Macro Letter – No 51 – 11-3-2016
How do we square the decline in trade with the rebound in industrial commodities?
- Global Manufacturing and Service PMI are in sharp decline
- Chinese Iron Ore rallied 19% on Monday alone
- Chinese GDP and trade data points to a continued decline
- The EIA forecast US oil production to be 8.7mln bpd in 2016 vs 9.4mln last year
The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally. World trade continues to slow as the chart of Manufacturing and Services PMI below reveals:-
Source: Bloomberg, JP Morgan
Chinese February trade data adds to the picture of a slowdown. Exports declined 25.4% YoY, while imports fell 13.8%. Analysts had forecast a 12.5% drop exports, and 10.0% in imports. The trade surplus fell to $32.59bln – against expectations of $50.15bln. This exceptionally sharp decline may be the result of the date of the Chinese New Year but the trend is disquieting.
At last weekends National People’s Congress the 2016 GDP growth forecast was revised downwards to 6.5 – 7%. This followed the release of Q4 2015 GDP at 6.8% and the PBoC’s decision to cut the reserve requirement ratio by 0.5% in order to insure ample liquidity – for large banks the ratio is now 17%.
These charts from the Wall Street Journal put things in a global perspective:-
Source: WSJ, WTO
Further evidence comes from this week’s Monday briefing from Deloitte – Carry on Consuming:-
Manufacturing activity is shrinking in the US and China, the world’s two largest economies. Output is still rising in the euro area, but at the slowest pace in a year. Britain’s manufacturing sector is back in recession.
Part of the problem is lacklustre global demand for manufactured products, particularly in emerging market economies. This has contributed to a slowdown in trade, one of the pre-crisis drivers of global growth. The value of global goods exports last year fell by 13.8% in dollar terms, the first contraction since 2009.
…And yet for me the big conclusion from last week’s meeting in Beijing was that, despite the storm clouds, the world economy should keep growing this year. None of my colleagues, in the US, China, India, Europe, Japan or Australia, anticipate a sharp slowdown in GDP growth in their region this year. All expect consumer spending, the dominant element in GDP everywhere, to hold up.
The performance of many emerging markets has been particularly dire of late, as so many, in order to balance government budgets and meet debt servicing obligations, are reliant on a high price for their commodities.
In an LSE Lecture, given at the beginning of February, Jaime Caruana – General Manager of the BIS – Credit, commodities and currencies – made a number of observations about commodity prices, emerging market debt and the rise of the US$:-
The global economy now finds itself at the centre of three major economic developments. The first is disappointing growth and downward revisions of projections, especially in emerging economies; the second is the large shifts in exchange rates, again especially for emerging market currencies against the US dollar; and the third is the sharp fall in commodity prices, hitting a number of commodity-exporting countries particularly hard, but at the same time providing a positive dividend to other economies.
…Total debt in the global economy, including public debt, has increased significantly since the crisis (end of 2007). True, private debt has been reduced in some countries, namely Ireland, Spain, the United Kingdom, the United States and others. However, public debt has increased significantly in advanced economies, and private debt has increased in emerging economies and some advanced economies less affected by the 2008 financial crisis.
Source: BIS, IMF, World Bank
…Increased leverage would be less of a concern if debt is used to finance productive and profitable investments. However, the profitability of EME non-financial companies has fallen. Traditionally, EME firms have been more profitable than their advanced economy peers, but this is no longer the case…
Source: BIS, Datastream, S&P, Capital IQ
…Based on the most recent reading for the third quarter of 2015, global liquidity conditions may have begun to tighten for emerging economies. A key yardstick is the US dollar-denominated debt of non-bank borrowers outside the United States. It stood at $9.8 trillion in September 2015, unchanged from the previous reading in June, and the dollar borrowing by non-banks in the emerging economies stood at $3.3 trillion, again unchanged from June (Graph 3). This is the first time since 2009 that the latter has stopped increasing.
One important aspect of this additional borrowing in dollars is the strong association between the strength of the dollar and dollar-denominated borrowing by EME borrowers.
…As a rule of thumb, a 1% depreciation of the US dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of US dollar-denominated cross-border lending outside the United States.
…Unlike in previous EME crises in the 1980s and 1990s that had the attributes of a sharp “sudden stop” in lending to EME sovereigns or a run on the banking system, the borrowing in dollars in recent years has been undertaken by private sector non-bank borrowers – mainly non-financial firms. Even if a firm operates in a country whose central bank holds large foreign exchange reserves, there is the question of how the dollars are transferred from the central bank to the firm itself. Unless there is some mechanism that transfers resources from the foreign exchange reserves to the firms themselves, the firms with dollar debts will need to curtail operations and reduce leverage, leading to a direct hit on overall economic growth.
Mr Caruana’s concerns seem at odds with the sudden upturn in a number of industrial commodities, commodity related equities and resource-centric currencies. The rebound started with Aluminium and spread to Copper:-
Collapsing warehouse stocks tell a part of the story:-
The move has been even more pronounced in Zinc:-
A similar pattern has begun to occur in Iron Ore, which bottomed at the end of December; I regret, the five year Swap Futures chart below doesn’t capture the dramatic rise from $52 to $62 seen in the spot price on Monday:-
This move occurred in the face of data from the World Steel Association – January 2016 crude steel production showing a 7.1% decline globally.
Energy prices have remained subdued, with crude oil making fresh lows in February, but even here the sentiment may have changed:-
Although Coal and Natural Gas have yet to catch a significant bid:-
Source: Trading Economics, ICE
A nascent rally is also evident amongst the precious metals complex, here are Palladium and Platinum for good measure:-
As to whether the real economy is beginning to recover I would not put too much weight on the recent rebound in the Baltic Dry Index, it tends to be, at best, lagging indicator:-
The inelastic nature of prices in many commodity markets and the shipping sector in particular, make it extremely dangerous to imply that a small “flight of swallows makes a summer”.
Conclusion and investment opportunities
Whilst have I written about specific aspects of commodity markets, it has been some while since I last focused on commodities in a general sense. In February of last year I wrote – Where is the oil price heading in 2015? In which I looked at the oil futures contango – despite a decline of almost a third in the spot price of WTI (from $45 to $30 per bbl) the contango has not increased as shown by a comparison of the one year futures spreads (March 15-16 vs March 16-17):-
Source: CME, SpreadCharts.com
Producer pain also shows up in US energy production data. Crude oil rig count peaked at 1,609 rigs in October 2014 reaching a low of 439 in February. The Kansas City Federal Reserve – The Reallocation of Energy-Sector Workers after Oil Price Booms and Busts is a timely research response to the 140,000 mining jobs lost during 2015.
Oil production peaked at 9.6mln bpd in April 2015 and is estimated to be down by more than 400,000 bpd. The EIA – Short-Term Energy Outlook forecasts production will decrease to 8.7mln bpd in 2016 and to 8.2mln bpd in 2017.
In December 2014 in How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks I wrote: –
The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.
Looking even farther back to my second Macro Letter in December 2013 – Commodity super-cycles in a fiat currency world I concluded:-
Looking ahead to 2014 I can see little reason, thus far, to be broadly long commodities – as mentioned at the beginning I encourage all investors to view each market on its own particular merits. However, just like 2013, I am waiting for bearish sentiment to turn. To misquote St Augustine’s teenage prayer “Give me commodities Lord, but not yet!”
With anaemic growth and slowing global trade, I believe the current rebound in commodity prices will be relatively short-lived. Chart patterns suggest room for further upside in the next couple of months, possibly aided by seasonal factors, but, with a mounting burden of debt hanging over the global economy – especially those parts which are expected to deliver stronger structural growth – I do not anticipate the beginning of the next commodity upturn for a while.