European Bonds – warning knell or cause for celebration?

European Bonds – warning knell or cause for celebration?


Macro Letter – No 85 – 13-10-2017

European Bonds – warning knell or cause for celebration?

  • Greek bonds have been the best performer in the Eurozone year to date
  • IMF austerity is still in place but there are hopes they will relent
  • Portuguese bonds have also rallied since March whilst Spanish Bonos declined
  • German Bund yields are up 28bps since January heralding an end to ECB QE

Writing, as government bond yields for peripheral European markets peaked in Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? I felt that another Eurozone crisis could not be ruled out:-

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016.

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Greece vs Germany 10yr yield 2017

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Bond_yields_Jan_vs_October_2017 (1)


This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

Where now for European bonds?

A good place to start when attempted to divine where the European bond markets may be heading is by considering the outcome of the German election. Wolfgang Bauer of M&G Bond Vigilantes – Angela Merkel’s Pyrrhic victory – writing at the end of last month, prior to the Catalan vote, takes up the story:-

Populism is back with a vengeance

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

European Unemployment - BNP Paribas

Source: BNP Paribas Asset Management, Datastream

The rate of economic expansion in European is increasing and measures of the popularity of the Eurozone look robust. Nathalie Benatia of BNP Paribas – Yes, Europe is indeed back puts it like this:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

EZ survey July 2017

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-



Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.


Japan – Politics, Central Banking and the Nikkei 225


Macro Letter – No 84 – 29-09-2017

Japan – Politics, Central Banking and the Nikkei 225

  • PM Abe called a snap general election for October, amid rising geopolitical tensions
  • The BoJ maintain QQE despite Federal Reserve plans to reduce its balance sheet
  • Japanese stocks will benefit if the ‘Three Arrows’ of Abenomics continue
  • Japanese wages are rising whilst inflation is stuck at zero

On Monday Japanese Prime Minister, Shinzo Abe, called a snap general election. During the press conference in which he made the announcement he said:-

It is my mission as prime minister to exert strong leadership abilities at a time when Japan faces national crises stemming from the shrinking demographic and North Korea’s escalating tensions…

He went on to outline a JPY 2trln stimulus package, to be implemented before year end. This will be financed by raising the consumption tax rate from 8% to 10% in October 2019. The tax increase is expected to generate JPY 5trln/annum and, if any revenue remains after the stimulus, it will be used to reduce government debt. With a further JPY 2trln earmarked for education and social programmes it seems unlikely the maths will add up.

Meanwhile, despite the Federal Reserve’s announcement, last week, that they will begin balance sheet reduction, the Bank of Japan (BoJ) continue their policy of quantitative and qualitative easing (QQE) involving the unorthodox ‘yield curve control’ measures. From more on this please see Macro Letter – No 65 – Yield Curve Control – the road to infinite QE which I published in November 2016. I stand by my conclusion, although my prediction about the JPY (I thought it would continue to weaken) has yet to come to pass:-

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

In the long run demographic forces may halt Abenomic attempts to debase the Yen. This 2015 paper from the Federal Reserve Bank of St Louis – Aging and the Economy: The Japanese Experience – makes fascinating reading. Here is a snippet, but I urge you to read the whole article for an overview of the impact of an ageing population on economies in general, Japan exhibits some unique characteristics in this respect:-

In a third study, economists Derek Anderson, Dennis Botman and Ben Hunt found that the increased number of pensioners in Japan led to a sell-off of financial assets by retirees, who needed the money to cover expenses. The assets were mostly invested in foreign bonds and stocks. The sell-off, in turn, fueled appreciation of the yen, lowering costs of imports and leading to deflation.

Returning to the current environment, on Monday, in a speech to business leaders in Osaka entitled – Japan’s Economy and Monetary PolicyBoJ Governor Haruhiko Kuroda made several observations about the economy, labour market and inflation:-

The economy is expanding moderately, and the real GDP growth rate for the April-June quarter registered a firm increase of 2.5 percent on an annualized basis. It is the first time in eleven years, since 2006, that it has continued to mark positive growth for six consecutive quarters…

The year-on-year rate of increase in hourly wages of part-time employees, which are particularly sensitive to the tightening of the labor market, has registered about 2.5 percent. This is higher than that of full-time employees, implying that the difference in wage levels between part-time and full-time employees has become smaller…

In the labor market as a whole, the unemployment rate has declined to around 3 percent, which is equivalent to virtually full employment, and the active job openings-to-applicants ratio stands at 1.52, exceeding the highest figure during the bubble period and reaching a level last seen as far back as in 1974…

The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has increased to around 0.5 percent recently, but that which also excludes the effects of a rise in energy prices has been relatively weak, remaining at around 0 percent…

Kuroda-san went on to defend the BoJ 2% inflation target and explain the logic behind their ‘QQE with Yield Curve Control’ mechanism. I am struck by the improving affluence of the average worker in Japan. Inflation is zero whilst wage growth, except for the dip in July to -0.3%, has been positive for most of this decade. Real Japanese wages have been rising which is in stark contrast to many of its G7 peers. See Pew Research – For most workers, real wages have barely budged for decades for more on this subject.

The minutes of the July 19th/20th BoJ – Monetary Policy Meeting – were released on Tuesday.  They left policy unchanged. The short-term interest rate target at -0.10% and the long-term rate (10yr JGB yield) at around zero. Commenting on the economy they noted continued solid investment, especially by larger firms and the sustained improvement in private consumption. The consumption activity index (CAI) for Q1 2017 showed a fourth consecutive quarterly increase. I was interested in the statement highlighted below (the emphasis is mine):-

…members shared the view that, with corporate profits improving, which mainly reflected the growth in overseas economies, business fixed investment plans were becoming solid on the whole. They also shared the recognition that the employment and income situation had improved steadily and private consumption had increased its resilience. Members then concurred that a positive output gap had taken hold, given the recent tightening of labor market conditions and the increase in capacity utilization rates, with the latter reflecting a rise in production. Based on this discussion, they agreed to revise the Bank’s economic assessment upward to one stating that Japan’s economy “is expanding moderately, with a virtuous cycle from income to spending operating” from the previous one stating that the economy “has been turning toward a moderate expansion.” One member pointed out that Japan’s economy was shifting from a recovery dependent on external demand to a more self-sustaining expansion brought about by an improvement in domestic demand. This member continued that it was also becoming evident that improvements in economic activity had been spreading across a wider range of areas, urban to regional.

The current QQE policies were reconfirmed (emphasis mine):-

With regard to the amount of JGBs to be purchased, it would conduct purchases at more or less the current pace — an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen — aiming to achieve the target level of the long-term interest rate specified by the guideline.

With regard to asset purchases other than JGB purchases, many members shared the recognition that it was appropriate for the Bank to implement the following guideline for the intermeeting period. First, it would purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding would increase at annual paces of about 6 trillion yen and about 90 billion yen, respectively. Second, as for CP and corporate bonds, it would maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

An independent summation of the current environment and the prospects for the Japanese economy comes from an article by Kazumasa Iwata – President of the Japan Center for Economic Research – AJISS – The Future of the Japanese Economy: The Great Convergence and Two Great Unwindings:-

Since bottoming out in November 2012, the Japanese economy has been in an expansionary phase that reached its 58th month in September of this year. Although not yet as long as the economic expansion achieved during the Koizumi reforms (73 months), the current phase exceeded the mark set by the Izanagi boom of the late 1960s (57 months). While this phase is technically termed expansionary, it lacks strength. In contrast to the average growth rate of 1.8% seen during the Koizumi reforms, the average rate in the ongoing expansion has only been about 1%.

The economic strategy underlying Abenomics is to put the Japanese economy on the road to 2% growth. The experiences of the Koizumi reforms demonstrate that it is quite possible to realize 2% growth by implementing an effective growth strategy. This is evidenced by the theory of convergence through technology diffusion. The catch-up attained by China, India and other emerging countries since the 1990s through offshoring and the construction of global value chains has been astounding. Professor Richard Baldwin argues that the start of the Industrial Revolution ushered in an era of Great Divergence for the global economy via technological innovation and capital accumulation in the developed countries and elsewhere, and that from the 1990s we have been in an age of Great Convergence due to rapid drops in information and telecommunications costs.

In contrast to the brisk development enjoyed by emerging countries, Japan has found itself in a two-decade-long period of stagnation, its economy falling far below the convergence line predicted by Convergence Theory…

Japan already failed to boost its productivity during the 1st IT Revolution of the mid-1990s, and it is now in the 2nd IT Revolution, otherwise known as the 4th Industrial Revolution, centered on IoT, AI, and Big Data. OECD research shows that the top 5% frontier companies have not seen a decline in productivity growth since the financial crisis. Other companies lag behind these frontier companies in globalizing and using digital technology (digitalization), which has only widened the productivity gap between them. Were all companies in Japan able to boost their performance on par with the top ten companies utilizing AI and IoT, Japan’s growth rate could be accelerated by 4% (JCER 2017).

It is interesting to note that Iwata-san sees the greatest risk coming from the unwinding of QE by the Federal Reserve and the ECB, combined with the increasingly protectionist stance of US trade policy. He does not appear to expect the BoJ to reverse QQE, nor Abenomics to falter.

Market Impact

What does the forthcoming election and continuation of infinite QQE mean for Japanese financial markets? Firstly here are three 10 year charts, of the USDJPY, 10yr JGBs and the Nikkei 225:-

USDJPY 10yr - monthly - Tradingeconomics

Source: Trading Economics

!0yr JGB - 10yr monthly - Tradingeconomics

Source: Trading Economics

Nikkei 225 - 10yr monthly - Tradingeconomics

Source: Trading Economics

The Yen has been trading a range this year; it has strengthened against a generally weakening US$, whilst weakening against a resurgent Euro. 10yr JGBs have been held in an effective straightjacket by ‘Yield curve control’. Meanwhile the Nikkei 225 has followed the lead of other equity markets, both in Asia and the US, and marched steadily higher. A break above the highs of August 2015 would see the index trading at its highest since 1997. A dividend yield of 2% (source: Star Capital – as at 30/6/2017) looks attractive compared to JGBs or inflation, although a P/E ratio of more than 17 times and a CAPE ratio above 26 may be cause for caution.

An assessment of financial markets would not be complete without a review of real estate. The BoJ mentioned that house prices have been fairly flat this year. Below is a r chart of the Japan Housing Index and the CPI Index since the financial crisis of 2008:-

Japan Housing Price Index and CPI 10yr Trading Economics

Source: Trading Economics, Japan Ministry of Internal Affairs

Real Estate rental yields are currently around 2.5% making property an alternative to stocks for the long term investor. Personally, with dividend yields around 2%, I would want more than 50 basis points to invest in such an illiquid asset: chacun a son gout.

The Geopolitics of North Korea makes Japan vulnerable: Japan’s currency will bear the brunt of this. Given that much of the recent economic growth has been export led, this Yen weakness is unlikely to damage the prospects for the stock market, except perhaps in the short-term.

If Abe wins a convincing mandate on 22nd October, military spending may be added to the mix of public sector stimulus. Pervious consumption tax increases have proved damaging to the nascent economic recovery, this time, dare I say it, might be different. With wages increasing and domestic demand finally beginning to rise, a moderate tax hike maybe achievable, although I still think it more likely that implementation will be deferred.

The table below, which shows the top 10 best value stocks in the Nikkei, was calculated on 28th April. It is produced by Obermatt – click on the name to find out more about Obermatt’s excellent range of services and their valuation methodologies:-


Source: Obermatt 

To be clear, being a top-down macro investor, I have not personally delved into the relative merits of the stocks above, but I am comforted to note that most of them are household names, even outside Japan. A testament to the quality of many Japanese corporations.

From a technical perspective one should have bought the chart breakout back in November 2016. The market is close to resistance at 21,000 and I would like to see a monthly close above this level before risking additional capital, however, after nearly three decades of deflationary adjustment, the Japanese economy may be beginning to find sustainable growth. I believe this is despite, rather than as a result of, government and central bank policy: but that’s a topic for another time.



Is Chinese growth about to falter?

Is Chinese growth about to falter?


Macro Letter – No 83 – 15-09-2017

Is Chinese growth about to falter?

  • The IMF revised Chinese growth forecasts higher in July – were they premature?
  • Retail sales, industrial output and fixed investment have slowed
  • The Real Estate sector is still buoyant but home price increases are moderating
  • Narrow money supply growth has slowed, other parts of the economy will follow

China has long been the marginal driver of demand for a wide array of commodities. In an attempt to understand the recent rise in the price of industrial metals, the strength of Chinese demand is a key factor. The picture is mixed.

The chart and commentary below is taken from Sean Corrigan’s August newsletter – Cantillon Consulting – China: Is the tide turning?:-


Source: Cantillon Consulting

As Corrigan goes on to say:-

As the deceleration has progressed, the PMI has shown its expected downward response. In due course, company revenues – and ultimately profits – will follow if this is long maintained.

Greater recourse to receivables financing (funded partly by recourse to shadow finance) can delay full recognition of this awhile, but it cannot fail to impair either the magnitude or the quality of earnings as it works through the economy.

At the heart of the credit equation lies the Real Estate market:-


Source: Cantillon Consulting

During 2016 property prices in China increased by 19%, new homes by 12.4%, the fastest since 2011, but the market has cooled of late due to government intervention to subdue its speculative excess. New-home prices, excluding government-subsidized housing, gained from the previous month in 56 of 70 cities in July, compared with 60 in June. New Home Sales for August were the weakest in three years at +3.8%, however, investment in Real Estate development increased 7.8% last month – this is hardly a collapse. House prices are still forecast to rise by 6.8% in 2017 with growth driven by continued increases in second and third tier cities:-

China house prices - 2nd and 3rd tier cities - Bloomberg

Source: Bloomberg

There are concerns that the property market may crash later this year but Chinese authorities seem to be cogniscent of this risk. They lifted restrictions on international bond sales in June, allowing cash strapped property developers to tap international markets. Bloomberg – Indebted China Developers Get Funding Relief as Bond Sales Soar – covers this story in greater detail.

With Real Estate contributing around 15% to GDP this more moderate pace of expansion is expected to temper the pace of growth for the second half of 2017. In Q2 GDP was estimated at 6.9%, the same level as Q1 – this puts nominal growth near to a five year high.

The tide appears to have turned; Industrial output, fixed investment and retail sales all slowed during the summer. Industrial output rose 6% in August, the weakest this year. Retail sales rose 10.1% down from 10.4% and 11% in July and June. Fixed-asset investment in urban areas was up 7.8% in the year to August, the slowest since 1999:-

China growth indicators - Bloomberg

Source: Bloomberg

In a paper published at the end of August The Kansas City Federal Reserve – Has China’s Growth Reached a Turning Point? provide further support for expectations of a slowdown in Chinese growth. As they note, judging whether the recent rebound in China’s growth is temporary or more sustained, is a complex issue:-

The Chinese economy is undergoing a transition in which economic growth is rising in some sectors of the economy but declining in others. At the same time, China’s official quarterly GDP figures have been criticized for being overly smooth and less informative. Moreover, Chinese government policies have stimulated or cooled the economy at different times, further muddling the signal from economic data.

The authors construct a factor model but find that:-

…no single common factor explains the majority of the variation in Chinese activity. This is consistent with the view that the Chinese economy is in a transition, so different sectors are less synchronized. Indeed, our analysis shows that the five most important factors together account for about 75 percent of the total variation in the selected Chinese data.

The heat-map matrix – darker colour = greater importance – is shown below (apologies for the poor resolution):-


Note: “M” corresponds to manufacturing, “I” corresponds to investment, “T” corresponds to trade, “C” corresponds to consumption, “S” corresponds to services, “R” corresponds to real estate and finance, and “P” corresponds to policy.

(Sources: Wind and authors’ calculations.)

Source: Kansas City Federal Reserve

Here are the weightings which the authors assigned to each factor and the cumulative total:-


Source: Kansas City Federal Reserve

In conclusion the authors look in detail at the evolution of the drivers behind their principal factor – Factor 1:-


Source: Kansas City Federal Reserve

As China is transitioning from an investment- and export-driven economy to a more consumption-driven economy, the recent improvement in the manufacturing, investment, and trade group is likely to be temporary. Indeed, this improvement may reflect the rebound in global commodity prices that led to higher industrial profits and production; an increase in fiscal spending, which supported investment; and improvement in global growth coupled with the depreciation in the Chinese currency at the end of last year, which boosted Chinese exports. These driving forces may prove to be temporary, casting doubts on the sustainability of recent strength in the manufacturing, investment, and trade group.

This suggests that the increase in commodity demand outside China has led to increases in prices and that this has helped boost Chinese GDP growth.

Indian, an economy with a large enough GDP to tip the scales, has been slowing since Q1 2016 so the KCFR conclusion seems like the cart leading the horse, it’s little wonder they express it tentatively.

Which brings me to a recent article from Mauldin Economics – or, more accurately China Beige Book – China: Q2 Early Look Brief in which Leland Miller takes issue with the idea that Chinese growth has peaked, corporate deleveraging is the cause, and that the commodity sector is in slowdown mode.

Here’s an extract which gives a flavour of Miller’s contrarian perspective:-

Why Rebalance When You Can Have Both?

The second quarter saw minimal progress in moving away from manufacturing toward services leadership in the economy. This was an excellent failure, however, since services performed well and manufacturing almost as well. Manufacturing tapered but extended its powerful rally since the first half of 2016. Revenue, hiring, and new orders were all higher on-quarter and sharply higher on-year. Still, services outperformed manufacturing in revenue and profits. Hiring in services has been uneven, but Q2 was solid.

Commodities Surprises to the Upside.

Defying early signs of a slowdown, our biggest Q2 surprise was another robust performance in commodities. Make no mistake, the warning signs look like Times Square: the second quarter saw huge across-the-board jumps in inventory, sliding sales price growth in three of four sub-sectors, and rising input costs. Yet, more firms again saw rising sales prices than input cost hikes, sales volumes accelerated, and cash flow moved from red to black, bolstering balance sheets.

Away from Markets’ Gaze, Aluminum Shines.

Commodities’ unsung hero: aluminum. CBB data show aluminum firms wildly outperforming the current market narrative, seeing broad Q2 gains in revenues, profits, volumes, output, and new orders, as well as cash flow, which jumped into the black for the first time in our survey’s history. The why is less clear than the what, but one obvious possibility is aluminum is the latest recipient of some of China’s excess liquidity. The #moneyball may have struck again.

Miller goes on to admit that Real Estate has slowed, credit conditions have deteriorated (outside the property space) and inventories in manufacturing, retail, and commodities hit all-time highs. By one estimate China’s unused steel capacity equals the output of Japan, India, America and Russia combined. Personally I only take issue with Miller’s spelling of aluminium!

China Beige Book remain more optimistic than the majority of commentators but they end their review on a note of caution:-

China’s attempt at deleveraging has been discussed to no end, but its implications are not well understood. In Q1, corporate reporting to CBB showed credit tightening was limited to interbank markets. In Q2, it hit firms: bond yields and rates at shadow banks touched the highest levels in the history of our survey, and bank rates their highest since 2014. So why did borrowing not collapse, denting the broader economy? One reason is what we call the “Party Congress Put.” While borrowing did see a mild drop for the third straight quarter, companies’ six-month revenue expectations remain robust in every sector save property. Companies assume deleveraging is transient, likely because they are skeptical the Party will allow economic pain in 2017. It will not be until 2018 when we find out whether deleveraging is genuine – because it won’t be until 2018 that it will actually hurt.

This brings me back to the question, what caused the initial increase in commodity prices? Part of the impetus behind the rise has been a deliberate curtailing of supply by the Chinese authorities, however, investors should be wary of equating a rise in prices with a sustainable recovery in demand. The Economist – Making sense of capacity cuts in China described it thus:-

Stockmarkets have been on a tear over the past 18 months. Shares are, on average, up by a third globally. Commodities have rallied. And the optimism has infected corporate treasurers, who, for the first time in five years, are spending more on new buildings and equipment. Plenty of factors have fed into the upturn, from Europe’s recovery to early hopes for the Trump presidency. But its origins date back to a commitment by China to demolish steel mills and shut coal mines.

On the face of it, that is an unlikely spark for a change in sentiment. Normally, growth comes from the investment in new facilities, not the closure of those in use. In fact, China’s case is a rare one. By taking on extreme overcapacity, its cutbacks have provided a boost, for itself and for the global economy. The risk, however, is that the way the country is going about the cuts both disguises old flaws and creates new ones.

In early 2016 China announced plans to reduce steel and coal capacity by at least 10% over five years – equivalent to around 5% of global supply. By 2020 they aim to reduce coal output by 800m tonnes – 25% of Chinese production. Steel capacity is set to be slashed by 100m-150m tonnes – 20% of total output – and aluminium, by 30%.

This is not the first time China has attempted to manipulate global commodity markets, yet previous forays disappointed. This time it’s different – a dangerous phrase indeed! Higher prices for steel are likely to encourage domestic investment in new supply. Iron Ore stocks at Chinese ports have reached record levels. Meanwhile the underlying problem – oversupply – has not been addressed. Signs of a roll-back in policy are already evident in the coal industry, where mines which had their production capped at 276 days in 2016, have been permitted to revert to 330 days production this year.

Conclusion and Investment Opportunities

Returning to my original question – is Chinese growth about to falter? In his recent article for the Carnegie Endowment – Is China’s Economy Growing as Fast as China’s GDP? Michael Pettis writes:-

… I would argue that “the end of China’s stellar growth story” has already occurred, and occurred quite a long time ago. Growth in the Chinese economy has collapsed, but growth in economic activity has not collapsed (let us assume, with Grenville, that somehow the reduction in GDP growth from over 10 percent to 6.5 percent does not represent a slowdown in economic activity). The growth in economic activity has instead been propped up by the acceleration in credit growth and by the failure to write down investments that have created economic activity without having created economic value. In that case, high GDP growth levels simply disguise the seeming collapse of underlying economic growth in a way that has happened many times before—always in the late stages of similar apparent investment-driven growth miracles.

The question which springs from Pettis’s article is, when will the non-performing investments be written off? Given the relatively modest government debt to GDP ratio in China (69%) there is still scope to postpone the day of reckoning, but in the shorter-term, trade tensions with the US and a certain reticence on the part of major Central Banks to embrace infinite QE, risks interrupting the current rebound in global growth over the next two years.

The IMF WEO – July 2017 update left global forecasts for global GDP growth unchanged at 3.5% for 2017 and 3.6% for 2018, but their forecasts for China were revised higher by 0.1% and 0.2% respectively. The increasing levels of debt, inventory build and buoyancy of the Real Estate sector may be sufficient for China to avoid a slow-down in GDP growth, but this will be the result of a further inflating of their debt bubble.

Chinese stocks, which continue to trade on single digit P/E ratios, look inexpensive, but this is how they almost always look. Chinese government 10yr bond yields have risen by more than 1% since October 2016 to 3.67% (14-9-2017). Despite the rhetoric emanating from Washington DC, the RMB has retraced much of the ground it lost during 2016 – since January the RMB has strengthened by 4.7% against the greenback.

An economic slowdown in China will prompt the authorities to provide liquidity, this in turn should feed through to lower interest rates, which in turn will help to support domestic stocks. US pressure, such as economic sanctions or the imposition of regulatory constraints, is likely to lead to a renewed weakening of the Chinese currency. A process lower domestic bond yields will help to accelerate. Chinese equities remain in a technical up-trend, as does the currency, while the direction of bond yields is upward as well. This favours remaining; long stocks, short bonds and long the RMB.

When might things change? It is difficult to forecast – I am a trend follower by inclination. The, possibly apocryphal phrase, attributed to Keynes, that ‘The markets can remain irrational longer than I can remain solvent,’ is etched firmly on my heart. The Chinese edict limiting coal production was, perhaps, the catalyst for present rally. I prefer to trade leaders rather than laggards and will therefore be watching the price of Chinese coal closely. Below is the five year chart:-



There is room for a downward correction – to fill a technical gap – but I see no reason to sell industrial commodities on the basis of this price pattern. Notwithstanding Pettis’s more nuanced view, I believe growth, as we understand it on a month to month basis, may slow. If it occurs the slowdown will be gradual, moderate and, if the government intervenes, might be deferred: though, in the long run, not indefinitely.

Does the rising price of industrial metals herald the beginning of the next commodity super-cycle?

Does the rising price of industrial metals herald the beginning of the next commodity super-cycle?


Macro Letter – No 82 – 01-09-2017

Does the rising price of industrial metals herald the beginning of the next commodity super-cycle?

  • Industrial Metals have been rising sharply during the last quarter
  • Global economic growth remains muted but is accelerating in emerging markets
  • Capital Expenditure in the mining sector has been weak leading to supply constraints
  • A short-term cyclical recovery seems more likely than the beginning of a new super-cycle

Super-cycle theory

In a 2012 paper for the United Nations/DESA – Super-cycles of commodity prices since the mid-nineteenth century – Bilge Erten and José Antonio Ocampo review the literature on the theory of Commodity Super-Cycles and go on to suggest that the current cycle began in 1999. Here is an extract from their concluding remarks:-

The decomposition of real commodity prices based on the BP filtering technique provides evidence of four past super-cycles ranging between 30 to 40 years. For the total real non-fuel commodities, these cycles have occurred (1) from 1894 to 1932, peaking in 1917, (2) from 1932 to 1971, peaking in 1951, (3) from 1971 to 1999, peaking in 1973, and (4) the post-2000 episode that is still ongoing. These long cycles, which possess large amplitudes varying between 20 to 40 percent higher or lower than the long-run trend, are also a characteristic of sub-indices. Among the agricultural indices, the tropical agriculture exhibits super-cycles with much larger amplitude relative to non-tropical agriculture. The amplitudes of super-cycle components of real metal and crude oil prices are comparable to those of agricultural products in earlier parts of the twentieth century, but they become much more pronounced and strong in the latter parts of the century. The presence of co-movement among non-fuel commodity indices is supported by the correlation analysis across the entire sample, and a marked co-movement between oil and non-oil indices is present for the second half of the twentieth century.

Another important finding of the paper is that, for non-oil commodities, the mean of each supercycle has a tendency to be lower than that of the previous cycle, suggesting a step-wise deterioration over the entire period in support of the Prebisch-Singer hypothesis*. This finding applies especially to tropical and non-tropical agricultural prices, as well as metals in previous cycles. An exception to this rule is that of metals during the current super-cycle, when the mean last cycle is higher than the preceding one; however, the contraction phase of this cycle has not even began yet, which can lower the mean of the whole cycle in the upcoming years. Another way of capturing these trends is through long-term trends, with tropical agricultural prices experiencing a long severe long-term downward trend through most of the twentieth century, followed by non-tropical agriculture and metals. The duration of the long-term downward trends across all non-fuel commodity groups is on average 100 years. The magnitude of cumulative decline during the downward trend is 47 percent for the non-fuel commodity prices, with recent increases of around 8 percent far from compensating for this long-term cumulative deterioration. In contrast to these trends in non-oil commodity prices, real oil prices have experienced a long-term upward trend, which was only interrupted temporarily during some four decades of the twentieth century.

The recent commodity price hike of the early twenty-first century has commonly been attributed to the strong global growth performance by the BRIC economies, and particularly China, which is particularly metal- and energy-intensive. Based on the VECM results, it is found that super-cycles in the world output level are a good predictor of the super-cycles in real non-fuel commodity prices, both for the total index and sub-indices. This finding confirms that the global output accelerations play a major role in driving the commodity price hikes over the medium run. Therefore, the ongoing commodity price boom could last only if China and other major developing countries are capable of delinking from the long period of slow growth expected in the developed countries.

* Prebisch-Singer hypothesis – suggests that over the long run the price of primary goods such as commodities declines in proportion to manufactured goods.

What is clear from this research is that commodities are far from homogeneous. A strong trend in industrial metals may not coincide with a strong trend in tropical soft commodities or North American grains. Nonetheless, the idea of the super-cycle is beguiling, because it ties the demand for all commodities to economic growth. The Russian economist Nikolai Kondratiev (1892-1938) developed a theory of Long Waves in the early 1920’s. He discarded exogenous factors, such as wars and revolutions, in favour of endogenous drivers, like technological advances and capital accumulation. The Austrian economist Joseph Schumpeter took these ideas further, developing his theory of ‘Creative Destruction’.

From Theory to Practice

Enough of the theory, where are we now? To answer this I will start with one of my favourite charts, one which regular readers have seen before:-


Source: Economist

This chart shows commodity prices between 1850 and 2005, adjusted for inflation. Schumpeter’s theory of Creative Destruction looks compelling; periods of high commodity prices spur innovation which leads to a lowering of prices in response to productivity gains.

Since 2008 the Bloomberg Commodity Index has weakened:-


Source: Bloomberg, Financial Times

The above chart – which is not inflation adjusted – shows the current commodity super-cycle since January 1999. The meteoric rise, the impact of the Great Recession of 2008-2009, the subsequent rebound, as QE kicked-in, and the continuation of the downward trend, marking a complete retracement of the upward move from 1999 to 2008, are all clearly evident. Now a number of commodities have begun to rise simultaneously.

Has the period of creative destruction run its course and permanently reduced supply? Or is the current rebound merely a shorter-term correction which, through higher prices, will encourage new capital investment in productivity enhancing techniques which will rapidly lower those prices once more – 17 years, after all, would make this the shortest super-cycle to date? To answer these questions we need to consider the state of the world economy, especially the growth potential of emerging and developing countries.

The Global Economy and Commodity Demand

Global economic growth has been muted during the past decade. The chart below shows World GDP growth from 1999 to 2015:-

world-gdp-growth-annual-percent-wb-data - 1999-2015

Source: Trading Economics, World Bank

Recent data – and forecasts – from the IMF, suggest that drivers of global growth are changing. Here is an extract from the IMF WEO for July:-

The pickup in global growth anticipated in the April World Economic Outlook remains on track, with global output projected to grow by 3.5 percent in 2017 and 3.6 percent in 2018. The unchanged global growth projections mask somewhat different contributions at the country level. U.S. growth projections are lower than in April, primarily reflecting the assumption that fiscal policy will be less expansionary going forward than previously anticipated. Growth has been revised up for Japan and especially the euro area, where positive surprises to activity in late 2016 and early 2017 point to solid momentum. China’s growth projections have also been revised up, reflecting a strong first quarter of 2017 and expectations of continued fiscal support. Inflation in advanced economies remains subdued and generally below targets; it has also been declining in several emerging economies, such as Brazil, India, and Russia.

The IMF goes on to opine that, despite the stable outlook for 2017/2018, global growth remains below pre-crisis levels for the majority of advanced economies and, more importantly, for commodity-exporting emerging and developing countries. These tentative conditions seem unlikely to favour the beginning of a sustained upswing in commodity prices, nonetheless, prices, especially for industrial metals, have shown impulsive strength. The chart below compares the Bloomberg Commodity sub-indices over the past year, industrial metals appear to be the only game in town:-

Bloomber Indices 1yr Aug 2017

Source: Bloomberg  

Even these sub-indices mask some individual trends. Palladium, a constituent of the precious metals index, made a 16 year high at $945/oz. on 29th August – up 122% from its January 2016 low. Lesser known PGMs, Ruthenium and Rhodium are both up more than 60% in the nine months to May 2017. Copper, the bellwether of industrial metals tested $3.08/lb, its highest since October 2014. LME 3 month Aluminium traded $2,121.75/ton, the highest since February 2013 and 3 month Zinc traded $3,179.50/ton, its highest level for a decade.

Mining companies have rallied in the wake of these higher prices. Market commentators argue that a combination of tight supply and increased demand, especially from China – whose growth forecast was revised from 6.2% to 6.7% by the IMF last month – are the principal near-term factors behind the rally. Additional factors include the relative weakness of the US$ and a, widely anticipated, more hawkish, central bank stance on interest rates.

A fascinating analysis on the relationship between Chinese growth and commodity prices is contained in this article from Jodie Gunzberg of S&P – Chinese Demand Growth Lifts Every Commodity:-

Overall the S&P GSCI only moves in the same direction as Chinese GDP growth changes in about 57% or 26 of 46 years. However, when the Chinese GDP growth is split into rising and falling periods, commodity returns seem to be more influenced by rising growth than slowing growth.  Of the 46 years, growth rose 19 times with 15 or 79% positive annual commodity returns.  The slowing growth years were much less influential, driving down commodity performance in only 11 of 27 years, or in 41% of time.  Though, big negative years like in 1976, 1981, 1986, 2008, and times with consecutive years of falling growth like in 1997-98, 2013-15 seemed to bring commodities down.

Ms Gunzberg goes on to look at the breakdown by sub-sector, finding that only Livestock and Agricultural commodities which fall in response to a decline in Chinese GDP growth. The table below, which drills down to the behaviour of individual commodities, is particularly instructive:-


Source: S&P Dow Jones Indices

Some industrial metals, such as Lithium – used in the manufacture of lightweight car batteries – have seen a dramatic increase in underlying demand. It has risen from a low of $62/ton in February 2016 to $122/ton this week. However, an entire range of other industrial metals has also witnessed rising prices over the past 12 months:-


Source: Trading Economics, Infomine

In an attempt to answer my initial question I quote from PWC – Mine 2017 – Stop, Think…Act


In 2016, traditional players continued balance sheet bolstering to calm the market and stop the angst associated with financial distress. A heavy emphasis was placed on shedding debt. The brakes were firmly applied to exploration activities which continued to shrink, and what little was undertaken was generally allocated to “safe” jurisdictions. Capex fell dramatically again, by a further 41 percent, to a new record low of just $50 billion, and there was a lack of significant greenfield projects announced or commenced. Production was generally flat. While the Top 40 faced external headwinds in the form of increased oil prices, prudent cost control measures ensured operating expenditure was constrained. Traditional miners were rewarded with a strong upswing in their market cap, and earned some breathing space. Many planned disposals were called off in response to better market conditions. The exception to this was the 11 Chinese companies within the Top 40. China defied conventional industry behaviour and invested at the bottom of the cycle. Indeed, the most significant asset buyers among the Top 40 were Chinese companies.


In the short term, shareholders may appreciate the strengthening of balance sheets and increases in share prices. But the industry will need to execute a longer term vision or it will remain at the mercy of commodities speculators. Shareholders will demand performance from the existing asset base, culminating in dividends, or they will simply reallocate their capital if the mining sector cannot provide a long-term growth vision. There is clearly a divergence in thinking between Chinese companies and the rest of the Top 40 as their goals are different and Chinese capital is more patient. China aside, the old guard have donned hard hats, high viz jackets and steel-capped boots in a bid to protect themselves from the pitfalls of the recent past. Praise should be given for the efforts to repay debt, innovate and adopt new efficiency measures – all of which have helped to curb costs and restore credit ratings and investor trust. But where will this thinking take the industry if a “playing it safe” attitude to investment prevails in the future? We argue that it will lead back to old habits of lavish spending in a boom followed by a wave of write-offs during the bust that inevitably follows.


Balance sheet clean-ups require discipline and much hard work has been done. We witnessed the tailing-off of impairments, the avoidance of any new bankruptcies, the absence of any significant streaming transactions and the general passing of distress. The market rightly applauded this, reinstating a positive gap between market caps and net book values that was absent in 2015. Healthier price-to-earnings (P/E) multiples returned. And, even as price growth slowed early this year, valuations continued to rise until April. This provides a platform for the industry to act into the future. What we failed to see was significant action on the future direction of the Top 40, at least by the traditional players. We’ve called the industry out in the past for reacting to short-term price movements, and thankfully this did not happen in 2016. Is the pause an indication of longer term thinking by the industry? One major (Rio Tinto) may think so. Recognising the long-term, cyclical nature of the industry, it has publicly stated that its new CEO has a “10-year mandate…Emerging market companies, who are also focused on new world minerals, are increasingly integrated. In the traditional markets, we are seeing new players seeking to secure supply and even calls by stakeholders for BHP to get on board the battery train. It remains to be seen if a major will pivot in this direction. What will be the results of this reflection for the remainder of 2017? Will action come in the form of investment in greenfield projects, M&A or technology? The latter, we think, simply cannot be ignored. Aside from the completion of new projects, none of the majors has signalled bold intentions for future growth. But who could blame them when early 2017 has heralded further volatility in prices and the subsequent reversal of some of the 2016 gains. Few things are certain in this industry, but we know that China is unwavering in its strategy, shareholder activism is rising, government interventions are becoming more commonplace and new players are disruptive. Will the industry also act, or simply react?

Conclusion and Investment Opportunities

It is too early to predict the beginning of a new up-trend in the next commodity super-cycle, however, mining companies, outside of China, have reduced capital expenditure over the last few years and, given the long lead times in the mining industry, the current uptrend in prices is probably a function of supply constraints, emanating from a lack of investment, combined with a marginal increase in global demand. I believe, however, that this trend can continue for some while. Inflation in the US and Europe remains subdued, deflation remains a near and present danger in Japan; therefore the major Central Banks are likely to maintain a low interest rate regime. The current long economic expansion will continue for a while yet.

During the last major uptrend in commodity prices, China was the main source of additional demand. Since announcing their 12th Five Year Plan in March 2011, China has adopted a policy of ‘Rebalancing’ towards domestic demand, away from mercantilist export oriented growth. Under this new regime, the services sector should expand faster than manufacturing and demand for raw materials, such as industrial commodities, should decline structurally. July saw the publication of a new paper from the IMF – Financial Development Resource Curse in Resource-Rich Countries: The Role of Commodity Price Shocks – it develops some of the ideas contained in the Prebisch-Singer hypothesis. I suspect the Chinese authorities have known the advantage of diversifying their economy away from basic materials from many years. Barring a significant increase in demand from other emerging and developing economies, such as India, the current up-trend in industrial metals is likely to be relatively short-lived, another year to 18 months should see new capital expenditure deliver increased supply. Prices will diminish.

Individual industrial commodities, such as Cobalt and Lithium, will see higher prices, even from their current elevated levels, due to structural demand increases. Other industrial commodities will be more likely to revert to mean as new supply meets global demand over the next couple of years.