 500 earnings doubled and companies bought back $2 trillion of shares. Those gains overwhelmed fund outflows and pushed the proportion of equity holdings 12 percentage points above the six-decade average of 29 percent.

“In the long term, stock prices and values are going to be driven by the underlying fundamentals,” said John Canally, chief economic strategist at LPL Financial Corp., which oversees $485.4 billion in Boston. “The earnings outlook is not awesome,” he said, “but it’s solid and that’s enough.”
 
More than $5 billion was withdrawn from U.S. equity ETFs last week, ending three weeks of inflows, data compiled by Bloomberg show.
 
The outflow from stocks partly reflects investors raising cash at a time when they’re not getting much from bonds, according to Howard Ward, chief investment officer of growth equities at Gamco Investors Inc. Deeper losses in fixed income will make stocks more appealing and the bull market won’t end until stock holdings exceed half of assets, he said.
 
Asset Rotation
 
“Capital chases returns and stocks are the only game in town,” said Ward, whose firm oversees $47.5 billion in Rye, New York. “Returns on bond funds will now be turning negative and that should compel investors to reallocate toward stocks.”
 
Americans already own a lot more stocks than they usually do. At 57 percent, the current holdings relative to bonds and cash are far from their peak at 66 percent in 2000, but they’re approaching levels that have coincided with market peaks in the past. The low was hit in 1982 at 27 percent.
 
When equity allocation among U.S. households was in the top 20 percentile since 1952, the S&P 500 rose at an annualized rate of 3.5 percent 10 years later, data compiled by Ned Davis show. That’s about one-fifths of the gain when the ratio was at the lowest.
 
“The challenge with data points like this is, there are only a few historically, so you don’t know if there is a magic level,” said Ed Clissold, U.S. market strategist at Venice, Florida-based Ned Davis. “This trend could go on for a while if the bond market entered a long-term bear. But what it tells you is there is potential for demand to be muted.”
 
Valuation Argument
 
Because price appreciation has been behind the growth in stock allocations, arguing that the amount of shares held by households is bearish is similar to saying stocks are vulnerable due to valuations. The S&P 500 trades at 18.6 times profit, 13 percent above its 10-year average.
 
After two years of almost straight-up appreciation, gains have come harder in 2015, a year in which S&P 500 earnings are forecast to rise 1.2 percent after averaging 15 percent since 2009.
 
At 2.1 percent, this year’s increase in the S&P 500 represents the worst first-half rally since the bull market began.
 
“Stocks just aren’t as cheap as they once were a few years back, so you’ve got that headwind, and then you’ve got a headwind of corporate earnings that are still growing but they’re growing at a much slower pace,” said Bob Landry, a portfolio manager who helps oversee $23 billion at USAA Investment Management Co. in San Antonio. “Expectations for future stock returns should be a lot more modest.”