Friday, February 28, 2014

The Economic Crisis in Ukraine

With Ukraine being in the news on a daily basis over the past few weeks, I wanted to post a summary of key points about the nation's economy, particularly since very few of us have any deep knowledge of the country.

Ukraine has a population of 45.59 million people (2012) and is considered a lower middle income nation by the World Bank.  The nation is composed of two main ethnic groups; Russians who comprise around 17 percent of the population and Ukrainians who comprise 78 percent of the population.  Life expectancy at birth is 71 years, up slightly from 68 in 2004.

Economic growth has been a problem for Ukraine, particularly since the Great Recession.  Here is a graph showing GDP in billions of current United States dollars:

Between 2004 and 2009, Ukraine's economy grew by between 2 and 12 percent.  When the Great Recession hit, the economy shrank by 15 percent in 2009, rising 4 percent in 2010 and 5 percent in 2011.  Unfortunately, 2012 saw growth of only 0.2 percent, a scenario that continued in 2013 as shown on this graph:

The World Bank projects economic growth of 2.0 percent in 2014, 1.0 percent in 2015 and 0.7 percent in 2016.  

Ukraine's current account balance is in very poor shape.  Current account balance is defined as the difference between what a country has in savings and what it invests.  It is the sums of the value of imported goods and services plus net returns on investments held abroad minus the value of exports of goods and services.  When a current account balance is negative, it means that nation has more of its economy financed by foreign nations and investors.  Here is a graph showing the trend in Ukraine's current account balance compared to its European and Central Asian peers:

Ukraine's current account balance as a percentage of GDP fell from -2.2 percent in 2010 to -8.4 percent in 2012, rising very slightly to -8.1 percent in 2013.

According to the CIA World Factbook, Ukraine has one of the world's largest current account deficits when measured in dollar terms, coming in 181st place in a 193 nation ranking with an estimated deficit of $11.92 billion in 2013.  Which nation has the world's largest current account deficit?  The United States with a deficit of $360.7 billion in 2013 although, on the upside, it is a rather small percentage of GDP, coming it at around -2.2 percent in the third quarter of 2013.

Now, let's look at Ukraine's debt.  Here is a graph showing what has happened to Ukraine's government debt-to-GDP since 2000:

Fitch estimates that Ukraine's debt-to-GDP could be around 48 percent by the end of 2014 due to the growing government deficit, weak economic growth and the devaluation of the hyrvnia.  According to the Ukraine News Agency, data from the nation's central bank shows that Ukraine's total state debt grew by 13 percent or $8.434 billion in 2013 to $73.078 billion with growth of $4.247 billion in December 2013 alone.  In 2014, Ukraine will have to repay $8.2 billion on the foreign state debt which exceeds one-third of the National Bank's reserves.  Foreign reserves held by Ukraine's central bank dropped by 16.9 percent or $4.1 billion in 2013 and an additional 12.8 percent in the month of January 2014 alone.  As a result, Fitch has lowered Ukrainian debt to a pre-default level of CCC.

Now, let's focus on the portion of Ukraine's debt that is owed to the World Bank.  Here is a graph showing the size of the World Bank's International Bank for Reconstruction and Development (IBRD) loans to Ukraine:

Of the total of nearly $5.807 billion in loans, $4.454 billion has been disbursed and $903 million has not been disbursed.  Over the past two decades, loans were made for a wide variety of projects including housing, water projection, hydropower rehabilitation, urban infrastructure and road improvements.  A substantial number of the loans mature in 2014, fortunately most of the loans have an interest rate that is well under 1 percent with many of them being interest-free as shown on this chart:

Ukraine's total current obligation to the World Bank is $3.314 billion.  Many of these loans are in U.S. dollars which will make it more difficult for Ukraine to pay back since its currency has plunged in value as shown here:

Ukraine is just in the initial phase of its economic crisis which has been brought to the forefront now that the nation is in geopolitical no-man's-land.  Once again, it looks like the IMF will force itself into the fray, bailing out yet another debtor nation in a desperate attempt to stave off another world economic crisis just like they did for Greece.

Thursday, February 27, 2014

The Impact of QE on Economic Growth

brief study by economists at the Federal Reserve Board of San Francisco looks at the stimulatory effects of QE (or large scale asset purchases) on the U.S. economy.  Here are some of the salient points.

The authors, economists Vasco Curdia and Andrea Ferrero, look at the impact of QE2, the second stage of the Fed's grand experiment, announced in November 2010.  In this stage, the Fed was set to purchase $600 billion of long-term Treasuries in an attempt to push long-term interest rates down, push up inflation to avoid deflationary pressures and boost economic growth.  The authors note that the forward guidance offered by the Fed was key to the program's success.

Here's how successful QE 2 was:

Real GDP growth increased by 0.13 percentage point in late 2010
Inflation increased by 0.03 percentage point

Without forward guidance, QE2 would only have added 0.04 percentage point to GDP growth and 0.02 percentage point to inflation.

Here is a graph showing the change in real GDP growth related to QE and how the impact of large scale asset purchases declines over time to zero:

Here is a graph showing the change in inflation related to QE and how the impact of the asset purchases declines over time:

Please note that the grey bands around the red lines on both graphs show the 50, 70 and 90 percent probability and that the red line shows the median.  In the case of GDP growth, you can see that within four quarters, the impact of QE is essentially zero.

The authors note that a standard 0.25 percentage point cut in the federal funds rate would have a far greater impact on the economy as shown here:

Rather than increasing GDP by 0.13 percentage points in the case of QE, a 0.25 percentage point cut in interest rates would increase GDP by 0.26 percent, twice the impact with far less uncertainty as to the outcome.  Unfortunately, the Fed has backed itself into an interest rate corner from which there is only a painful means of escape.

The authors conclude by noting that asset purchase programs like QE2 have "at best, moderate effects on economic growth and inflation".  They go on to note that if the Fed hopes to be successful with its tapering program, it needs to ensure that it continues its policy of forward guidance.

After reading through this research, one has to wonder if the $3 trillion plus, unprecedented monetary experiment was worth it given the risks involved?

Tuesday, February 25, 2014

Bitcoin - It's All in the Head and Shoulders

Updated March 9, 2014

In light of the MtGox exchange debacle, the price pattern of Bitcoin got me thinking.  I recall having an analyst explain the concept of a "head and shoulders" stock chart pattern for me on a stock that I held that explained why the stock price was unlikely to rise to its previous high.

For those of you that aren't familiar with the concept, here is a very basic explanation from Investopedia:

A head a shoulders pattern is one where the price of a share:

"1. Rises to a peak and subsequently declines.

2. Then, the price rises above the former peak and again declines.

3. And finally, rises again, but not to the second peak, and declines once more.

The first and third peaks are shoulders, and the second peak forms the head."

This is what a head and shoulders pattern looks like:

This pattern is considered to be one of the most reliable trend-reversal indicators.  The downward pattern is made up of a period of falling peaks and troughs, indicating a weakening price trend when compared to the head.  Price is most likely to continue to decline once the price breaks below the neckline of the pattern.

Now, here is a chart showing the trading price of a Bitcoin in U.S. dollars between  November 1, 2013 and January 1, 2014 from Bitstamp, one of the world's largest Bitcoin exchanges based in Slovenia:

While the shoulder on the rising portion of the chart (the left shoulder) is rather narrow and not as pronounced as in the example given above, the presence of a prior uptrend is one of the key parts of a head and shoulders pattern.  As well, the volume on the left shoulder is generally higher than the volume when the head is formed, another signal.  Trading volume then increases during the price decline with several days of very high volume in early- and mid-December 2013.  The right shoulder forms between December 7th and 17th.  It is rather difficult to draw a line that forms the neck, however, it is somewhere between $700 and $800.

Here is a graph showing the trading price of a Bitcoin from November 2013 to the present:

This last Bitcoin chart looks very similar to this chart showing the price of Goldman Sachs during 2011, with the exception being Bitcoin's narrow left shoulder:

Using a head and shoulders pattern, one can predict the price decline by measuring the distance between the neck and the top of the head.  This distance is then subtracted from the neckline to give us the target price.  If the head measures at $1140 and the neck measures at $750, the distance is $390.  If this is subtracted from the neck at $750, the target price is then $360, about $250 lower than its current level.  As you may have noticed on the chart for Goldman Sachs, the price dropped substantially lower than the target.

The head and shoulders reversal pattern can take many months to complete.  When a stock breaks below the neckline, there is no longer any support and very rapid price declines can occur, often with an increase in volume as we are currently seeing for Bitcoin.

Only time will tell us whether Bitcoin is following a typical head and shoulders pattern or whether the recent price decline will reverse itself.

Consumers and the Health of the American Economy

As shown on this graph, consumer spending is a key part of the economy in the United States today, making up just under 69 percent of GDP:

According to the University of Michigan Consumer Sentiment index, consumers are a happier bunch than they were during the depths of the Great Recession as shown here:

Unfortunately, as you can quickly deduce, consumer sentiment is still well below levels seen during the recoveries after the 1980 - 1981, 1991 and 2001 recessions.

Here's a graph that shows the growth in real consumer spending since the beginning of the Great Recession in December 2007:

Note that real consumer spending fell to $9.843 trillion in 2009 but has risen by 9 percent to its current level of $10.728 trillion, a new high.

What doesn't look as healthy is the growth rate of consumer spending.  Here is a graph that shows the compounded annual growth rate in consumer spending all the way back to 1929:

Including all recessions (and the Great Depression as well), over the 95 years in the data base, consumer spending rose by an compounded average rate of 2.81 percent.  Please keep in mind that this includes the four years between 1930 and 1933 when consumer spending shrank by between 2.2 percent and 9.0 percent annually.

Here is a detailed look at the annual growth rate of consumer spending since 2007:

2007 - 2.2 percent
2008 - minus 0.4 percent
2009 - minus 1.6 percent
2010 - 2.0 percent
2011 - 2.5 percent
2012 - 2.2 percent
2013 - 2.0 percent

Last year's growth rate of 2.0 percent was the lowest level of growth in consumer spending since 1982, excluding the recession in 1991 when consumer spending still rose by 0.2 percent in spite of the economic contraction.  From the graph, you can easily note that, when measured using the annual growth rate of real consumer spending, this is one of the most modest recoveries in the past century.

Just in case you thought that consumers were being more prudent and taking on less debt, here is a graphic showing the fourth quarter 2013 household debt figures from the Federal Reserve Bank of New York:

Non-housing debt in the fourth quarter of 2013 rose by 3.3 percent from the previous quarter with gains of $18 billion in auto loans and $11 billion in credit card debt.  On a year-over-year basis, auto loan debt rose by $80 billion to $863 billion and credit card debt rose by $4 billion to $683 billion.  It certainly appears that consumers are not particularly adverse to taking on additional debt and that the spectre of debt isn't keeping at least some consumers from spending.

While the headlines suggest that the American economy is on the mend, with so much of economic growth relying on consumers, the rather modest growth in consumer spending compared to historical inter-recessional periods would suggest that economic growth will continue to be less than stellar and may go a long way to explaining why this recovery hasn't really seemed like the recoveries that we all remember so fondly.

Mutual Fund Equity Flows - Are They Telling Us Something?

Interesting data from the Investment Company Institute gives us a sense of where America's retail investors are expecting the stock market to head.  The weekly cash flow data are estimates that covers 95 percent of the investment industry totals and the monthly flow data are actual cash flow numbers reported by the mutual fund industry.

Here is a graph showing the monthly net new cash flow for all equity funds (both domestic and world equities) since January 2007 before the Great Recession really took hold and gave equity investors a good shake:

It's quite easy to see how retail equity investors viewed the markets over the time period between 2007 and the end of 2013.  You can see massive net withdrawals during mid-2008 with net withdrawals of $70 billion in October 2009 and $50 billion in September 2008 as it looked like the market would never stop dropping.  There were also substantial withdrawals from June to December 2011 as the Eurozone crisis wound up and it looked like Spain, Italy, Greece and other debt transgressors could default and that the crisis could impact North America's economy.

What I do find interesting is the net increase in cash flow into equity funds over the past year.  Between January 2013 and December 2013, investors pumped $160.9 billion more into equity funds than they withdrew and invested a further $28.9 billion over the four weeks between the beginning of January and mid-February 2014 for a net total increase of nearly $190 billion.  This is by far the longest period of net positive cash flow into mutual funds since the beginning of 2007.

All of this makes me wonder if the "late converts" to the apparent strength of the stock market aren't tossing in their hard-earned cash trying to play catchup.

As shown on this chart, going back to 1932, the median bull market has lasted 60 months or five years with a range of between 14 months and 148 months:

The most recent bull market which began on March 9, 2009 according to Forbes, is just about to celebrate its fifth anniversary.  One has to wonder if all of the last-minute converts aren't now dumping billions of dollars into what could be a losing proposition, yet again, proving P.T. Barnum correct.  For those of us that are contrarians, the evidence is already in thanks to ICI's mutual fund flow data.