Dissecting the Volkswagen scandal

The Volkswagen scandal is a very interesting story.

The scandal was uncovered by an independent study that was just looking at the Volkswagen emissions. It was not at all trying to debunk the clean diesel story that Volkswagen had sold. However, through the process, it discovered that in a real life drive scenario, the diesel Volkswagen vehicle emissions was a lot higher than the emissions from the regulator run tests. The EPA caught wind of the research and did a deep dive into it. The EPA discovered eventually that Volkswagen had manipulated their software so that emissions would be reduced in the test situation.

What was done was cheating at the highest level. It means that diesel is not as clean as it was sold. Some may say “What is the big deal, the car still works.”

But the consequences of cheating are always huge. It is like a spouse being caught on Ashley Madison. These are some of the consequences that I can see that stem out of the scandal

1)   The amount of the fines imposed by regulators is unknown but is likely to be massive. This will not only be from the US where it was discovered but also all the other jurisdictions where Volkswagen has cheated in.

2)   The scandal kills the brand of German engineering that has been built on quality. It will take years to rebuild the brand.

3)   Customers that have bought the product are unhappy because the resale value is lower.

4)   Although management has said that they had no idea and the deceit was from a few engineers. This is considered an incredulous story and it is likely that the culture of deceit is pervasive in the company. To change the culture will be a mammoth task by itself.

5)   The fact that diesel is not as clean as sold will fundamentally change the auto industry. This scandal questions the test outcomes of the other diesel cars in the industry. If clean air is the direction that governments support despite the cost, then diesel cars are going to be the death route for car companies.

The size of the scandal is larger than most of us realise given the fragile situation of the Eurozone.  It is large enough for the German government to step in and even the Eurozone head Jeroen Dijsselbloem to comment on it.

The German economic minister has met Elon Musk. The tampering of emissions data shows that diesel technology is limited and showcases why Tesla as a company is so valuable.

Volkswagen Scandal shows that there is a myth with blue chip stocks- that it is stable investing. The current age of technology means that huge companies can easily lose their edge if they do not work hard at innovating and when their only motivation is profit.

Fundamentals vs Markets

The recent developments around the US economy has been interesting.
In the past year, the US economy seemed to have a fairly steady run with things that seemed to be getting back into shape. Then the Sep US job numbers was bad- 142k created compared to the expected 200k. The numbers were lower than expected across all sectors and not surprising jobs dropped off in mining and manufacturing.
On top of that, there were downward revisions to the Jul and Aug numbers.

This all does not bode well for the global environment where the US is the only marginally bright spot. It also makes decision making difficult for the Fed as they prepare to start what possibly the loosest tightening in recent history. The obvious is that the chances for an Oct rise have been reduced.

The US markets reacted first by dropping by about 200 points and then ended with a slight rally. Following that all markets in the world rallied on Monday.
Ultimately, the global markets became "happy happy" on the possibility of a delay in interest rate raises giving risk assets another leg up.

This is a very dangerous symptom. The Fed numbers should have raised alarm bells on markets. However, the rally reaction only shows again that the markets are still fuelled and dependent on cheap money instead of moving based off fundamentals (poor numbers).

I am not a pessimist by any means. But watching Carl Icahn "Danger ahead" video, I am incline to agree that the future is bleak.

We are in a situation where fundamentals and the markets have a real gap. At some stage, reality will bite.

The question is when and how deep.

The Chinese problem

The stock market rallied 5.3% today with current talk that the government intervened. Chinese also apparently cut its holdings of US treasuries to raise dollars needed to support the Yuan.

The Chinese cannot decide what they want or rather they cannot let go. They want a matured economy but are too frightened to let the markets decide. This makes them seem erratic and indecisive. None of those qualities are investor trustworthy.

What the Chinese don’t seem to understand or value is that trust is inherent in a market. Once a market loses trust in a system, there will be no way to get it back. This is a fundamental of human life.

None of the damage they have done is irreversible and the implications are yet to be fully realised.

Is a global recession on the cards?

The Shanghai Index ended down about 7.6% today while the European market and US futures are showing a rebound.

The view of most economists is the market is oversold and the economic fundamentals are not as bad as the magnitude of the selloff. This plunge will allow valuations to return to fundamentals.

Most economists seem to be looking mainly at the US market where the fundamentals are moderately strong. The numbers have been consistently getting better and corporate America has strong balance sheets.

When we look at the Global economy, the story looks quite different. For many OECD countries, house price to income ratios remain above historical averages. The initial rout we see in the current stock market has not hit the more illiquid asset classes like property. If all asset prices fall, the wealth effect from inflated assets will fade. This can lead to a further reduction in demand and a recessionary cycle.

The other issue is that central bank tools may no longer be as effective in revert a crisis. Interest rates are at historical lows and in some cases in Europe even negative. This form of government intervention has helped in artificially elevating asset prices but not done much for the real economy. Fiscal policy requires financial muscle and the deficits in many countries refrained the governments there from using those tools. Central banks do not have many more tools left on hand to contain a fallout. Thus, making a Global recession more likely.

The China slowdown story is one that everyone is familiar with. So one may ask how can the slowdown cause a global recession. In the last financial crisis, America was falling apart but it had China to help pull global grow along. Today, global growth is faltering, China GDP levels have fallen to around 7% with further drops expected. If a massive slowdown occurs, America is unlikely to have enough traction to be able to move the Global economy along. Although at best in a global recession, it may not be as heavily affected.

In many markets, housing prices are still red hot. Economic cycles can take a long time to develop. We will see in time if the current stock market rout is just a mere dip or more. 

Why stay in the USD in the current market?

The USD will strengthen even though it is currently at its highest point in years. Currencies are all about comparative advantage.

These are 4 comparables that make the USD attractive.

1)   China instability leading to world instability

The Yuan devaluation starting on Aug 11 was not large. It was China’s way of playing with another form of monetary policy following poor export numbers the week before. However, this was followed by shock waves in the currency and stock markets indicating that the world no longer believes in China as the locomotive of global growth.

2) Reduced revenues for commodity dependent countries

For months commodities have been dropping like a falling knife reflecting falling global demand. The falling commodity prices will mean a drop in revenues from commodities for resource-exporting countries, which will in turn lead to further pain for economies.

3)   Euro zone issues

While the last Euro PMI number was positive, reiterating the strength in German manufacturing, the France manufacturing PMI fell from 49.6 to 48.6.

The Euro zone has plenty of complicated issues that include the Russia Ukraine conflict, thousands of migrants flooding in, the Greece economy issue and the ISIS problem in their backdoor causing anti-Islam sentiment.

4)   Japan stagnation

Japan has been in a deflationary cycle since the 1990s and has been unable to break out of it even with fiscal and monetary policies. The Abenomics has not shown signs of success.

While the markets have reflected some of the above instability, the severity of these issues is yet to be fully realised.

US economy vs Global economy

As you can see from above, the global slowdown is happening. The US economy is strengthening but it is not strong enough to drive the other global economies as an engine of growth. It is also not immune from the global economy as seen from the Q2 2015 US company earnings where most have reflected a China slowdown. However, it is showing more strength compared with other economies.

The 2008 economic crisis forced the US to go through a painful economic restructure to return to fundamentals. The current asset levels in the US are only currently going back to pre-crisis levels.

As a result, US asset valuations are closer to fundamentals compared with the assets of the other economies that have shot up due to easy monetary policies (a good example is the housing prices in the US compared with the rest of the world.) Hence, a global crisis is less likely to cause as much pain to it than the rest of the world.

A lot of people are looking to the US Fed to gauge USD strength with the opinion that the central back may not hike in Sep due to the current stock market.

However, the rate hike is no longer as relevant to USD weakness or strength if the panic of the stock market continues. In situations of panic, people will revert back to the currency of the last resort- cash or gold. In this case, cash will be the core currencies, which are usually JPY, EUR, GBP, USD and of which the USD is the strongest.

Even if the stock panic stops, the fundamentals still show that the US economy is currently the strongest economy and the currency will reflect that.

The stock market panic will only serve to quicken its pace.

The economy

The recent economic events is my motivation to start this blog 24th Aug 2015.
This comes 2 weeks after the Yuan devaluation on the 11th of Aug and possibly a bit late given the plunge of the stock market in the last 2 weeks.
Regardless, I am starting it now because I believe the worse is yet to come and we live in interesting times.
It's my way of tracking my analysis about events and time.
Please give me feedback as you wish, it is always interesting to hear these things.