May 14, 2012

Goldⁱ and silver continued moving lower this morning as risk aversion remains the preeminent consensus among market participants. Political uncertainty in Greece has triggered large equity losses and has driven yields on “safe haven” bonds lower. Slowing growth in China, subsequently falling commodity prices, and low risk tolerance have sustained commodity currencyⁱ (i.e. Australian, Canadian, New Zealand, etc.) losses against the U.S. dollar.

With recent elections in Greece failing to provide any single party a majority, the various parties in the Greek parliament have been ineffectually pursuing a coalition government. Syriza, Greece’s largest anti-bailout party has consistently refused to join any coalition backing the bailouts saying:

“We are being asked to agree to the destruction of Greek society.”

The Greek President Karolos Papoulias has passed the mandate to broker the terms of a coalition government from one unsuccessful party leader to the next. The following quote from this Bloomberg article references the latest mandate provided to Syriza’s party leader Alexis Tsipras:

Tsipras failed to reach an accord with other leaders after giving them an ultimatum to renounce support for the EU-led rescue in order to enter the government. Both Antonis Samaras, the leader of New Democracy, and Venizelos rejected the request. Samaras, whose party finished first, gave up trying to forge a coalition after six hours of talks on May 7.

Antonis Samaras and his New Democracy party were the first to be provided the mandate for creating a coalition government. Per the excerpt, Samaras returned this mandate to the Greek President after only six hours (of a three day mandate). This move provides disconcerting insight into the contentious nature of the situation. If the leader of the most powerful party relinquished a three day mandate in only six hours, it seems highly unlikely that the ongoin Greek political drama will be amicably resolved.

More than likely, Greeks will have to head back to the voting booths for a new election; an election which polls show would favor the Syriza party as the main benefactor. While it is highly unlikely that Syriza will win an outright majority, a better showing by the anti-bailout parties could create dramatic implications for Greece’s adherence to bailout-mandated austerity measures.

German Finance Minister Wolfgang Schaeuble was quoted saying: "If the Greeks have an idea of what we could do, in addition, to promote growth, we can always talk and think about this," Schaeuble was quoted as saying. "But ultimately it is about making Greece competitive again, allowing the economy to grow and opening the path to the financial markets again. That requires the agreed, fundamental reforms being carried out, otherwise the country has no prospects."

As can be seen by Schaeuble’s statement, Germany is open to Greek suggestions on the growth front but will probably be unaccommodating should Greece request a renegotiation of bailout terms. With it being estimated that Greece will run out of cash in early July, the remittance of bailout payments is imperative to continued Greek solvency. Whether or not Greece can convince its paymasters that it is committed to austerity, amidst new elections, will be the major question going forward.

On the commodities front, prices continue to come under pressure as the twin concerns – the European debt crisis and the Chinese slowdown - continue to weigh on the asset class. The Standard and Poor’s GSCI Spot Index of 24 raw materials has lost 6.5% in the eight trading days through May 11th. This represents the longest consecutive move lower since December 2008.

Driving this trend is consistently disappointing emerging market economic data, as referenced by the Bloomberg article linked above: China’s industrial output expanded 9.3 percent in April, the slowest pace since 2009 and missing analysts’ forecasts for growth of 12.2 percent, government data showed May 11. Production at Indian factories, utilities and mines unexpectedly declined 3.5 percent from a year earlier, the Central Statistical Office said May 11. The median of 32 estimates in a Bloomberg survey was for a 1.7 percent gain.

In response to lackluster data, Chinese policy makers cut bank reserve requirements by 50 basis points (0.5%) for the third time in six months. This measure is anticipated to release some $60 billion in bank capital back into the Chinese economy. China’s reactionary measures have failed to elicit a significant market response. Commodities, especially oil, and commodity currencies are broadly lower this morning in a continuation of the risk aversion that has driven them lower in recent weeks. It seems that markets want more substantive policy action from China before commodity prices will be bid higher in the short-term.

Contrary to previous statements about empowering Chinese consumers and stimulating domestic demand, Chinese policy makers have refrained from interest rate hikes or allowing significant Yuan appreciation. By simply reducing bank reserve requirements, China may be unable to reverseⁱ the entrenched deceleration currently being experienced by its economy. Additionally, by eroding bank capital reserves, Chinese leaders could be effectively increasing the chances of a confidence crisis should non-performing loans jump as a percentage of bank balance sheets.

With property sales slowing, and valuations dropping, the likelihood of growth in non-performing loans continues to rise. With slowing economic expansion, municipal tax receipts continue to fall; this creates an environment ripe for funding pressure as state-owned financing vehicles have an increasingly hard time servicing and refinancing existing loans.

Should Chinese policy makers hike interest rates, it would create an environment even more precarious for municipal borrowers (not to mention the downward pressure such action would apply to property prices). As such, China will probably not adopt this type of tightening measure in the short-term. However, by avoiding such policy measures China is on a path diametrically opposed to where the regime claims it wants to be (i.e. stimulating domestic demand).

While China’s core inflation rate has moderated to 3.4%, food inflation continues to provide cause for concern. With March’s food prices 7% higher than a year before, and food expenditures commandeering over 30% of the average Chinese consumer’s budget (as reported by the UN Food and Agriculture Organization), social disenchantment could foster popular backlash against China’s static interest rates. Without more substantive Yuan appreciation, Chinese consumers will continue to be pressured by rising food prices and the overall cost of living.

All things considered, it seems the trend of weakening commodities and risk assets has some traction and could remain with us for the foreseeable future. How long remains to be seen but will be inextricably tied to monetary policy in the U.S. Should Bernanke decide there is sufficient downside risk facing the U.S. economy, further economic stimulus or QE could precipitate a spike in commodity prices and risk assets going forward.

Alex Canahuate