Is the Baltic Dry Canary telling us something?

The US economy continues to grow at a cracking pace, or so we are told again and again. Unemployment is down to record lows, and the stock market is back to record highs. Corporate profits are at record highs, and the (US) economy grew at 4.2% in the second quarter of 2018. Europe continues to grow, at least that is the message, Brexit or not. Not one month ago, the Baltic Exchange Dry Index (BDIY), a key measure of the cost of transport and a bellwether of international trade volumes, was at an annual high of $1774.

Is there anything to suggest that all is not well?

Officially, all is good in Economy-Land. Unless you are in the Emerging Markets (EM) where all is going to hell in a handcart. And if you do watch the BDIY as I suggested last month, you may have reason to worry.

https://www.bloomberg.com/quote/BDIY:IND

Years of Growth Ahead?

Some time ago (18 August 2017) I asked if the collapse of the employment participation rate during and after the Great Recession of 2008 had actually set the US up for years of economic growth as ejected labour re-entered the market, creating a multi-year pool of “new” labor. Was the unemployment rate artificially low due to the definitions used to define “unemployed”, and was there, in fact, a giant pool of untapped labour just waiting to be absorbed?

Certainly, European economies have had a chronic underemployment problem for the past twenty years, so there should be no shortage of labour, unless your production is in Germany (a problem that was supposed to be solved through the importation of millions of ‘refugee’ migrants to provide the new working underclass). 

Or black Swans a swimming?

Or, as I pointed out last month (6 August 2018) are there too many Black Swans flocking, ready for the first to set off a global contagion? Some are pointing to the ongoing EM route and collapse of so many international currencies (Turkish Lira, Argentine Peso to name two) as the “Black Swan de jour” that may cause contagion in developed markets. Are the US markets being kept artificially buoyant with cash fleeing EM countries? 

Or, are tariffs actually beginning to impact? Or, the EM route simply an indicator of the level of international uncertainty, with tariffs being one re-enforcing element?

If tariffs and the EM markets are all part of the same flock of Black Swans, then we should be able to see the rot in international trade. 

On the 6th of August I wrote:

"We need to keep watching indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDIY."

And so I have been watching the Baltic Dry Index, and it has not been pretty. In the month since I wrote the above, the BDIY has fallen from an annual high of $1774 down to $1477 today (6 September 2018), representing a 16% fall in that month.

As a reminder, the BDIY is a measure of the cost of freight, and as such is an indicator of volumes of international trade in terms of shipping. It is reasonable to expect the BDIY to rise and fall over time due to total shipping capacity, with fleets expanding too quickly for anticipated growth in trade resulting in a slowly lowering BDIY, and fleets falling as uneconomic ships are retired from the fleets and scrapped resulting a slowly gaining BDIY. But that is for the long-term trend line only.

What we have seen this year is the BDIY increase significantly in the second quarter, just as tariffs were being mooted, but before they were actually brought into force. As I speculated in early August, the robust second-quarter GDP print could have been a factor of forward-purchasing and inventory padding to ride-out any transitory tariff impact. If that were the case, I suggested that we would see a fall in trade volumes in the third quarter, with the BDIY providing an early warning sign of such a fall in trade.

We are now seeing that fall, and while one month and a 16% fall could be a transitory fluctuation, it could also be an indicator that trade volumes are being hit, and we should expect a must worse third quarter GDP print.

If the BDIY continues to fall, it will be the clearest sign yet that the tariffs are biting, and that trade volumes are indeed falling.

Even as the BDIY was increasing through July, the Netherlands Bureau for Economic Policy Analysis was reporting that global trade volumes fell in June (I await the July figures).

As I said in early August, I will continue to watch the BDIY, as this may be one of our best canaries in the global trade coal mine.

Flocking Black Swans

Thinking and talking about "Black Swans" as unexpected or unforeseen market or economic events has become almost blase, yet the use of the term in this context is quite new, dating to Taleb's analysis of the 2008 financial crisis. Now almost anything that we don't (or didn't) see coming is a "Black Swan".

How many of these Black Swans are actually unforeseen? How many are simply emerging risks that have come to fruition? Should we really be unprepared for these events?

Right now, without even adding meteors or pandemics, I can list a series of potential Black Swans, any of which could have a serious impact on the global economy. These range from Tariffs/Trade War to Brexit induced recessions in the UK and Europe, to Emerging Market credit crises or Chinese economic woes. It reminds me, again, of one of my favourite phrases: "It is easy to predict the future; getting the dates right it the difficult part".

And so the question; When? Some of these Black Swans could be brewing now, and may already have caused the underlying damage that will only be apparent with hindsight. Others may eventuate at any time. 

Flocks

When considering Black Swans, the most important difference between "reality" and the concept is that Black Swans, the birds, stand out because they tend to be a solitary, and are not intermingled in flocks of White Swans. 

Swans, while solitary, do pair and can be seen in bevies, eyrars, or even gargles or herds, especially on the River Thames, where all "mute" or unmarked swans are property of the Queen (Act of Swans, 1482). Each year the Upping of the Swans takes place in the third week of July, when over a section of the Themes, all swans are caught, inspected, given a health check, and then released. 

All this to say that we think of Black Swans (back to the the economic events) as singular events, when in reality they cluster, or to use some of the collective nouns for swans, there could be a "bank of (black) swans", or even a "whiteness of (black) swans". The initiating event may not even be readily apparent during the period of crisis. 

Contagion

So which was the primary cause of the Global Financial Crisis: the collapse in values due to the MBS/CDO sub-prime collapse, or the resulting impact of Mark-to-Market and resulting impact on the capital value of financial institutions? It could be argued, and was, that as financial institutions typically match their assets to their liabilities from a duration perspective, they were holding securities that were to be held to maturity, and therefore there was not financial impact unless they were required to sell their bond holdings.

The point is that any of a number of Black Swans may arrive concurrently or with only a few months between. Some will create the conditions that bring about additional crisis.

So to timing

As mentioned above, it is quite possible that some of our Black Swans have already inflicted the damage, and we are simply waiting for the evidence to come through - the evidence that may push some other situations over the edge.

The Trade War, Emerging Market debt, and the Chinese Economy are good examples of potential contagion. 

The recent +4.1% GDP change print for the US is being presented as a great result, but is it a reflection of underlying economic strength, or a reaction to threats of higher costs from tariffs? I do not know the answer, and we will only know with certainly at the next GDP print in October, just in time for the mid-terms.

One thing we do know is that the tariffs and global uncertainty aremdriving the value of the US$ higher, imposing additional costs on Emerging Markets while also suppressing US exports. This is supporting an expansion of the US trade deficit, and is hitting Emerging Market bonds with significantly higher costs.

So if, and it remains a big "if", the GDP print this past quarter is a reflection of anticipation of the impact of tariff and a Trade War, then we will know for certain in three months. But the damage will already be done, and the US economy may well have flipped into recession by then.

Equally, the Trade War may drive another potential Black Swan; an Emerging Markets financial crisis. Certainly that crisis may arrive all by itself, with an end-of-credit-cycle unwinding of EM opportunities as US, UK and EU treasuries are forced to pay higher yields, and a consequent "flight to safety".

Mixed in with all of this, there is the potential Black Swan of a serious credit squeeze in China, resulting in another huge stimulus program, and a potential draw-down of US treasuries to pay for the stimulus. When Russia sold almost $50 billion in US treasuries earlier in 2018, US 10-year rates jumped to 3.1% from a around 2.9%. What would be the impact of a $100 or $200 sale of US treasuries by China as part of a stimulus programme?

Let's guess at timing

We need to keep watching  indicators from around the world, and look for specific activities. The Baltic Dry Index provides a good indicator for us to watch. In the past moths, the Index has risen from $1250 to over $1700 now. The Baltic Dry Index provides a reliable surrogate for global trade volatility, with higher trade volumes increasing the cost of freight, and falling freight volumes driving down the BDI. 

It is also is a close to real-time indicator, with pricing of freight being highly sensitive to the actual trade volumes and projected volumes. 

I will be watching that over the next three months, looking to see if the Index remains high, or if as I suspect, pre-tariff activity will taper off, and we will see the Index fall.