A Decisive Quarter

Doug Nolan


June 29 - Financial Times (Peter Wells): "The buck is back. Tighter domestic monetary policy and global trade turmoil have set the US dollar for its best quarterly performance since December 2016. The DXY index, which tracks the US currency against a weighted basket of global peers, was up 5.2% in the three months to June 29. That has been achieved via a three-month winning streak, its first such run since December 2016, too."

Chicken or the egg? U.S. dollar strength or emerging market weakness? It's most likely a mix of both, but either way it was a quarter where "Periphery and Core Analysis" offered insight. Global financial conditions tightened significantly during the quarter.

The U.S. dollar gained 5.2% against the euro, 4.0% versus the Japanese yen, 6.7% versus the Swedish krona, 6.5% against the New Zealand dollar, 5.8% versus the British pound, 3.8% against the Norwegian krone, 3.7% against the Swiss franc, 3.6% versus the Australian dollar and 1.8% against the Canadian dollar.

There were large moves in "developed" currencies, though the larger drama played out in the emerging markets. The Argentine peso collapsed 30%, forcing the Macri government into an unpopular $50bn aid package from the IMF. Political uncertainty heading into fall elections, sinking stocks, destabilizing labor unrest and general strife led to a 14.7% drop in the Brazilian real. Surging inflation, a faltering boom, excessive debt and strongman President Erdogan's threats on central bank independence were behind the Turkish lira's 13.9% drop for the quarter. Vulnerable as well, the South African rand fell 13.7% versus the dollar.

Especially late in the quarter, Asian currencies were under heavy selling pressure. Declines for the quarter included the Thai baht's 5.8%, the Indian rupee's 4.8%, the South Korean won's 4.6%, the Taiwanese dollar's 4.5%, the Malaysian dollar's 4.3%, the Indonesian rupiah's 3.9% and the Singapore dollar's 3.7%.

While not garnering much attention, "developing" Europe faced significant currency weakness during the quarter. Losses included the Hungarian forint's 10.0%, the Russian ruble's 8.9%, the Polish zloty's 8.7%, the Czech koruna's 7.5%, the Iceland krona's 6.5%, the Romanian leu's 5.3%, the Bulgarian lev's 5.2%, the Serbian dinar's 5.0% and the Croatian kuna's 4.5%.

In Latin America, the Venezuelan bolivar sank 48.5%, the Mexican peso 8.7%, the Chilean peso 7.7% and the Colombian peso 4.6%.

Headlines capture the dramatic change in market perceptions that unfolded during the pivotal second quarter. From Morningstar back in mid-April: "ETF Investors Favour Emerging Markets in 2018." And Thursday afternoon from CNBC: "Global stocks see biggest loss of investor cash since the financial crisis."

A quarter that began with the trumpeting of "synchronized global expansion" ended with increasing fears of EM-induced global recession. After beginning the year in speculative melt-up mode, emerging equities fell back to earth in Q2.

Chinese stocks led the rout. The Shanghai Composite sank 10.1% during the quarter. The small cap CSI 500 lost 14.7%, and the CSI Midcap 200 fell 12.5%. China's growth/tech ChiNext index was slammed 15.5%. Hong Kong's Hang Seng financials index dropped 10.7% during the quarter, led by losses from the Chinese securities firms. As for China's two largest banks, Industrial and Commercial Bank of China dropped 12.6% during the quarter and China Construction Bank lost 15.5%. Trouble brewing in Chinese Credit. Unfolding capital flight issue? Losing 1.75% in the final week of the quarter, the Chinese renminbi dropped a notable 5.2% during Q2.

June 29 - Bloomberg (Denise Wee): "Asia junk bond spreads blew out further this week as concerns about Chinese issuers mounted amid a selloff in that nation's shares and currency. Yield premiums on the notes spiked 25.3 bps on Thursday, leaving them poised for a 45.5 bps jump this week, the sharpest in more than five months… Adding to concerns in Asian credit markets this week, people familiar with the matter said that China is slowing approvals for offshore bonds and weighing whether to ban short-dated issuance in dollars."

June 29 - Bloomberg: "Asian high yield dollar bonds are set to post the biggest quarterly loss since 2013, with Chinese companies leading declines, as heavy pipeline of new bond deals and rising defaults dented market confidence. Asian junk bonds are set to post negative returns of about 3.3% in 2Q after a loss of 1.1% in 1Q, making it the worst quarter since 2Q 2013, when returns were negative 4.5%, according to Bloomberg Barclays Asian High-Yield Dollar Bond Index… Eight out of the 10 worst performers this quarter were Chinese firms compared to just three in 1Q."

Japan's Bank Index fell 4.8%, though Japan's Nikkei rallied 4.0% during the period (on yen weakness). The quarter saw equity market losses of 4.9% for South Korea (KOSPI), 4.7% in Singapore, 10.2% in Thailand, 9.2% in Malaysia, 6.3% in Indonesia, 9.9% in Philippines and 18.2% in Vietnam. Not all was red in Asia. India's stocks (SENSEX) gained 7.5%. Stocks gained 7.6% in Australia and 7.5% in New Zealand.

Big bank stock losses were not limited to Asia. There was carnage in Brazil, home to Latin America's largest banks. Banco do Brasil sank 30.2%, Banco Bradesco dropped 30.3% and Itau Unibanco fell 21.4%. Brazil's Ibovespa index sank 14.8% during the quarter (27.3% in U.S. dollars).

Bank losses led European indices on the downside. European Banks (STOXX600) dropped 6.9% during the quarter, increasing y-t-d losses to 12.4%. Interestingly, German banks led on the downside, with Deutsche Bank dropping 41.9% and Commerzbank sinking 34.3%. Other losses included Bankia's 19.6%, ING's 19.6%, ABN Amro's 17.4%, Danske's 17.3%, Credit Agricole's 17.1% and Societe Generale's 16.1%. European and Latin American banks competed during the quarter for largest jumps in Credit default swap prices.

Despite the weak banking sector, developed European equities indices for the most part posted gains for the quarter (supported by currency weakness). Major indexes were up 8.2% in the UK, 3.0% in France, 1.7% in Germany, 0.2% in Spain and 1.5% in Sweden. Italy's MIB index dropped 3.5% during the quarter.

Meanwhile, instability reemerged throughout European bonds markets. After beginning the quarter (and May) at 1.78%, Italian yields spiked to 3.13% in late-May. For the quarter, Italian yields rose 89 bps to 2.67% (2-yr yields up 103bps to 2.64%!). Spain's 10-year yields rose 17 bps and Portugal's 18 bps. Spreads widened significantly versus German bunds. The quarter saw bund yields drop a notable 19 bps to 30 bps. German two-year yields declined six bps to negative seven bps (traded as low as negative 77bps in late-May).

U.S. treasuries saw their share of volatility. Ten-year yields began the quarter at 2.73%, jumped to 3.13% on May 17th, before reversing back down to 2.78% on May 29th - before ending the quarter at 2.86%. The first half of the quarter saw yields respond to a booming U.S. economy, the second half to a bursting EM Bubble and the rising prospect of protectionism afflicting a vulnerable global economy.

Local currency EM bonds were hammered. Ten-year yields rose 393 bps in Turkey (to 16.17%), 214 bps in Brazil (11.62%), 123 bps in Hungary (3.60%), 107 bps in Indonesia (7.69%), 86 bps in South Africa (86 bps), 76 bps in Romania (5.17%), 75 bps in Peru (5.57%), 63 bps in Russia (7.66%), 51 bps in India (7.90%), and 27 bps in Mexico (7.58%). It's worth highlighting a few big moves in dollar-denominated EM bonds. Yields surged 200 bps in Argentina (8.65%), 109 bps in Brazil (5.96%) and 95 bps in Turkey (6.79%).

The surging dollar, fading global growth prospects and trade issues made for an interesting quarter in the commodities. WTI crude surged 14.2%, and NYMEX gasoline gained 8.0%. Meanwhile, the strong dollar pressured the precious metals. Golds fell 5.5%, silver 1.5% and Platinum 8.5%. Copper declined 1.3%. Agriculture commodity prices moved all over. Wheat jumped 10.3%, while corn dropped 9.7%. Soybeans sank 17.8%.

And saving the most intriguing for last, U.S. equities. A Friday Bloomberg headline: "Wall Street Left Reeling as 2018 Upends Almost Every Bet." A long central bank-induced bull market ensured too much "money" swirling around global markets. Crowded Trades were faltering left and right throughout the quarter.

The S&P500 rose a solid but un-noteworthy 2.9% during the quarter. The noteworthy lurked below the surface. The unloved retail stocks (XRT) surged 9.6%. Tiffany gained 34.8%, Macy's 25.9% and Kroger 18.8%. Q2 saw a rather spectacular short squeeze, with the Goldman Sachs Most Short Index gaining 15.0% for the quarter. Notable quarterly gainers included Twitter (50.5%), AMD (49.2%), Under Armour (46.9%), Trip Advisor (36.2%), Chipotle (33.5%), Netflix (32.5%), Tesla (28.9%), and Facebook (21.6%). A big energy sector short squeeze saw Chesapeake Energy gain 73.5%, Ensco 65.4%, Oasis Petroleum 60.1%, Diamond Offshore Drilling 42.3% and Hess 32.1%. The New York Arca Oil index surged 14.3%.

The higher-risk sectors generally outperformed. The Nasdaq Composite jumped 6.3%, the Nasdaq100 7.0% and the Biotechs (BTK) 5.5%. Relatively removed from EM and global trade concerns, broader U.S. equities outperformed. The small cap Russell 2000 jumped 7.4% and the S&P400 Midcaps rose 3.9%. The REITs gained 6.8%. While the unloved surged higher, the darling financial stocks were under moderate pressure. The banks (BKX) declined 2.5% for the quarter, and the NYSE Financials fell 3.1%.

June 29 - Bloomberg (Molly Smith): "Blue-chip corporate bonds are on track to be the worst-performing U.S. asset class this year, and money managers caution that it may be too soon to start looking for bargains… It's not clear how much longer the pain will persist for investment-grade bonds. Issuance is likely to slow down in the second half of the year, cutting into supply, and foreign buyers may be more inclined to buy now as the U.S. dollar appreciates… Investment-grade corporate debt has fallen 3.3% this year through June 28 on a total-return basis, on track for the worst first half of a year since 2013…"

June 29 - Financial Times (Alexandra Scaggs): "Investment-grade US corporate bonds recorded a second negative quarter in the three months to the end of June, marking the first back-to-back losses since the financial crisis, as the Federal Reserve raised interest rates and foreign buyers of corporate bonds retreated in the first half of this year… The spread between yields on corporate credit and comparable Treasuries widened to 130 bps from 90 bps in early February, according to ICE BofAML index data. Spreads widened as the pace of investment-grade bond issuance from US companies remained unexpectedly persistent this year, while rising hedging costs dented demand from non-US investors, previously a major buyer group, compared to 2017… The volume of investment-grade bond issuance in the first half of 2018 was just 5% lower than last year… This has confounded strategists' predictions of declines in issuance of as much as 16%."

Investment-grade bonds (LQD) returned negative 1.14% for the quarter, notably underperforming junk bonds (HYG) that returned positive 1.21%. Interesting to see investment-grade and junk bond spreads diverge. With cracks forming at the global Periphery (EM), flows gravitated to the Core (US) securities markets. This worked to overpower the rise in Treasury yields. The reversal lower in market yields supported U.S. equities generally, which spurred quite a short squeeze at the "Periphery of the Core" (the fringe of U.S. securities). This tended to bolster more fundamentally-challenged U.S. equities, in the process also supporting higher-risk bonds. And as higher beta and the fundamentally challenged began outperforming the S&P500, the Performance Chase was on.

There's nothing like a short squeeze and perceptions of loose corporate Credit to spur speculative fervor. I would urge caution. I view the performance of the investment-grade market as the single most important market indicator for prospective U.S. equities returns. At this point, I would discount the outperformance of "short" stocks, the small caps, the higher beta sectors, big tech and high yield. This week's selling in the banks, brokers and transports portends challenges ahead.

The faltering Chinese and EM Bubbles abruptly altered global market dynamics, catching many players poorly positioned (over their skis in some areas and significantly underweight others). My sense is that many hedge funds suffered a challenging quarter, as their longs generally underperformed the market while their shorts significantly outperformed. This dynamic was instrumental in Q2's short squeeze. De-risking forced cutting back on favorite longs and reducing favorite shorts - with a plethora of Crowded Trades on both sides. Fascinating yes, but none of this is bullish.

The U.S. currency and equities market were beneficiaries of the rapidly deteriorating global backdrop. This market dynamic stoked the booming American economy. I would argue there is a clear downside to bubbling U.S. markets and economic output: For one, the environment emboldens both the Fed and President Trump. The Powel Fed is emboldened to follow through with rate and balance sheet normalization. The President, meanwhile, is emboldened to push through with his aggressive trade and political agenda - prominently with plans for major tariffs and additional tax cuts.

Booming markets ensure imaginations run wild. Importantly, reality began to gain the upper hand during the quarter. The global Bubble faltered. The world is not robust - there are, indeed, fragilities everywhere. EM is a potential disaster. China is increasingly vulnerable. China and Asian debt has become a huge global risk. I worry about Brazil.

And this age of populism and the "strongman" politician actually does matter to the markets. Trump Tariffs. China ready to "punch back." Erdogan to dictate Turkish rate policy? The new Italian government to play hardball with the EU. Immigration becoming a pressing political issue from Washington to Frankfurt. A new leftist President in neighboring Mexico. Well, booming markets were content to disregard the global rise of populism, divisiveness and autocracy. Faltering markets will now amplify these troubling trends. All the makings for savage bear markets.

It was A Decisive Quarter: The world became more divided; the "Atlantic Alliance" became more divided; Europe became more divided; Asia became more divided; and the United States turned only more divided. U.S. stock performance during the quarter should not distract from the ominous storm clouds forming globally - in the markets, economically, socially and geopolitically. Global markets were also more divided, though I would expect Contagion from the Periphery to now make more discernable headway toward the Core.

The Italian challenge to the eurozone

In addition to feeble productivity growth, Italy has a large competitiveness handicap

Martin Wolf



The euro has been a failure. This does not mean it will not endure or that it would be better if it disappeared. The costs of a partial or complete break up are far too great. It means that the single currency has failed to deliver economic stability or a greater sense of a European identity. It has become a source of discord.

The story of Italy is revealing and, given its size, of crucial importance. This is not to blame the euro for the stagnation of Italian productivity and output since it joined the eurozone. These reflect domestic failings. Nevertheless, the fact that Italy is inside the eurozone makes its failings a matter of shared concern. It also destroys the link between politics and power. Not least, it turns what would otherwise have been brief exchange rate crises into long-running macroeconomic disasters.

All of this was predicted. In his excellent EuroTragedy, Princeton University’s Ashoka Mody cites a critique of the 1970 Werner Committee report, the first blueprint for a monetary union, by Nicholas Kaldor, a British economist of Hungarian origin. Kaldor argued there would need to be fiscal transfers. That would require a political union. But the conflicts created by the currency union would fester, making moves towards such a union more difficult. So it has proved: Andreas Kluth wrote in Handelsblatt Global this month: “A common currency was supposed to unite Europeans. Instead, it increasingly divides them.” He is right.

The decision to accept Italy as a founding member of the eurozone was made by former German chancellor Helmut Kohl, over the objections of his own officials and other governments. Prof Mody notes that Italy promised to bring its public debt ratio down from 120 per cent to 60 per cent by 2009. Instead it stabilised, before jumping to 130 per cent, after the eurozone crisis.

Not surprisingly, with this year’s real gross domestic product per head forecast by the IMF to be 8 per cent below its 2007 level and only 4 per cent above where it was in 1997, Italy elected populist parties to power. A combination of establishment and markets promptly neutralised their programme. Spreads vis a vis German Bunds have accordingly stabilised. (See charts.)



This might be a workable solution if a sustained return to prosperity were likely.

Unfortunately, in addition to feeble productivity growth, Italy suffers from a large competitiveness handicap, as shown by a recent IMF paper. This argues that Italy suffered a loss of competitiveness against Germany in excess of 40 per cent between 1995 and 2010.

The two initial problems for Italy, then, were the high level of public debt, which exposed it to financial market panic, and a huge prior loss of external competitiveness. Italy’s external balances are currently in surplus, largely because unemployment is so high. A strong expansion of internal demand is likely to generate unfinanceable external deficits. Northern European taxpayers fear they might have to pay for these. They will surely not do so. 



According to the IMF, “a real depreciation on the order of 10 per cent is estimated to be needed to realign Italy’s current account with fundamentals”. The recommended solution is an “internal devaluation”, via falling nominal wages and higher productivity. But Italy has not had much of either. Employment and investment have been slashed instead, with dire consequences. The fact that inflation has been so low in the eurozone as a whole has made the adjustments more difficult. Asymmetric adjustment is hard.

Outside the eurozone, the relevant adjustments would have occurred, as they did frequently before, through a currency depreciation. Yes, that would have been no long-run solution. But it would surely have been better than the social and political damage that has turned one of the most pro-EU countries into what is now one of the most sceptical. Nor is this over. The politics of Italy might not heal soon, or at all.



Part of the adjustment mechanism built into the currency union is the pro-cyclical impact of monetary policy: real interest rates are higher in countries forced through internal devaluations. The mechanism of adjustment in the eurozone is therefore essentially that of the 19th-century gold standard. Prolonged recessions are a feature, not a bug. They are how competitiveness adjusts to changing circumstances.

Neither a banking union, nor a capital market union, nor national fiscal flexibility can obviate these recessions, without persistent external support. Such mechanisms can only cushion economies against relatively transient changes, or shift losses abroad. Shifts in competitiveness require permanent changes in prices. These, in turn, follow recessions. The more rigid the economies and the bigger the adjustments, the more prolonged or deep the recessions. None of this is news. It was known by critics of the project before it began.



So what is to be done? A weak euro is a part of the answer. So is significantly higher inflation in surplus countries. But the European Central Bank is, for understandable reasons, unable, even under Mario Draghi, to pursue the hyper-aggressive monetary policies needed to generate real overheating in Germany or the Netherlands. Meanwhile, the latter see little reason to help.



Adjustment will always fall mainly on deficit countries. In the absence of sustained fiscal transfers, they have no alternative to reforms aimed at accelerating productivity growth and labour market flexibility. Spain has done that. Is it possible in Italy? If not, the bet on its entry into the eurozone could get worse.

Good fences make good neighbours. A currency of one’s own is a good fence. It is such a pity this was forgotten.

In Germany, Politics Recollects History

By George Friedman

The Despot and the Diplomat

Christopher R. Hill




DENVER – Back in 2005, when I was the United States’ lead negotiator at the six-party talks on North Korea’s nuclear program, I looked at the instructions I received for my first meeting, a Chinese-hosted banquet that included a North Korean delegation. If there was any toasting (not unheard of at Chinese banquets), I was not to join in. Apparently, I was expected to sit there, without touching my glass, glowering with arms folded until everyone else had placed theirs back on the table. Later, when I visited North Korea for the first time, I was instructed not to smile at my hosts. Apparently, I was expected to offer only angry stares.

Donald Trump has obviously modified those instructions. In fact, with his unending praise of Kim Jong-un’s leadership, his clumsy, impromptu salute of one of Kim’s generals, and his endorsement of all things North Korean (especially the potential for beachfront property development), Trump has all but abandoned any pretense that the US promotes a broader set of values. But while Trump may have overshot the mark, the idea that the US delegation should sit with glasses untouched during a toast also strikes the wrong tone.

In September 1995, during the final month of the Bosnian War, the US delegation to peace negotiations, led by Assistant Secretary of State Richard Holbrooke, arrived in Belgrade for talks with Serbia’s dictator, Slobodan Milošević. According to Milošević, he could not compel the Bosnian Serbs to withdraw their heavy weapons and lift the bloody four-year siege of Sarajevo. He asked Holbrooke to meet with the Bosnian Serb leaders, Radovan Karadžić and Ratko Mladić, both of whom were later convicted of committing war crimes. Holbrooke asked where they were. “Over there in that villa,” Milošević replied. “Can I call for them?”

Holbrooke hastily brought our delegation together for a quick parley. “Should we meet them?” he asked me. “And if we do, should I shake their hands?” Thinking about the hundreds of thousands of Sarajevans – the many who had been murdered and those facing starvation as a result of the continuing siege – I replied, “Shake their hands and let’s get this over with and go home.” We did. The siege of Sarajevo was lifted the next day.

Whether shaking a hand helps or not, negotiating while shaking a fist has little record of success. During this year’s Pyeongchang Winter Olympics, Vice President Mike Pence was scheduled to meet with the North Korean delegation. Perhaps to cover his back at home, Pence delivered what were then the usual tough-sounding talking points before the meeting. The North Koreans promptly canceled, as if to ask, What would be the point?

During the period I dealt with the six-party talks, I avoided adding my voice to the anti-North Korean invective. I knew that soon – often every other week – I would have to meet them again, and while a display of moxie might help me in Washington, it would not help at the tip of the spear, where it was my job to negotiate away the North Koreans’ nuclear ambitions. There is a big difference between talking tough on television talk shows and sitting across from the North Koreans. Direct diplomacy is a serious means to a serious end. Posturing from a distance is not part of it.

Sometimes body language is hard to get right. As US ambassador to Iraq, the instructions I received from Washington rarely came with any commensurate sense of responsibility for the outcome. I was told that my job included helping the Iraqi opposition rid themselves of then-Prime Minister Nuri al-Maliki. US officials reveled in their amped-up toughness in Washington meeting rooms, like high school athletes banging on the lockers before a big game. But when they actually came out on the field and met with Maliki, they gave him no reason to believe they wanted anything but the best for him.

I would sit in such meetings watching Maliki glance over at me, wondering why I had previously warned him of diminishing US government patience with his autocratic rule and dire consequences. Meanwhile, the visitors from Washington made points that were so subtle and nuanced that Maliki would have needed a decoding device to comprehend their real meaning.

Any diplomat must be purposeful in a negotiation on behalf of his or her country, which means being clear-eyed about the desired outcome and the best way to achieve it. In Singapore, the issue was the North Korean nuclear weapons program. Nothing else really mattered.

Time will tell whether the North Koreans reciprocate Trump’s professed affection for them.

Kim gave away little, and was probably stunned when, for the first time ever, a US president accepted at face value North Korea’s supposed anxiety about US joint military exercises with South Korea (which the North Koreans know to be defensive in purpose). That was too large a concession, and, one way or another, it will have to be taken back. More broadly, a framework for peace and security that includes all the directly affected parties – South Korea, Japan, Russia, and China – will need to be designed.

Similarly, North Korea’s human rights record, one of the world’s worst, will have to be taken up in the future – perhaps, as I signaled during the six-party talks, as a component of eventual diplomatic relations. But, for now, the North Korean nuclear program must be at the top of any negotiating agenda.

Whether Trump’s approach actually works with North Korea will depend on the diplomacy that follows the Singapore summit. Over to you, Secretary of State Mike Pompeo.


Christopher R. Hill, former US Assistant Secretary of State for East Asia, was US Ambassador to Iraq, South Korea, Macedonia, and Poland, a US special envoy for Kosovo, a negotiator of the Dayton Peace Accords, and the chief US negotiator with North Korea from 2005-2009. He is Chief Advisor to the Chancellor for Global Engagement and Professor of the Practice in Diplomacy at the University of Denver, and the author of Outpost.

Why Home Prices Have Nowhere to Go But Up

Low supply is keeping sales down despite higher rates and builders are in no rush to boost production

By Justin Lahart