Australia and Canada – Commodities and Growth

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Macro Letter – No 30 – 20-02-2015

Australia and Canada – Commodities and Growth

  • Industrial commodities continue to weaken
  • The BoC and RBA have cut official rates in response to falling inflation and slower growth
  • The RBA has more room to manoeuvre in cutting rates, Australian Bonds will outperform

The price of Crude Oil has dominated the headlines for the past few months as Saudi Arabia continued pumping as the price fell in response to increased US supply. However, anaemic growth in Europe and a continued slowdown in China has taken its toll on two of the largest commodity exporting countries. This has prompted both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) to cut interest rates by 25 bp each – Canada to 0.75% and Australia to 2.25% – even as CAD and AUD declined against the US$.

In this letter I will look at Iron Ore, Natural Gas and Coal, before going on to examine other factors which may have prompted central bank action. I will go on to assess the prospects for asset markets over the coming year.

Iron Ore

The price of Iron Ore continues to make fresh lows, driven by weakness in demand from China and Japan and the EU.

Iron Ore Fines 6 yr

Source: Infomine.com

Iron Ore is Australia’s largest export market, significantly eclipsing Coal, Gold and Natural Gas. It is the second largest producer in the world behind China. 2013 production was estimated at 530 Mt. Canada, with 40 Mt is ranked ninth by production but is the fourth largest exporter. Needless to say, Iron Ore production is of significant importance to both countries, although for Canada Crude Oil comes first followed by vehicle and vehicle parts, then Gold, Gas – including Propane – and Coal. It is also worth noting that the two largest Steel exporters are China and Japan – both major Iron Ore importers. The health of these economies is vital to the fortunes of the Iron Ore industry.

Natural Gas

Natural Gas is a more difficult product to transport and therefore the price differential between different regions is quite pronounced. Japan pays the highest price of all the major economies – exacerbated by its reduction of nuclear generating capacity – closely followed by Singapore, Taiwan and South Korea. The US – Henry Hub – and AECO – Alberta – prices are broadly similar, whilst Europe and Japan pay a significant premium:-

Chart-4-Global-Natural-Gas-Prices11

Source: Federal Reserve, World Bank, CGA

Here is an extract from the International Gas Union report – IGU Wholesale Gas Price Survey Report – 2014 Edition:-

Wholesale prices can obviously vary significantly from year to year, but the top two regions are Asia Pacific followed by Europe – both with average prices over $11.00. OPE* remains the primary pricing mechanism in Asia Pacific and still a key mechanism in Europe.

*Oil Price Escalation – in this type of contract, the price is linked, usually through a base price and an escalation clause, to competing fuels, typically crude oil, gas oil and/or fuel oil. In some cases coal prices can be used as can electricity prices.

Canada has significant Gas reserves and is actively developing Liquefied Natural Gas (LNG) capacity. 13 plant proposals are underway but exports are still negligible. It also produces significant quantities of Propane which commands a premium over Natural Gas as this chart shows: –

Chart-5-Energy-Commodity-Prices10

Source: StatsCan, Kent Group, CGA

Australia, by comparison, is already a major source of LNG production. The IGU – World LNG Report – 2014 Edition:-

Though Australia was the third largest LNG capacity holder in 2013, it will be the predominant source of new liquefaction over the next five years, eclipsing Qatari capacity by 2017. With Pluto LNG online in 2012, seven Australian projects are now under construction with a total nameplate capacity of 61.8 MTPA (53% of global under construction capacity).

Coal

Australia is the fourth largest Coal producer globally. According to the World Coal Association, it produced 459 Mt in 2013. Canada did not feature in the top 10. However when measured in terms of Coking Coal – used for steel production – Australia ranked second, behind China, at 158 Mt whilst Canada ranked sixth at 34 Mt.

The price of Australian Coal has been falling since January 2011 and is heading back towards the lows last seen in 2009, driven primarily by the weakness in demand for Coking Coal from China.

Australian Coal Price - Macro Business 2012 - 2014

Source: Macro Business

This is how the Minerals Council of Australia describes the Coal export market:-

Coal accounted for almost 13 per cent of Australia’s total goods and services exports in 2012-13 down from 15 per cent in 2011-12. This made coal the nation’s second largest export earner after iron ore. Over the last five years, coal has accounted, on average, for more than 15 per cent of Australia’s total exports – with export earnings either on par or greater than Australia’s total agricultural exports.

Australia’s metallurgical coal export volumes are estimated at 154 million tonnes in 2012-13, up 8.5 per cent from 2011-12. However, owing to lower prices the value of exports decreased by almost 27 per cent to be $22.4 billion in 2012-13.

Whilst the scale of the Coal industry in Canada is not so vast, this is how the Coal Association of Canada describes Canadian Coal production:-

Production

Canada produced 60 million close to 67 million tonnes (Mt) of coal in 2012. 31 million tonnes was metallurgical (steel-making) coal and 36 million tonnes (Mt) was thermal coal. The majority of coal produced in Canada was produced in Alberta and B.C.

Alberta produced 28.3 Mt of coal in 2012

British Columbia produced 28.8 Mt (most was metallurgical coal) – 43% of all production

To meet its rapid infrastructure growth and consumer demand for things such as vehicles and home appliances, Asia has turned to Canada for its high-quality steel-making coal. As Canada’s largest coal trading partner, coal exports to Asia accounted for 73% of total exports in 2010.

Steel-Making Coal

Global steel production is dependent on coal and more and more the world is turning to Canada for its supply of quality steel-making coal.

The production of steel -making coal increased by 5.5% from 29.5 Mt in 2011 to 31.1 Mt in 2012.

Almost all of Canada’s steel-making coal produced was exported.

Thermal Coal

Approximately 36 million tonnes of thermal coal was produced in 2012.

The vast majority of Canadian thermal coal produced is used domestically.

Currency Pressures

Until the autumn of 2014 the CAD was performing strongly despite weakness in several of its main export markets as the chart below of the Canadian Effective Exchange Rate (CERI) shows:-

CAD CERI - 1yr to sept 2014

Source: Business in Canada, BoC

Since September the CERI index has declined from around 112 to below 100.

For Australia the weakening of their trade weighted index has been less extreme due to less reliance on the US. There is a sector of the RBA website devoted the management of the exchange rate, this is a chart showing the Trade Weighted Index and the AUDUSD rate superimposed (RHS):-

AUD_effective_and_AUDUSD_-_RBA

Source: RBA, Reuters

Taking a closer look at the monthly charts for USDCAD:-

canada-currency

Source: Trading Economics

And AUDUSD:-

australia-currency

Source: Trading Economics

These charts show the delayed reaction both currencies have had to the decline in the price of their key export commodities – they may fall further.

Central Bank Policy

The chart below shows the evolution of BoC and RBA policy since 2008. Australian rates are on the left hand scale (LHS), Canadian on the right:-

australia and canadian -interest-rate 2008 - 2015

Source: Trading Economics

To understand the sudden change in currency valuation it is worth reviewing the central banks most recent remarks.

The BoC expect Oil to average around $60/barrel in 2015. Here are some of the other highlights of the latest BoC monetary policy report:-

The sharp drop in global crude oil prices will be negative for Canadian growth and underlying inflation.

Global economic growth is expected to pick up to 3 1/2 per cent over the next two years.

Growth in Canada is expected to slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015.

Canada’s economy is expected to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016, with a return to full capacity around the end of 2016, a little later than was expected in October.

Total CPI inflation is projected to be temporarily below the inflation-control range during 2015 because of weaker energy prices, and to move back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.

On 21 January 2015, the Bank announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent.

…Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016.

The RBA Statement on Monetary Policy – February 2015 provides a similar insight into the concerns of the Australian central banks:-

…Australia’s MTP growth is expected to continue at around its pace of recent years in 2015 as a number of effects offset each other. Growth in China is expected to be a little lower in 2015, while growth in the US economy is expected to pick up further. The significant fall in oil prices, which has largely reflected an increase in global production, represents a sizeable positive supply shock for the global economy and is expected to provide a stimulus to growth for Australia’s MTPs. The fall in oil prices is also putting downward pressure on global prices of goods and services. Other commodity prices have also declined in the past three months, though by much less than oil prices. This includes iron ore and, to a lesser extent, base metals prices. Prices of Australia’s liquefied natural gas (LNG) exports are generally linked to the price of oil and are expected to fall in the period ahead. The Australian terms of trade are expected to be lower as a result of these price developments, notwithstanding the benefit from the lower price of oil, of which Australia is a net importer.

…Available data since the previous Statement suggest that the domestic economy continued to grow at a below-trend pace over the second half of 2014. Resource exports and dwelling investment have grown strongly. Consumption growth remains a bit below average. Growth of private non-mining business investment and public demand remain subdued, while mining investment has fallen further. Export volumes continued to grow strongly over the second half of 2014, driven by resource exports. Australian production of coal and iron ore is expected to remain at high levels, despite the large fall in prices over the past year. The production capacity for LNG is expected to rise over 2015. Service exports, including education and tourism, have increased a little over the past two years or so and are expected to rise further in response to the exchange rate depreciation.

…Household consumption growth has picked up since early 2013, but is still below average. Consumption is being supported by very low interest rates, rising wealth, the decision by households to reduce their saving ratio gradually and, more recently, the decline in petrol prices. These factors have been offset to an extent by weak growth in labour income, reflecting subdued conditions in the labour market. Consumption growth is still expected to be a little faster than income growth, which implies a further gradual decline in the household saving ratio.

…Prior to the February Board meeting, the cash rate had been at the same level since August 2013. Interest rates faced by households and firms had declined a little over this period. Very low interest rates have contributed to a pick-up in the growth of non-mining activity. The recent large fall in oil prices, if sustained, will also help to bolster domestic demand. However, over recent months there have been fewer indications of a near-term strengthening in growth than previous forecasts would have implied. Hence, growth overall is now forecast to remain at a below trend pace somewhat longer than had earlier been expected. Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained. In addition, while the exchange rate has depreciated, it remains above most estimates of its fundamental value, particularly given the significant falls in key commodity prices, and so is providing less assistance in delivering balanced growth in the economy than it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash rate, the Board judged at its February meeting that a further 25 basis point reduction in the cash rate was appropriate. This decision is expected to provide some additional support to demand, thus fostering sustainable growth and inflation outcomes consistent with the inflation target.

Real Estate

Neither central bank makes much reference to the domestic housing market. Western Canada has been buoyed by international demand from Asia. Elsewhere the overvaluation has been driven by the low interest rates environment. Overall prices are 3.1% higher than December 2014. Vancouver and Toronto are higher but other regions are slightly lower according to the January report from the Canadian Real Estate Association . The chart below shows the national average house price:-

 

 

Canada natl_chartA04_hi-res_en

Source: Canadian Real estate Association

The Australian market has moderated somewhat during the last 18 months, perhaps due to the actions of the RBA, raising rates from 3% to 4.75% in the aftermath of the Great Recession, however, the combination of lower RBA rates since Q4 2011, population growth and Chinese demand has propelled the market higher once more. Prices in Western Australia have moderated somewhat due to the fall in commodity prices but in Eastern Australia, the market is still making new highs. The chart below goes up to 2014 but prices have continued to rise, albeit moderately (less than 2% per quarter) since then:-

Australian House Prices 2006 - 2014

Source: ABS

This chart from the IMF/OECD shows global Price to Income ratios, Canada and Australia are still at the expensive end of the global range:-

House pricetoincome IMF

Source: IMF and OECD

The lowering of official rates by the BoC and RBA will not help to alleviate the overvaluation.

Bonds

This chart shows the monthly evolution of 10 year Government Bond yields since 2008 in Australia (LHS) and Canada (RHS):-

australia-canada-government-bond-yield

Source: Trading Economics

Whilst the two markets have moved in a correlated manner Canadian yields have tended to be between 300 and 100 bp lower over the last seven years. The Australian yield curve is flatter than the Canadian curve but this is principally a function of higher base rates. Both central banks have cut rates in anticipation of lower inflation and slower growth. This is likely to support the bond market in each country but investors will benefit from the more favourable carry characteristics of the Canadian market.

Stocks  

To understand the differential performance of the Australian and Canadian stocks markets I have taken account of the strong performance of commodity markets prior to the Great Recession, in the chart below you will observe that both economies benefitted significantly from the rally in industrial commodities between 2003 and 2008. Both stock markets suffered severe corrections during the financial crisis but the Canadian market has steadily outperformed since 2010:-

canada australian -stock-market 2000-2015

Source Trading Economics

This outperformance may have been due to Canada’s proximity to, and reliance on, the US – 77% of Exports and 52% of Imports. The Australian economy, by contrast, is reliant on Asia for exports – China 27%, Japan 17% – however, I believe that the structurally lower interest rate regime in Canada is a more significant factor.

Conclusions and investment opportunities

With industrial commodity prices remaining under pressure neither Canada nor Australia is likely to exhibit strong growth. Inflation will be subdued, unemployment may rise. These are the factors which prompted both central banks to cut interest rates in the last month. However, both economies have been growing reasonable strongly when compared with countries such as those of the Eurozone. Canada GDP 2.59%, Australia GDP 2.7%.

The BoC has little room for manoeuvre with the base rate at 0.75% but the RBA is in a stronger position. For this reason I believe the AUD is likely to weaken against the CAD if world growth slows, but the negative carry implications of this trade are unattractive.

Canadian Real Estate is more vulnerable than Australia to any increase in interest rates – although this seems an unlikely scenario in the near-term – more importantly, in the longer term, Canadian demographics and slowly population growth should alleviate Real Estate demand pressure. In Australia these trends are working in the opposite direction. Neither Real Estate market is cheap but Australia remains better value.

The Australian All-Ordinaries should outperform the Canadian TSX as any weakness in the Australian economy can be more easily supported by RBA accommodation. The All-Ordinaries is also trading on a less demanding earnings multiple than the TSX.

The RBA’s greater room to ease monetary conditions should also support the Australian Government Bond market, added to which the Australian government debt to GDP ratio is an undemanding 28% whilst Canadian debt to GDP is at 89%. The Canadian curve may offer more carry but the RBA ability to ease policy rates is greater. My preferred investment is in Australian Government Bonds. Both Canadian and Australian 10 year yields have risen since the start of February. The last Australian bond retracement saw yields rise 46 bp to 3.75% in September 2014. Since the recent rate cut yields have risen 30 bp to a high of 2.67% earlier this week. Don’t wait too long for better levels.

Where is the oil price heading in 2015?

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Macro Letter – Supplemental – No 1 – 13-02-2015

Where is the oil price heading in 2015?

  • Growth in oil demand remains anaemic
  • Supply will gradually fall as contracts expire
  • Consolidation and declining volatility are the most likely outcome

The price of crude oil has rebounded strongly since the end of January. Is this the beginning of a new trend, a short-term correction prior to a further decline or the start of a period of consolidation?

Here is the price action for March 2015 WTI futures over the last four months:-

4month Mar15 WTI

Source: Barchart.com

Before jumping to any conclusions about the next trend it is worth taking a look at a longer term chart. This is the spot price chart for the period since 2005, it shows the period of the leveraged boom and the collapse during the Great Recession:-

10yr Oil

Source: Barchart.com

The collapse during the Great Recession was largely due to a reduction in demand as the world economy slowed dramatically. The price decline since the summer of 2014 has been driven by a combination of a delayed reaction to increased supply – specifically from the US – and a moderation in the rate of increase in demand associated with the slowing of Chinese growth and its policy of “rebalancing” towards domestic consumption. An additional factor has been the slowing of growth in Europe. An IEA report last December estimated that global oil demand had increased by only 0.75% between 2013 and 2014 – better, by 3.6%, than the 2009/2013 period but not excessive.

During 2013 and early 2014 geopolitical tension in the Middle East and Ukraine kept prices elevated amid expectations of supply disruptions. These disruptions failed to materialise. This coincided with an increase in US oil production. Finally the markets woke-up to the lack of geopolitical risk, the slowdown of growth in the EU and China, and the acceleration in US production. The price began to correct downwards taking out the 2012 lows. From here on it gathered momentum and, having taken out the majority of trading stop-losses, stabilised last month, not far from the 2009 lows.

Another look at the 10 year price chart shows the recovery in 2010/2011. At this stage the improvements in fracking and drilling technology were already becoming widely known, had it not been for geopolitical concerns the price would probably have begun to decline from this point – around $85. The widening price spread between Brent Crude and WTI shows the effect of increased US production:-

brent wti spread Goldman Sachs ZeroHedge

Source: Goldman Sachs and Zero Hedge

WTI begins to lag Brent Crude towards the end of 2010. Here is a chart of US versus World Oil production:-

US_vs_world_Oil_production

Source: EIA and Carpe Diem Blog

 

Price Prospects

What we have seen during the last six months is a delayed reaction to the increased supply of crude oil from the US. The recent decline has been very rapid and may have run its course, or may have further to fall. Either way, volatility is heightened and the price is likely to remain variable.

From a technical perspective I would expect the corrective rally to continue possibly to test the 2012 lows around $75/barrel. After such a rapid rise in the last few weeks, however, the price may retest the low first; there is an outside chance that the market takes out the January low to retest the 2009 bottom. The $75 level may be retested in the autumn as forward contracts expire and supply shortages appear. From this point a renewed decline is most likely, this phase will also be marked by declining volatility.

I have one concern with this technically bullish prediction – the steep contango in the futures market. At close of business on Wednesday 11th February the WTI futures settlements were as follows:-

Contract Last
CLY00 (Cash) 48.87s
CLH15 (Mar ’15) 50.43
CLU15 (Sep ’15) 57.15
CLH16 (Mar ’16) 60.14s
CLU16 (Sep ’16) 62.39s

 

Source: NYMEX and Barchart.com

The shape of the forward curve suggests that oil producers are not feeling quite as much pain as is implied by the spot price, the supply overhang may last into 2016.

Market views, as always, vary. At this week’s International Petroleum Week conference in London Igor Sechin – CEO of Rosneft predicted that oil prices may surge later this year due to supply shortages as a result of the precipitous decline. Meanwhile at the same conference Ian Taylor – CEO of Vitoil, questioned where oil demand would emanate from. His outlook was decidedly more bearish.

Moody’s research, published earlier this week, put a price target for 2015 is $55/barrel which makes sense if global growth slows: they see no boost to growth in China, Japan or the EU from a lower oil price but expect it to benefit India and the US.

I listened to a panel debate at the ICMA/JSDA – Japan Securities Summit on Wednesday where Takahiro Sato of the BoJ alluded to the positive impact lower oil prices might have on Japanese growth. He inferred that it would mean the BoJ undershot its inflation target. Here is a brief extract:-

On the price front, the inflation rates in major countries, including Japan, have been declining as a trend mainly due to the recent drop in crude oil prices. Under those circumstances, central banks in major countries have a common concern that major economies are trapped in a feedback-loop — the decline in the inflation rates would lead to a fall in people’s medium- to long-term inflation expectations, and it would result in a further decline in the actual inflation rates. That is why the Bank decided to expand the QQE last October.

As I cast a dissenting vote on that decision, I may not be an appropriate person to explain this policy.

The NY Times reported – KKR profits were down 89% in Q4 2014 due to turmoil in the US energy sector. New drilling has dried up in the last few months and concerns are growing about potential defaults by over-leveraged energy companies. This could slow US growth if the financial sector is wracked with contagion.

The prospects for the oil price is unclear; it will remain so for the next six months. For this reason I expect Moody’s price target of $55/barrel to be reasonably accurate even if their growth expectations prove wrong.

Obvious risk factors which could undermine my expectations include:-

  1. A dramatic slowdown in China
  2. An unravelling of the Eurozone currency union
  3. Russia and the US going head to head in the Ukraine

I think China is more likely to surprise on the upside if it does surprise at all. The Eurozone is still a difficult situation to predict but I think the Euro currency will survive and lower oil prices will aid Germany among other countries in the Euro area. The US may be performing well economically but its appetite for foreign conflict when the country is heading towards energy independence makes little strategic sense. They are likely to deploy their resources on dealing with ISIS first.

My 2015 outside range for WTI crude oil is $40 to $75 with an average of $55/barrel.

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

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Macro Letter – No 26 – 19-12-2014

How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks

  • Oil prices have fallen by more than 40% in H2 2014
  • Inflation expectations will be lowered further
  • US Growth should be higher longer-term
  • Near-term, contagion from the “energy bust” is under estimated by the market

 

With the recent collapse in the price of crude oil it seems appropriate to review the forecasts for inflation and growth in the US. Earlier this week, during an interview with CNBC, Bill Gross – ex-CIO of PIMCO – suggested that US growth would be around 2% going forward rather than the 3% to 4% seen in the recent past. The Atlanta Fed – Now GDP forecast for Q4 2014 was revised up to +2.2% from +2.1% on 11th December. This is higher than the Conference Board – Q4 GDP forecast of 2.0% from 10th December, here is their commentary:-

The U.S. growth momentum may pause in the fourth quarter, due to some special circumstances. The outlook for early 2015 shows some upside beyond the 2.5 percent pace. And this is despite continued slow economic growth around the world and a rise in the value of the dollar. The biggest disappointment right now is business spending on equipment which is slowing from an average pace of 11 percent over the past two quarters. But if final demand picks up as expected, business investment might also gain some momentum. One key driver of demand is continued improvement in the labor market. Job growth has been solid for the past year and the signal from the latest reading on The Conference Board Employment Trends Index™ (ETI) is that it will continue at least over the very near term. In fact, continued employment gains are likely to lead to better gains in wages in the first half of 2015. Job and income growth may provide some moderately positive momentum for the housing market. Low gasoline prices will also further support household spending. Finally, very low interest rates, at both the short and long end of the yield spectrum help consumers and businesses. The strengthening of domestic growth is intensifying pressures to increase the base interest rate, but speed and trajectory remain important questions.

There is a brief mention of the fall in gasoline prices and hopes for increased domestic demand driven by a better quality of jobs. Thus far official expectations have failed to shift significantly in response to the fall in oil. If the price remains depressed I expect these forecasts to change. The geographic make-up of US growth is quite skewed. The map below shows the breakdown of GDP growth by state in 2013:-

US GDP by State 2013

Source: Bureau of Economic Analysis

The predominant feature of many high growth states is strength of their energy sector. One state which has been a major engine of US employment growth in absolute terms, since the Great Recession, is Texas. In 2013 Texas jobs growth slowed from 3.3% to 2.5%. In percentage terms, it slipped into third place behind the stellar growth seen in North Dakota and Florida. Florida is an interesting indication of the process by which the drivers of growth are gradually switching away from the energy related impetus seen over the past few years. This article from the Dallas Fed – Texas to Remain a Top State for Job Growth in 2014 looks more closely at some nascent growth trends:-

Oil- and gas-producing states—leaders in the early years of the U.S. recovery—no longer predominated. This reflects the energy sector’s slowing expansion, although two states with the strongest shale activity, Texas and North Dakota, remained near the top. Meanwhile, several Sunbelt states hit hard by the housing crisis—Florida, Georgia and Arizona, for instance—are beginning to bounce back. In these states, employment remains significantly below the prerecession peak; in Texas, it is significantly above.

Texas is vulnerable, as are other energy rich US states, due to the weakness in the price of oil, however, Texas is also reliant on trade with Mexico for more than half of its exports. The down-turn in Mexican growth due to the weaker oil price, is an additional headwind for the “lone star” state.

You might expect this to be cause for some relief on the part of Richard Fisher – President of the Dallas Fed, yet, writing in mid-October in the Dallas Fed – Economic Letter – he remained, consistently hawkish on the prospects for inflation:-

The point is not that wage growth has been worrisomely high (it hasn’t been) or that we’re in imminent danger of a wage-price spiral (we likely aren’t). Rather, there’s nothing in the behavior of wage inflation over the course of the recovery to suggest that the unemploy­ment rate has been sending misleading signals about our progress toward full employment. A secondary point—a cau­tion, really—is that when trying to draw inferences about labor-market slack from the behavior of wages, it’s important to recognize that wage inflation’s response to slack is both nonlinear and delayed.

…Do we keep the accelerator pedal to the floor right up to the point where we reach our destination? Or do we ease up as we near our goal? The answer depends on an assessment of the costs of possibly delaying achievement of our objectives versus the costs of overshoot­ing those objectives. Proponents of a patient approach to removing accom­modation emphasize the risk of having to backtrack on policy, should either real growth or inflation expectations falter. On the other hand, Fed policymakers successfully “tapped the brakes” in the middle of three of our longest economic expansions (in the 1960s, 1980s and 1990s), slowing—but not ending—the unemployment rate’s decline. By com­parison, there are no instances where the Fed has successfully eased the unem­ployment rate upward after having first overshot full employment: When the economy goes into reverse, it has a pro­nounced tendency to lurch backward all the way into recession.

The Federal Reserve Bank of San Francisco – The Risks to the Inflation Outlook – November 17th – has a rather different view of the risks of inflation:-

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

The chart below shows the wide range of PCE forecasts, interestingly the IMF WEO forecast is 1.8% for 2015:-

PCE Inflation projection - FRBSF

Source: FRBSF

The author goes on to conclude:-

Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future.

The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model.

It would appear that even before the recent decline in the price of oil the Fed was not expecting a significant increase in inflationary pressure. What should they do in the current environment where the US$ continues to appreciate against its major trading partners and if the price of oil remains at or below $60/barrel? These are one-off external price shocks which are a boon to the consumer, however they make exports uncompetitive and undermine the longer term attractiveness of investment in the domestic energy sector. IHS Global Insight produced the following forecast for the Wall Street Journal earlier this month:-

US_Pricing_Power_and_Oil_-_IHS_Global_Insight_WSJ

Source: IHS Global Insight and WSJ

My concerns are two-fold; firstly, what if the oil price rebounds? The latest IEA report noted that global demand for oil increased 0.75% between 2013 and 2014 and is running 3.6% above the average level of the last five years (2009 – 2013) this leaves additional supply as the main culprit of the oil price decline. With oil at $60/barrel it is becoming uneconomic to extract oil from many of the new concessions – over-supply may swiftly be reversed. Secondly, the unbridled boon to the wider economy of a lower oil price is likely to be deferred by the process of rebalancing the economy away from an excessive reliance on the energy sector. In an excellent paper in their Power and Growth Initiative series, the Manhattan Institute – Where The Jobs Are: Small Businesses Unleash Energy Employment Boom– February 2014 conclude:-

According to a recent poll from the Washington Post Miller Center, American workers’ anxiety over jobs is at a four-decade record high. Meanwhile, the hydrocarbon sector’s contributions to America’s job picture and the role of its small businesses in keeping the nation out of a long recession are not widely recognized. Another recent survey found that only 16 percent of people know that an oil & gas boom has increased U.S. energy production—collaterally creating jobs both directly and indirectly.

America’s future, of course, is not exclusively associated with hydrocarbons or energy in general. Over the long term, innovation and new technologies across all sectors of the economy will revitalize the nation and create a new cycle of job growth, almost certainly in unexpected ways. But the depth and magnitude of job destruction from the Great Recession means that creating jobs in the near-term is vital. As former chair of the Council of Economic Advisers and Harvard professor Martin Feldstein recently wrote: “The United States certainly needs a new strategy to increase economic growth and employment. The U.S. growth rate has fallen to less than 2%, and total employment is a smaller share of the population now than it was five years ago.”

In a new report evaluating five “game changers” for growth, the McKinsey Global Institute concluded that the hydrocarbon sector has the greatest potential for increasing the U.S. GDP and adding jobs—with an impact twice as great as big data by 2020. McKinsey forecasts that the expanding shale production can add nearly $700 billion to the GDP and almost 2 million jobs over the next six years.

Other analysts looking out over 15 years see 3–4 million more jobs that could come from accelerating domestic hydrocarbon energy production. Even these forecasts underestimate what would be possible in a political environment that embraced growth-centric policies.

In November 2013, President Obama delivered a speech in Ohio on jobs and the benefits from greater domestic energy production. The president highlighted the role of improved energy efficiency and alternative fuels. But as the facts show, no part of the U.S. economy has had as dramatic an impact on short-term job creation as the small businesses at the core of the American oil & gas boom. And much more can be done.

A recent report by Deutsche Bank – Sinking Oil May Push Energy Sector to the Brink – estimated that of $2.8trln annual US private investment, $1.6trln is spent on equipment and software and $700bln on non-residential construction. Of the equipment and software sector, 25-30% is investment in industrial equipment for energy, utilities and agriculture. Non-residential construction is 30% energy related. With oil below $60/barrel much of that private investment will be postponed or cancelled. That could amount to a reduction in private investment of $500bln in 2015. This process is already underway; according to Reuters, new oil permits plummeted 40% in November.

Since 2007 shale producing states have added 1.36mln jobs whilst the non-shale states have shed 424,000 jobs. The table below shows the scale of employment within the energy sector for key states:-

State Hydro-carbon jobs 000’s
Texas 1800
California 780
Oklahoma 350
Louisiana 340
Pennsylvania 330
New York 300
Illinois 290
Florida 280
Ohio 260
Colorado 210
Virginia 190
Michigan 180
Kentucky 170
West Virginia 170
Georgia 160
New Jersey 150

Source: Manhattan Institute

This chart from Zero Hedge shows the evolution of the US jobs market in shale vs non-shale terms since 2008:-

Jobs in shale ve non-shale - Zero Hedge BLS

Source: Zero Hedge and BLS

2015 will see a correction in this trend, not just because investment stalls, but also as a result of defaults in the high-yield bond market.

Junk Bonds and Bank Loans

It is estimated that around 17% of the High-yield bond market in the US is energy related.  The chart below is from Zero Hedge, it shows the evolution of high yield bonds over the last four years. The OAS is the option adjusted spread between High Yield Energy bonds and US Treasury bonds:-

Energy_High_Yield_-_zero_hedge

Source: Zero Hedge and Bloomberg

Deutsche Bank strategists Oleg Melentyev and Daniel Sorid estimate that, with oil at $60/barrel, the default rate on B and CCC rated bonds could be as high as 30%. Whilst this is bad news for investors it is also bad news for banks which have thrived on the securitisation of these bonds. The yield expansion seen in the chart above suggests there is a liquidity short-fall at work here – perhaps the Fed will intervene.

As a result of the growth in the US energy sector, banks have become more actively involved in the energy markets. Here the scale of their derivative exposure may become a systemic risk to the financial sector. When oil was trading at its recent highs back in July the total open speculative futures contracts stood at 4mln: that is four times the number seen back in 2010. The banks will also be exposed to the derivatives market as a result of the loans they have made to commodity trading companies – some of whom may struggle to meet margin calls. Bad loan provisions will reduce the credit available to the rest of the economy. This will dampen growth prospects even as lower energy prices help the consumer.

The US Treasury Bond yield curve has also “twisted” over the past month, with maturities of five years and beyond falling but shorter maturities moving slightly higher:-

Maturity 17-Nov 17-Dec Change
2yr 0.504 0.565 0.061
3yr 0.952 1.005 0.053
5yr 1.607 1.534 -0.073
7yr 2.019 1.863 -0.156
10yr 2.317 2.078 -0.239

Source: Investing.com

On the 15th October, at the depths of the stock market correction, 2yr Notes yielded 0.308% whilst 10yr Notes yielded 2.07%. Since then the 2yr/10yr curve has flattened by 25bp. I believe this price move, in the short end of the market, is being driven by expectations that the Fed will move to “normalise” policy rates in the next 12 months. Governor Yellen’s change of emphasis in this weeks FOMC statement – from “considerable time” to “patient” – has been perceived by market pundits as evidence of more imminent rate increases. An additional factor driving short term interest rates higher is the tightening of credit conditions connected to the falling oil price.

Longer maturity Treasuries, meanwhile, are witnessing a slight “flight to quality” as fixed income portfolio managers switch out of High Yield into US government securities even at slightly negative real yields. According to an article in the Financial Times – Fall in oil price threatens high-yield bonds – 7th December $40bln was withdrawn from US High Yield mutual fund market between May and October. I expect this process to gather pace and breed contagion with other markets where the “carry trade” has been bolstered by leveraged investment flows.

Where next for stocks?

The New York Fed – Business Leaders Survey showed that, despite easing energy costs and benign inflation, business leaders expectations are not particularly robust:-

The Federal Reserve Bank of New York’s December 2014 Business Leaders Survey indicates that activity in the region’s service sector expanded modestly. The survey’s headline business activity index fell ten points to 7.8, indicating a slower pace of growth than in November. The business climate index inched down two points to -7.8, suggesting that on balance, respondents continued to view the business climate as worse than normal. The employment index climbed three points to 16.3, pointing to solid gains in employment, while the wages index drifted down five points to 25.6. After declining sharply last month, the prices paid index climbed four points to 42.2, indicating a slight pickup in the pace of input price increases, while the prices received index fell eight points to its lowest level in two years, at 5.4, pointing to a slowing of selling price increases. The current capital spending index declined ten points to 10.1, while the index for future capital spending rose six points to 25.0. Indexes for the six-month outlook for business activity and employment fell noticeably from last month, suggesting that firms were less optimistic about future conditions.

Set against this rather negative report from the Fed, is this upbeat assessment of the longer-term prospects for US manufacturing from the Peterson Institute – The US Manufacturing Base:

Four Signs of Strength it makes a compelling case for an industrial renaissance in the US. The four signs are:-

  1. US manufacturing output growth
  2. US manufacturing competitive performance relative to other sectors of the US economy
  3. US manufacturing productivity growth relative to other countries
  4. New evidence on outward expansion by US multinational corporations and economic activity by those same firms at home

Another factor supporting the stock market over the last few years has been the steady increase in dividends and share buybacks. According to Birinyi Associates, US corporations bought back $338.3bln of stock in H1 2014 – the most in any six month period since 2007. Here are some of the bigger names; although they account for less than half the H1 total:-

Name Ticker Buyback $blns
Apple APPL 32.9
IBM IBM 19.5
Exxon Mobil XOM 13.2
Pfizer PFE 10.9
Cisco CSCO 9.9
Oracle ORCL 9.8
Home Depot HD 7.6
Wells Fargo WFC 7.5
Microsoft MSFT 7.3
Qualcomm QCOM 6.7
Walt Disney DIS 6.5
Goldman Sachs GS 6.4

Source: Barclays and Wall Street Journal

Share buybacks are running at around twice their long run average and dividends have increased by 12% in the past year. On average, companies spend around 85% of their profits on dividends and share repurchases. This October 6th article from Bloomberg – S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts goes into greater detail, but this particular section caught my eye:-

CEOs have increased the proportion of cash flow allocated to stock buybacks to more than 30 percent, almost double where it was in 2002, data from Barclays show. During the same period, the portion used for capital spending has fallen to about 40 percent from more than 50 percent.

The reluctance to raise capital investment has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to annual data compiled by the Commerce Department.

I am cynical about share buybacks. If they are running at twice the average pace this suggests, firstly, that the “C suite” are more interested in their share options than their shareholders and, secondly, that they are still uncomfortable making capital expenditure decisions due to an utter lack of imagination and/or uncertainty about the political and economic outlook. Either way, this behaviour is not a positive long-term phenomenon. I hope it is mainly a response to the unorthodox policies of the Fed: and that there will be a resurgence in investment spending once interest rates normalise. This might also arrive sooner than expected due to a collapse in inflation rather than a rise in official rates.

The US economy will benefit from lower energy prices in the long term but the rebalancing away from the energy sector is likely to take time, during which the stock market will have difficulty moving higher. For the first time since 2008, the risks are on the downside as we head into 2015. Sector rotation is certainly going to feature prominently next year.

Last weeks National Association of Manufacturers – Monday Economic Report – 8th December 2014 shows the optimism of the manufacturing sector:-

Business leaders continue to reflect optimism about the coming months, with 91.2 percent of survey respondents saying they are either somewhat or very positive about their own company’s outlook. Moreover, manufacturers predict growth of 4.5 percent in sales and 2.1 percent in employment over the next 12 months, with both experiencing the strongest pace in at least two years. 

These findings were largely consistent with other indicators released last week. Most notably, the U.S. economy added 321,000 nonfarm payroll employees on net in November. This was well above the consensus estimate, and it was the fastest monthly pace since April 2011. Hiring in the manufacturing sector was also strong, with 28,000 new workers during the month. Since January, manufacturers have hired almost 15,000 workers on average each month, or 740,000 total since the end of 2009. In other news, manufacturing construction spending was also up sharply, increasing 3.4 percent in October and a whopping 23.0 percent year-over-year. 

These reports suggest that accelerating growth in demand and output is beginning to translate into healthier employment and construction figures, with businesses stepping up investments, perhaps as a sign of confidence. This should bode well for manufacturing employment as we move into 2015. In particular, the Institute for Supply Management’s (ISM) manufacturing Purchasing Managers’ Index (PMI) remains strong, despite edging marginally lower in November. For instance, the production index has now been 60 or higher, which indicates robust expansionary levels, for seven straight months. Similarly, the new orders index has been 60 or higher for five consecutive months, and the export measure also noted some improvements for the month. 

Speaking of exports, the U.S. trade deficit changed little in October, edging marginally lower from the month before. Still, growth in goods exports was somewhat better than the headline figure suggested, with the value of petroleum exports declining on lower crude oil costs. The good news is that year-to-date manufactured goods exports have increased to each of our top-five trading partners so far this year.

They go on to temper this rosy scenario, which is why I anticipate the interruption to the smooth course of stock market returns during the next year :-

…growth in manufactured goods exports remains sluggish through the first 11 months of 2014, up just 1.1 percent relative to the same time frame in 2013. Not surprisingly, challenges abroad continue to dampen our ability to grow international sales.  New factory orders have declined for the third straight month, a disappointing figure particularly given the strength seen in other measures. In addition, the NAM/IndustryWeek survey noted that the expected pace of exports decelerated once again, mirroring the slow growth in manufactured goods exports noted above.

This week saw the release of revised Industrial Production and Capacity Utilisation data – this was the commentary from the Federal Reserve:-

Industrial production increased 1.3 percent in November after edging up in October; output is now reported to have risen at a faster pace over the period from June through October than previously published. In November, manufacturing output increased 1.1 percent, with widespread gains among industries. The rise in factory output was well above its average monthly pace of 0.3 percent over the previous five months and was its largest gain since February. In November, the output of utilities jumped 5.1 percent, as weather that was colder than usual for the month boosted demand for heating. The index for mining decreased 0.1 percent. At 106.7 percent of its 2007 average, total industrial production in November was 5.2 percent above its year-earlier level. Capacity utilization for the industrial sector increased 0.8 percentage point in November to 80.1 percent, a rate equal to its long-run (1972–2013) average.

This paints a positive picture but, with Capacity Utilisation only returning to its long-run trend rate, I remain concerned that the weakness of the energy sector will undermine the, still nascent, recovery in the broader economy in the near-term.

Conclusion and investment opportunities

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.

Where the US stock market leads it is difficult for the rest of the world not to follow. The table below from March 2008 shows the high degree of monthly correlation of a range of stock indices to the Nasdaq Composite. In a QE determined world, I would expect these correlations to have risen over the last six years: –

Ticker Index Country 10 years 5 years 1 year
^IXIC Nasdaq Composite USA 1 1 1
^GSPC S&P 500 USA 0.8 0.86 0.83
^DWC Wilshire 5000 USA N/A 0.9 0.85
^AORD All Ords Australia 0.64 0.6 0.93
^BVSP Bovespa Brazil 0.62 0.53 0.83
^GSPTSE TSX Canada N/A 0.66 0.83
399300.SZ Shanghai Composite China N/A N/A 0.68
^GDAXI DAX Germany N/A 0.73 0.83
^HSI Hang Seng Hong Kong 0.6 0.54 0.79
^BSESN BSE Sensex India 0.44 0.5 0.75
^N225 Nikkei 225 Japan 0.51 0.49 0.87
^MXX IPC Mexico 0.67 0.56 0.33
RTS.RS RTS Russia N/A N/A 0.53
^KS11 Kospi South Korea 0.57 0.59 0.8
^FTSE FTSE100 UK N/A 0.57 0.87

Source: Timingcube.com

A decline in the S&P 500 will impact other developed markets, especially those reliant on the US for exports. 2015 will be a transitional year if oil prices remain depressed at current levels, yet the longer term benefit of lower energy prices will feed through to a recovery in 2016/2017. A crisis could ensue next year, but, with China, Japan and the EU continuing to provide quantitative and qualitative support, I do not believe the world’s “saviour” central banks are “pushing on a string” just yet. Inflation is likely to fall, global growth will be higher, but US stocks will, at best, mark time in 2015.

In bond markets, credit will generally be re-priced to reflect the increased risk of corporate defaults due to mal-investment in the energy sector. Carry trades will be unwound, favouring government bonds to some degree.

Recently heightened expectations of higher short term interest rates will recede. This should be supportive for the Real-Estate market. With a presidential election due in 2016 both the Democrats and the Republicans will be concocting policies to support house prices, jobs, average wages and the value of 401k’s. After three years of deliberation, the introduction of watered down QRM – Qualified Residential Mortgage – rules in October suggests this process is already in train.

Many investors have been waiting to enter the stock market, fearing that the end of QE would herald a substantial correction. 2015 might provide the opportunity but by 2016 I believe this window will have closed.

Oil and Growth

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Macro Letter – No 24 – 21-11-2014

Oil and Growth

  • The oil price has fallen by 30% since the summer
  • Global inflation expectations are starting to be revised downwards accordingly
  • Global growth, led by energy importers will be revised higher

 

The Oil Price

Since the summer crude oil prices have fallen sharply from above US$105 to below US$75/barrel. This price move has led to discussion of lower demand stemming from a slow-down in global economic activity. Whilst I expect a benign influence on inflation I am not convinced that the price decline is due to a reduction in global demand. Here is a daily chart for Spot West Texas Intermediate crude oil (WTI) since November 2007:-

TWI Spot - November 2007 - November 2014

Source: Barchart.com

The precipitous decline in 2008 was driven by the global recession following the US sub-prime crisis. The liquidity fuelled recovery in the oil price and the world economy was engineered by the largest central banks. During the same period the US$ Index rose and then declined in a broadly inverse manner to Oil though the motivation for the vacillations in the value of the US currency is broader:-

US Dollar Index - November 2007 - November 2014

Source: Barchart.com

Aside from the steady strengthening of the US$ there are a number of factors which have conspired to drive oil prices lower. Firstly there has, and will continue to be, additional supply emanating from the US where improved energy technology has produced significant increase in production over the last five years –from 1.8bln barrels in 2008 to 2.3bln barrels in 2013. In May 2014 it hit a 25 year high of 8.4mln barrels and the Energy Information Administration (EIA) forecast 2015 production will hit the highest level since 1972. The economic impact of cheaper US energy underpins a manufacturing renaissance which is slowly gathering momentum across America.

The next factor is Saudi Arabian production which has not yet been reduced in response to lower prices. Perhaps this, in turn, is a reaction to the secular decline in oil demand from developed countries; though the announcement, last week, of an emissions reduction agreement by China and the USA may add to the downward pressure. Brookings – The U.S. and China’s Great Leap Forward opined thus: –

The world’s two largest emitters of carbon dioxide together pledged deep reductions – well in advance of the pressure they will face in the upcoming UN Climate Change negotiations that begin in Lima later this month, and which are scheduled to conclude a year from now in Paris.  They also did so at a level deeper than many had expected.  While both countries have already begun efforts to cut emissions, the timing of the announcement and the depth of the reductions went beyond what many diplomats, businesses and environmental groups anticipated.

… Internationally, both countries have a range of other issues to address – including working with the poorest nations which lack the resources to make similarly dramatic cuts, but who are deeply affected by a warmer, wetter world. Still, even with all those obstacles ahead, today’s agreement is the beginning of a great leap forward for climate protection.

Additional supply could swiftly come on stream from Libya. Further talks are scheduled between the rival Libyan factions in Khartoum, Sudan, on December 1st.  The chart below shows how swiftly Libyan production has declined:-

Libyan crude_oil_production EIA

Source: EIA

Also hanging over the market is the prospect of Iranian production increases as international sanctions are reduced. Between 2011 and 2013 Iranian oil exports declined from 3mln bpd to less than 1mln bpd. This year they have rebounded strongly, averaging more than 1mbpd. Iranian production has been running at around 3 mbpd but the National Iranian Oil Company expects an increase to 4.3 mbpd next year – though several commentators are doubtful of Iran’s ability to achieve this increase in output. For more detail on the Iranian situation this article – Al Monitor – Iran takes steps to reduce economic risk of falling oil prices may be of interest.

There are some demand factors which may also undermine prices. Chinese growth has been slowing but, more importantly, the Chinese administration has adopted a policy of re-balancing away from production towards domestic consumption. In theory this process should reduce China’s energy demand; off-set, to some degree, by increased export demand from other emerging market countries as they seek to supply China’s consumption needs. I believe lower energy prices will help Chinese exporters to increase margins or export volumes – or both.

The latest IEA Oil Market Report made these observations: –

Oil’s rout gained momentum in October and extended into November, with Brent at a four-year low below $80/bbl. A strong US dollar and rising US light tight oil output outweighed the impact of a Libyan supply disruption. ICE Brent was last trading at $78.50/bbl – down 30% from a June peak. NYMEX WTI was at $75.40/bbl.

Global oil supply inched up by 35 kb/d in October to 94.2 mb/d. Compared with one year ago, total supply was 2.7 mb/d higher as higher OPEC production added to non-OPEC supply growth of 1.8 mb/d. Non-OPEC production growth is forecast to ease to 1.3 mb/d for 2015 from this year’s 1.8 mb/d high.

OPEC output eased by 150 kb/d in October to 30.60 mb/d, remaining well above the group’s official 30 mb/d supply target for a sixth month running. The group’s oil ministers meet on 27 November against the backdrop of a 30% price decline since they last gathered in June.

Global oil demand estimates for 2014 and 2015 are unchanged since last month’sReport, at 92.4 mb/d and 93.6 mb/d, respectively. Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.

OECD industry oil stocks built counter-seasonally by 12.6 mb in September. Their deficit versus average levels, after ballooning earlier this year, fell to its narrowest since April 2013. Preliminary data show that despite a 4.2 mb draw, stocks swung into a surplus to average levels in October for the first time since March 2013.

Global refinery crude demand hit a seasonal low in October amid peak plant maintenance and seasonally weak product demand. The 4Q14 throughput estimate is largely unchanged since last month’s Report, at 77.5 mb/d, as robust Russian and Chinese throughputs offset a steeper-than-expected drop in US runs in October.

Set against these forces, driving the price of oil lower, is the geo-political tension between Russia and NATO, the ISIS insurgency in Iraq and the continued instability of the Middle East emanating from the civil war in Syria. It is difficult to estimate how far the oil price would decline if the civil unrest in Ukraine and Syria ended tomorrow, I suspect, another 20% to 25%% -during the Kuwait War in the month of October 1990 the price of WTI declined from $40 to $27/barrel even before the war was over:-

WTI Spot - July 1990 - March 1991

Source: Barchart.com

From a technical perspective the breakout from the 2011 range to the downside suggests support around $66, $62, $58, with a final capitulation target of $46. There are, however, reasons to be more optimistic about the prospects for oil, even near-term.

A factor, mentioned by the IEA, which may lead to a reduction in supply, is the outcome of the forthcoming OPEC meeting due to take place on 27th November. Qatar has already begun, reducing production from 800,000 bpd to 650,000bpd last month. At the end of November they will reduce production further to 500,000 bpd – in total a 40% cut. They are not the only countries to be reducing production. The tables below are taken from the OPEC Monthly Report November 2014 which included Secondary Sources: –

OPEC-Secondary-Sources  September 2014

Source: OPEC

Whilst oil prices may trend somewhat lower the term structure of the TWI futures market has recently returned from several years of backwardation to contango – Brent Crude has been in contango for some while. This suggests that lower prices are beginning to reduce US domestic over-supply as smaller US operators cease to be able to produce oil profitably. Below $65 the EIA forecast for 2015 will probably need to be revised lower. Prices are likely to be better underpinned at their current levels.

Another encouraging factor is US domestic demand from refiners. US Crack spreads – the price spread between crude oil and its products – has started to widen in recent weeks. Oil demand should increase in response to higher product margins. The cracking margins have risen most dramatically for Gasoline but Heating Oil margins have also improved and may catch up if predictions of an exceptionally cold winter in the Northern hemisphere prove to be correct. NOAA – Winter Outlook from last month is reasonably sanguine – warm in the West and Alaska, cold in South and Rockies – but substantial snowfall in Siberia (the largest in October since 1967) is cause for caution.

Global Growth

This brings me on to the impact of lower oil prices on global growth. Obviously the large crude oil exporting countries will suffer from reduced revenue but the importers of oil – and gas, since many gas contracts are referenced to the price of oil – should be beneficiaries.  This recent article from Brookings – Oil – A Question of Economics – reminds readers of some of the ubiquitous benefits to the global economy of lower energy prices: –

Virtually all businesses will benefit from lower transportation costs by expanding their profit margins or passing the benefit to consumers at lower prices. The lower income groups, who spend a higher proportion of their incomes on transport, will see their disposable incomes rise, benefiting retailers who serve their needs and thereby increasing demand in the economy. Food prices are also likely to fall, as food production, processing and sales distribution are energy intensive activities, thereby benefiting lower income groups further. Increased consumption will stimulate aggregate demand, creating investment opportunities and economic growth. Governments in the west may also have the opportunity to increase fuel taxes to cover the real cost of the negative externalities of carbon emissions, or raise revenue to improve public transportation systems. Furthermore, governments in the Middle East and Asia will reduce spending on their fuel subsidies and may take the opportunity to improve the workings of market forces, which the IMF and Western powers have been seeking for them to do.

The effect of lower oil prices is felt quite rapidly by consumers globally. Oil consumers, at the household level, receive an immediate boost to their real income. This “wind-fall” is then either spent or saved. An explanation of these effects can be found in this Gavyn Davies article in the Financial Times – Large global benefits from the 2014 oil shock (Some of you may need to subscribe to this “limited free service”). He uses IMF data to produce two very interesting charts: –

Oil and GDP - IMF Fulcrum

Source: IMF and Fulcrum

The fall in inflation will be of greater concern to the ECB than the other major central banks. The BoJ has already acted aggressively in response to the economic slowdown in Japan, the Abe government has deferred a scheduled tax increase and announced an early election. The Federal Reserve, having completed its tapering of QE, will be focussed on wage growth. As central bank to the world’s second largest and rising oil producer, the Fed will be concerned about the drag on growth from a slowdown in the energy and utility sectors; market expectations of interest rate increases will be deferred once again. If the ECB act aggressively to head off the chimera of deflation this may be enough to improve global confidence – I believe this makes the blue line prediction more likely. If WTI should plummet towards $60, the improvement in economic growth should be even greater.

As recently as last month the IMF – World Economic Outlook – forecast for Oil prices was $102.76 for 2014 and $99.36 for 2015. They continue to cling to their forecasts based on expectation of increased geo-political tensions. Given that their 2015 forecast is around 30% above current levels if they are mistaken and the oil price remains subdued their global growth forecast could be around 0.6% too low.

Last month The Economist – Cheaper Oil: Winners and Losers – took up the theme of lower oil prices:-

A 10% change in the oil price is associated with around a 0.2% change in global GDP, says Tom Helbling of the IMF. A price fall normally boosts GDP by shifting resources from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. If increased supply is the driving force, the effect is likely to be bigger—as in America, where shale gas drove prices down relative to Europe and, says the IMF, boosted manufactured exports by 6% compared with the rest of the world. But if it reflects weak demand, consumers may save the windfall.

The authors go on to discuss farmers as the main direct beneficiaries of cheaper oil. India especially but other economies with a large agricultural sector as well: –

Energy is the main input into fertilisers, and in many countries farmers use huge amounts of electricity to pump water from aquifers far below, or depleted rivers far away. A dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods, says John Baffes of the World Bank. Farmers benefit from cheaper oil. And since most of the world’s farmers are poor, cheaper oil is, on balance, good for poor countries.

Take India, home to about a third of the world’s population living on under $1.25 a day. Cheaper oil is a threefold boon. First, as in China, imports become cheaper relative to exports. Oil accounts for about a third of India’s imports, but its exports are diverse (everything from food to computing services), so they are not seeing across-the-board price declines. Second, cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment.

Third, cheaper oil cuts India’s budget deficit, now 4.5% of GDP, by reducing fuel and fertiliser subsidies. These are huge: along with food subsidies, the total is 2.5 trillion rupees ($41 billion) in the year ending March 2015—14% of public spending and 2.5% of GDP. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. As in China, cheaper oil should reduce the pain of cutting subsidies—and on October 19th Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

The price move has also prompted a response from the researchers at the Dallas Fed – Oil Prices Fall Despite Global Uncertaintywhilst their concern is broadly domestic they note that it is Non-OECD demand which is driving the increase in oil demand. The largest beneficiaries of lower oil prices will be oil importing emerging market countries: China, India and, to the extent that they are still considered an emerging economy, South Korea. Other candidates include Singapore, Taiwan, Poland, Greece, Indonesia, South Africa, Brazil and Turkey.

Conclusion and Investment Opportunities

Foreign Exchange

The fall in oil prices has been mirrored, inversely, by the rise of the US$. This trend is already well established but I expect it to continue. This is not so much a reflection of the strength of the US economy as the moribund nature of growth expectations in the EU and Japan.

Government Bonds

Lower inflation expectations, combined with central bank inflation targets, should ensure a delay to interest rate tightening even in response to a resurgence of wage growth. Bond prices will continue to be underpinned. At any sign of a slowing of economic growth, yield curves will flatten further. Convergence of EZ bond yields will continue.

Equities

The chart below shows the relative performance of the S&P500 Index vs MSCI Emerging Market ETF (EEM) over the last five years, after an initial rebound from the Great Recession the US stock market began to outperform other stock markets, driven by the economic boon of oil and gas technology, the implementation of TARP  and the highly accommodative policies of the Fed. With the current round of QE at an end, US investors may need to look further afield in search of value :-

EEM vs SandP 5yr

Source: Yahoo Finance

Expectation of “Lower for Longer” interest rates and cheaper oil is supportive for stock markets in general although there will be sector specific winners and losers. Geographically, lower oil prices will favour those economies most reliant on oil imports, especially if their exchange rate is pegged to the US$. Given the under-performance of many emerging market equities over the last few years I believe this offers the best investment opportunity going forward into 2015. Those countries with floating exchange rates such as India have already benefitted from currency devaluation of 2013; however, there is still potential upside for equities, even after the strong performance of 2014. The SENSEX Index (BSE) started the year around 21,000 and is currently making new highs at 28,000, but during the last three months it has tended to track the performance of the S&P 500 Index – despite the fall in oil prices. I anticipate a general re-rating of emerging market equities next year.

Canada – Australia – New Zealand – Commodities vs Housing

 

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Macro Letter – No 11 – 09-05-2014

Canada – Australia – New Zealand – Commodities vs Housing

  • Commodity prices continue to decline due to slowing Chinese growth
  • Rising real estate prices in Canada, Australia and New Zealand ignore commodity demand
  • What does this mean for their stock, bond and currency markets?

Since the initial recovery in 2010 the price of Iron Ore and Coking Coal has declined due to lower demand from China. Australian Coking Coal hit a six year low in April. This downturn in demand has also been evident in the price of Copper and other industrial metals. Last year grain prices also tumbled adding to the pressure on commodity exporting countries: although prices for New Zealand’s Dairy Products remained firm.

Since Australia and New Zealand have similar major trading partners, and are geographically close when compared to Canada, they tend to be considered together whilst Canada is grouped with other NAFTA countries. I want to review these three countries together. To begin I’ve constructed a table which highlights some of the similarities and differences between these “commodity” countries.

Country Main Exports Export Markets
Canada Oil, Wood Products, Chemicals USA (73%) EU (5%) UK (4%)
Australia Coal, Iron, Wheat, Aluminium China (30%) Japan (19%) S. Korea (8%)
New Zealand Dairy Products, Meat, Wool Australia (21%) China (15%) USA (9%) Japan (7%)

 

During the decline in commodity prices the currency markets have reflected these dynamics quite accurately. The CAD and AUD have been steadily falling vs the US$  – although these trends may be starting to reverse. The NZD by contrast has continued to appreciate not only against the US$ but also against its “commodity cousins”.

The chart below shows the NZD Trade-weighted index up to mid 2013 – it has continued to appreciate since then.

NZD TWI - source ricardianambivalence.com

Source: ricardianambivalance.com

The AUD Trade-weighted index chart is updated to the beginning of 2014 – it continued to weaken until last month.

AUD TWI - source FXstreet.com

Source: fxstreet.com

The third chart is of the CAD effective exchange rate – it also shows foreign capital flows.

CAD effective exchange rate and capital flows

Source: Business in Canada

Plus ça change, plus c’est la même chose

The currency markets reflect Canada and Australia’s reaction to the weakness of Chinese demand, the rising NZD points to other factors. Before I delve into the real estate market I thought the table below might be useful, it looks at a number of economic indicators across the three countries. In many respects these economies are quite similar.

Country GDP Unemploy CPI Current A/C Budget Base Rate 10 yr Debt/GDP
Canada 2.7 6.9 1.5 -3.2 -1 1 2.35 89.1
Australia 2.8 5.8 2.9 -2.9 -1.2 2.5 3.82 20.5
New Zealand 3.1 6 1.5 -3.4 -2.1 3 4.31 35.9

 

New Zealand is delivering the strongest GDP growth with the highest real interest rates, but all three countries are suffering from twin budget and current account deficits. Considering the weakness of commodity markets and their reliance on those export markets it is clear that other factors are driving growth.

A quick review of the central bank policy reports reveals another common theme – real estate.

Bank of Canada – Monetary Policy Report – April 2014

Inflation in Canada remains low. Core inflation is expected to stay well below 2 per cent this year due to the effects of economic slack and heightened retail competition, and these effects will persist until early 2016. Total CPI inflation is forecast to be closer to 2 per cent over the coming quarters and remain close to target thereafter.

The global economic expansion is expected to strengthen over the next three years, as headwinds that have been restraining activity dissipate.

In Canada, the fundamental determinants of growth and inflation continue to strengthen gradually, as anticipated.

The Bank continues to expect Canada’s real GDP growth to average about 2 1/2 per cent in 2014 and 2015 before easing to around the 2 per cent growth rate of the economy’s potential in 2016.

No mention of concern about an overheated real estate market in the highlights, however later in the summary they do state: –

Recent developments are in line with the Bank’s expectation of a soft landing in the housing market and stabilizing debt-to-income ratios for households. Still, household imbalances remain elevated and would pose a significant risk should economic conditions deteriorate.

Perhaps the BoC don’t believe it’s their job to reign in the housing market. The Canadian government has imposed several rule changes to curtail the allure of property but, whilst price rises have slowed the correction has yet to materialise. March 2014 house prices were unchanged for the first time in 15 years – it’s too early to predict the top just yet.

The Economist picked up on real estate earlier this month. They pointed out that Canadian household debt has increased from 76% of GDP in Q3 2007 to 93% in Q3 2013. On their measure Canadian property is 76% above its long-term average and on a rent to income basis, 31% overvalued.

The BoC summary also ignores a dichotomy within Canada. Since the crisis of 2008 the populous manufacturing heartlands, Ontario and Quebec (60% of Canada’s population) have seen little economic recovery. The commodity exporting Western states, by contrast, have rebounded – although they are now slowing in response to weaker Chinese demand. Government energy policy remains focussed on supplying the Chinese and Japanese markets with Oil and LNG. China has also been a major investor in Canadian energy companies both directly and indirectly. Since 2007 China is estimated to have invested C$119bln in this sector according to a recent Jamestown Foundation report.

A sustained US economic recovery may insure that Canadian economic growth becomes more balanced over the next couple of years – after all, 73% of Canadian exports are to the US – however, the Canadian government has a gaping budget deficit to plug. In 2008 they were in surplus – they hope to balance the books once more by 2015/2016. This may be a tall order; at the provincial level Ontario has the largest debt of any Canadian state and a debt to GDP ratio of 37.5% – the outstanding amount, C$267.5bln, is significantly larger than the debt of California. Quebec, not to be eclipsed, boasts the largest debt to GDP ratio at 49%, although its total is lower. The Fraser Institute forecast that this will rise to 57% of GDP by 2022/2023 if they continue with their current policies.

Canadian real estate prices are also a concern for the international markets since six Canadian financial institutions dominate the domestic mortgage market. They have combined financial assets equivalent to five times Canada’s GDP – unlike the US Canada has a “Too big to bail” problem.

Reserve Bank of Australia – Monetary Policy Committee Minutes – April 2014

Recent indicators for the global economy suggested that activity in Australia’s major trading partners in the early part of 2014 had expanded at around its average pace…

…In China, data for the first few months of 2014 had suggested a continuation of the easing in economic growth that had started in the latter part of 2013…The targets for inflation and money growth in China were also unchanged for 2014.

Recent data for the United States were consistent with further moderate growth in the economy…

In Japan, domestic demand growth had remained strong, with activity picking up prior to the consumption tax increase at the beginning of April…In the rest of east Asia, growth had continued at around the average of the past decade, while economic conditions in India remained subdued…

Global commodity prices had declined since the previous Board meeting. The spot price for iron ore had been volatile over recent weeks, while steel prices in China had declined and spot prices for coking and thermal coal were well below current contract levels. The fall in the price of steel in China over recent weeks was consistent with a softening in demand. At the same time, the supply of steel appeared to have been constrained by a tightening in credit conditions reflecting the Chinese authorities’ concerns about pollution. Base metals prices had also declined, though rural commodity prices were a little higher.

Domestic Economic Conditions

Members began their discussion of the domestic economy with the labour market, which remained weak despite a strong rise in employment in February and an upward revision to employment in January…Meanwhile, a range of indicators of labour demand suggested a modest improvement in prospects for employment, although the unemployment rate was still expected to edge higher for a time.

The national accounts, which had been released the day after the March Board meeting, reported that average earnings growth over the year to the December quarter 2013 had remained subdued. With measured growth in labour productivity around the average rate of the past two decades, nominal unit labour costs were unchanged over 2013.

Members recalled that the national accounts reported that GDP rose by 0.8 per cent in the December quarter and by 2.8 per cent over the year, which was a little stronger than had been expected. In the quarter, there had been further strong growth of resource exports, while growth in consumption and dwelling investment picked up a little and business investment declined. Public demand had made a surprisingly strong contribution to growth, but planned fiscal consolidation at state and federal levels was likely to weigh on public demand for some time…

Retail sales had increased by 1.2 per cent in January, continuing the pick-up in momentum that began in mid 2013. The Bank’s liaison with firms suggested that, more recently, retail sales growth may have eased from this strong rate. Motor vehicle sales declined further in February, as had measures of consumer confidence over recent months, but the latter were still around their long-run averages.

Housing market conditions remained strong, with housing prices rising in March to be 10½ per cent higher over the year on a nationwide basis. Members noted that dwelling investment had increased moderately in the December quarter, with a pick-up in renovation activity, and that the high level of dwelling approvals in recent months foreshadowed a strong expansion in dwelling investment…

Business investment fell in the December quarter, driven by a large decline in machinery and equipment investment and falls in engineering and non-residential building construction. While much of the decline appeared to have been driven by mining investment, non-mining business investment was also estimated to have declined in the quarter. More recently, non-residential building approvals had increased in January and, in trend terms, were at their highest level since 2008, with increases evident across a range of categories, including the office, industrial and ‘other commercial’ sectors…

Conditions were not sufficiently robust to prompt a change in monetary policy. Perhaps this is because the markets are focussed on next week’s deficit busting budget. What is clear is that manufacturing continues to struggle. According to a report from the Boston Consulting Group, Australia has the highest manufacturing cost of the top 25 largest exporting nations. This poor performance is reinforced by a report from the Productivity Commission pointing to a -0.8% fall in Multi-Factor Productivity (MFP).

The biennial IMF Fiscal monitor – published last month – placed Australia at the top of the list of developed countries with the fastest deteriorating economies relative to forecast. They focussed on the government budget deficit – currently the third largest of all developed nations, behind Japan and Norway. They urged the Australian government to take draconian measures to bring Debt to GDP ratio down toward 70% by 2020.

There has been much discussion of potential changes to the tax treatment of mortgages which could puncture the buy to let market, where “negative gearing” has been prevalent.  The RBA acknowledged that housing construction is now “Strong” vs “Solid” at its March meeting. The Australian Bureau of Statistics – Trends in Household Debt  was released this month showing household debt is at the highest level in real term for 25 years. The Household debt to Income ratio is currently the highest in the developed world at 180%, though Canada isn’t far behind at 165%.

Before you rush to sell your second home down-under it is worth noting that on the basis of Mortgage Interest to Income Australian property is not that expensive. The current ratio is 7% down from 12% in 2008 – although still above the 50 year average of 5%, it reflects today’s benign inflation and lower interest rate environment.

Longer term commodities are still a major source of economic growth, but Australia is ranked 79 in terms of Economic Complexity, with New Zealand at 48 and Canada at 41. All three countries have falling productivity; Australia’s average is -1.3, New Zealand -1.2 and Canada -1.1. In the shorter term, it seems that real estate is the main driver of growth and that growth is based on leveraged household debt.

Reserve Bank of New Zealand – Monetary Policy Statement – March 2014

The Reserve Bank today increased the OCR by 25 basis points to 2.75 percent.

New Zealand’s economic expansion has considerable momentum, and growth is becoming more broad-based.

GDP is estimated to have grown by 3.3 percent in the year to March…

Prices for New Zealand’s export commodities remain very high, and especially for dairy. Domestically, the extended period of low interest rates and continued strong growth in construction sector activity have supported recovery. A rapid increase in net immigration over the past 18 months has also boosted housing and consumer demand. Confidence is very high among consumers and businesses, and hiring and investment intentions continue to increase.

Growth in demand has been absorbing spare capacity, and inflationary pressures are becoming apparent, especially in the non-tradables sector. In the tradables sector, weak import price inflation and the high exchange rate have held down inflation. The high exchange rate remains a headwind to the tradables sector. The Bank does not believe the current level of the exchange rate is sustainable in the long run.

There has been some moderation in the housing market. Restrictions on high loan-to-value ratio mortgage lending are starting to ease pressure, and rising interest rates will have a further moderating influence. However, the increase in net immigration flows will remain an offsetting influence.

While headline inflation has been moderate, inflationary pressures are increasing and are expected to continue doing so over the next two years. In this environment it is important that inflation expectations remain contained. To achieve this it is necessary to raise interest rates towards a level at which they are no longer adding to demand. The Bank is commencing this adjustment today. The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures.

By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank is seeking to ensure that the economic expansion can be sustained.

I have always been impressed by the hawkish credentials of the RBNZ, governor Graeme Wheeler is taking a proactive approach to potential inflationary pressure. However, since these minutes were published the RBNZ has announced that it will intervene on the foreign exchanges to stem any excessive rise in the value of the NZD. The New Zealand currency is near to a 40 year high. Rather than keeping interest rates artificially low to reduce the attraction of NZD as a destination for foreign capital flows, they have chosen to intervene. Governor Wheeler identifies four economics risks which might presage a reversal in NZD strength: –

  1. Weakening of US growth
  2. Fall in dairy prices
  3. Fall in Chinese growth
  4. Increase in financial market volatility leading to a “Risk-Off” environment

The RBNZ has also been courageous in articulating another problem with the current New Zealand policy mix in relation to the “High Immigration Policy”. Board member, Michael Reddel’s working paper – The long-term level “misalignment” of the exchange rate – discusses this subject, it  observes that immigration does not guarantee rising living standards for everyone. He goes on to suggest that “Capital Deepening” from immigration has failed to show up improved MFP. The undesirable side-effects of the policy, however, can be seen in rising land and property prices due to finite supply and increased demand from immigrants, together with foreign capital inflows which have supported the NZD. This has led to a reduction in real incomes and an increase in real interest rates.

The New Zealand government has established a housing affordability target of four time income – this being the long-run average. The current level in Auckland is seven times.

It is worth noting that Australia has similar policies on immigration and similar problems with housing affordability.  The foreign buyers are often Chinese – as the Chinese real estate bubble implodes, one has to wonder how long this will continue.

Real Estate, Currency, Bonds or Stocks

The real estate markets in Canada, Australia and New Zealand are all at or near all time highs, their levels of household debt are similarly extended. Given the illiquid nature of real estate as an asset class now is not the time to buy. The trend is still upward, but when markets reverse those with poor liquidity “gap” lower; the risks in real estate look asymmetric, now is a good time to reallocate to more liquid assets.

I’ve already reviewed the relative merits of the three currencies but, to reiterate, I continue to favour NZD over CAD and, because Canada has a more balanced economy in terms of export markets and economic complexity, I favour CAD over AUD – although CAD/AUD is not a compelling trade in itself.

Canadian 10 yr bonds made their highs in July 2012 yielding 1.56%, by September 2013 they had followed US Treasuries lower to yield 2.83%. Now at 2.4% they are in a neutral range.

By contrast the TSX Index has made new highs this month. Momentum is slowing but the trend remains firmly in tact – remain long but be tentative if establishing new positions. The BoC are not expecting a dramatic increase in growth in 2015/2016 – thereafter they expect growth to slow towards 2%.

Australian 10 yr bonds also hit their highs in July 2012 at 2.68%. In line with the weakness of US Treasuries they declined until yields reached 4.50% in December 2013. Since then they have rallied to 3.83%. The beginning of an up trend is in place, supported by expectations of an extended period of unchanged policy from the RBA. The Australian governments decision to freeze fuel taxes last month means they have an additional A$5bln shortfall in income – the fiscal tightening required to balance the budget is likely to stay the RBAs hand for some time to come – of the three countries, this is my favoured bond market.

With fiscal tightening on the cards it was surprising to see the ASX Index making new highs in April. The momentum is stronger than in Canada and the trend is quite clear. Once the terms of the budget are announced next week it may be easier to consider establishing new longs; I would prefer to see the market make new highs by way of confirmation; if Canberra bites the bullet, Australian stocks might bite the dust.

New Zealand 10 yr bonds made their highs in May 2013 at 3.17%, by December 2013 they had fallen to 4.88%. In line with most other bond markets they have rallied this year to a current yield of 4.31%. The recovery looks weak and the recent interest rate hike by the RBNZ, together with their more up-beat assessment of potential growth and inflation, makes NZ bonds the least attractive of the three bond markets. The three markets have almost identical yield curve shapes (1.30/1.35 bp positive) but, starting with structurally higher rates, I believe the New Zealand curve should be steeper at this stage in the cycle. I’ve tried to trade the Kiwi yield curve in the past and been burnt by the pro-active policies of the RBNZ – please don’t regard this as a recommendation.

The NZ 50 Index, along with the Canadian and Australian indices, has made new highs in the past month. The momentum is stronger than in the TSX or ASX, which is justified by the fundamental assessment of the RBNZ. The negative impact of a strengthening currency should be tempered by RBNZ intervention. This will also encourage capital flows into stocks, since the “carry trade” is capped. RBNZ tightening in expectation of inflation is likely to encourage liquidation of bond holdings, again favouring stocks.

The only cloud on an otherwise rosy horizon is the liquidity risk associated with New Zealand markets in general. In the latest survey of GDP growth by The World Bank, Canada was ranked 11th,Australia 12th whilst New Zealand came in at 55th. As RBNZ governor Wheeler pointed out, one of the risks to the New Zealand economy is a reversal of foreign capital flows if financial market volatility increases. Barring a return of the “Risk-Off” trade, I favour New Zealand Equities; hedged, but only if you really need to, by a short position in New Zealand bonds.

El Nino – Commodities and the export of Emerging Market inflation

400dpiLogo                     

Macro Letter – No 7 – 14-03-2014

El Nino – Commodities and the export of Emerging Market inflation

Emerging markets currencies have been under pressure since the middle of 2013. Many of these markets have above target inflation but have been helped during the past three years by falling commodity prices. Whilst industrial metals continue to decline and energy products mark time, some key perishable commodities have seen sharp price increases since the beginning of 2014. In part this is due to increased expectation of an El Nino weather pattern developing in the second half of 2014.

For emerging economies food prices are a more significant proportion of consumer prices than for developed economies; as food prices rise, wages will need to follow. The one-off impact of currency weakness will help EM exporters in the near-term, but, once this process has run its course, emerging markets will attempt to export their higher inflation.

Commodity indices

Since the spring of 2011 commodity prices have fallen significantly as the CRB Index chart below shows.

CRB Index - monthly 2006 - 2014

Source: Barchart.com

With the start of 2014 resurgence has begun. It is still nascent, but this may mark the beginning of a new trend. What is driving this process, which commodities are leading, which are lagging and where will the inflationary impact of higher prices show up first?

The CRB Index is one of many commodity indices but it is reasonably diversified and has a heavier weighting to perishable commodities than some other indices. Here is the current list of constituents: –

Raw Industrials: Hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, rosin, and rubber (59.1%).

CRB BLS Foodstuffs: Hogs, steers, lard, butter, soybean oil, cocoa, corn, Kansas City wheat, Minneapolis wheat, and sugar (40.9%).

For comparison here is the GSCI, a trade-weighted index of commodities by value. This index is energy heavy (70%) with Crude representing nearly 50% of the index. The weighting for industrial metals is just over 6% and grains around 12%:-

GSCI Index - monthly 2004 - 2014

Source: Barchart.com

The table below gives a brief snapshot of a narrower range of commodity futures over the past year, these prices were taken this morning (14th March) UK time:-

Commodity

Daily

1 Week

1 Month

YTD

Copper

0.09%

-5.12%

-10.33%

-16.82%

Brent   Crude

0.07%

-1.67%

-1.84%

-2.60%

WTI

-0.04%

-4.36%

-2.19%

5.05%

Nat   Gas

-0.66%

-5.71%

-16.15%

12.50%

US   Corn

-0.41%

-0.92%

8.30%

-32.77%

US   Wheat

0.06%

2.91%

12.55%

-7.00%

 Source: Investing.com

I will review these key markets, adding some commentary on Iron Ore, Coal, Soybeans and Rice since these are critical constituents of industrial metals, energy and agriculture globally.

Copper and Iron Ore

Copper prices remain depressed due to a lack of industrial demand, especially from China. Shanghai Copper dropped to a four year low last week after the publication of weak trade data (-18% vs a  forecast of +5%).

This chart shows US High Grade Copper. Further weakness may cause a rout: –

US Copper - monthly - 2004 - 2014

Source: Barchart.com

The lack of Chinese industrial demand is also seen in this chart of Dalian Iron Ore Futures: –

Dalian Iron Ore Futures - Oct 2013 - March 2014

Source: Macrobusiness.com.au

Crude Oil

The disparity between the performance of Brent Crude and WTI is not a topic I want to discuss on this occasion; however, using WTI as a proxy, the chart below indicates that prices have remained stable with a small upward bias over the last couple of years. During this same period the US economy has slowly begun to recover:-

WTI Monthly - 2004 - 2014

Source: Barchart.com

Part of the subdued nature of the price action is due to increases in US domestic production. The US has been fortunate in its ability to harness new technology to increase energy productivity but, as this article from the Manhattan Institute – New Technology for Old Fuel – points out, this is a process which has evolved over many decades; here’s an extract from the executive summary:-

…The key findings of this paper include:

• Between 1949 and 2010, thanks to improved technology, oil and gas drillers reduced the number of dry holes drilled from 34 percent to 11 percent.

• Global spending on oil and gas exploration dwarfs what is spent on “clean” energy. In 2012 alone, drilling expenditures were about $1.2 trillion, nearly 4.5 times the amount spent on alternative energy projects.

• Despite more than a century of claims that the world is running out of oil and gas, estimates of available resources continue rising because of innovation. In 2009, the International Energy Agency more than doubled its prior-year estimate of global gas resources, to some 30,000 trillion cubic feet—enough gas to last for nearly three centuries at current rates of consumption.

• In 1980, the world had about 683 billion barrels of proved reserves. Between 1980 and 2011, residents of the planet consumed about 800 billion barrels of oil. Yet in 2011, global proved oil reserves stood at 1.6 trillion barrels, an increase of 130 percent over the level recorded in 1980.

• The dramatic increase in oil and gas resources is the result of a century of improvements to older technologies such as drill rigs and drill bits, along with better seismic tools, advances in materials science, better robots, more capable submarines, and, of course, cheaper computing power.

In a number of less developed countries the geopolitics of oil are more relevant. On the United States doorstep is Venezuela – ranked 9th by Crude production (3mln bpd). The political and economic situation within the country is getting worse in the post-Chavez environment. This short article from The Peterson Institute – Can Venezuela Learn from Ukraine? Sums up the current situation: –

 For Venezuela’s sake, President Maduro should be watching events unfold in Ukraine and act to avoid the sort of bloodshed that finally led to the ouster of Yanukovych. If he does, he may buy himself some more time to devise a strategy to unwind some of the most egregious economic distortions.

Last April, at the Peterson Institute’s spring Global Economic Prospects meeting, we predicted [pdf] that Venezuelan President Maduro would be unable to continue Hugo Chavez’s legacy of 21st century socialism because of serious economic and political pressures. Those pressures have only increased. With his own party far from united, question marks regarding the role of the military, and a strengthening protest movement, it is only a matter of time before Venezuela also reaches a breaking point. Perhaps helped by a coordinated effort by the Mercosur countries and the United States, Venezuela should step up to the challenge.

Another political hot-spot is Russia. Producing 10.9 mln bpd, Russia is the largest Oil producer globally. She is unlikely to reduce production but may divert supply away from Europe should the Ukrainian impasse deteriorate further. On balance this may not be catastrophic for the global economy since China may be an obvious beneficiary.

Shia, Saudi Arabia (ranked 2nd – producing 9.9 mln bpd) has a veneer of stability, but the increasing dialogue between the developed nations and Sunni, Iran (ranked 4th – producing 4.2 mln bpd) concerning their nuclear development programme, is inherently destabilising.

Barring a collapse in world economic growth, I believe Crude Oil prices will be robustly supported. Excepting the benign influence of US domestic productivity gains, the risks are skewed to the up-side.

Natural Gas

Unlike Crude Oil, Natural Gas is geographically constrained by distribution bottlenecks. At a global level Natural Gas can be divided into three price groups as the chart below illustrates: –

Nat Gas Price - 2007 - 2014

Source: World Bank and Knoema

Please note: this chart doesn’t incorporate the price increase in Europe since the Ukrainian revolution began. These price differentials are a source of opportunity and will encourage technological development, especially in the area of natural gas liquification.

The steady increase in US Nat Gas since early 2012 is seen more clearly in the next chart: –

US Nat Gas - Monthly - 2004 - 2014

Source: Barchart.com

The latest up-surge has been driven by the extreme cold weather which affected much of the US. This is a reminder of the natural cyclicality of Nat Gas prices in response to extremes of cold or hot. The current price is towards the upper end of its post 2009 range. Improvements in fracking technology make any price increases attractive for producers to increase supply. Production improvements are evident even in areas where conventional extraction techniques are employed. The Potential Gas Committee – April 2013 press release paints a rosy picture for production in general: –

The Potential Gas Committee (PGC) today released the results of its latest biennial assessment of the nation’s natural gas resources, which indicates that the United States possesses a total technically recoverable resource base of 2,384 trillion cubic feet (Tcf) as of year-end 2012. This is the highest resource evaluation in the Committee’s 48-year history, exceeding the previous high assessment (from 2010) by 486 Tcf. Most of the increase arose from new evaluations of shale gas resources in the Atlantic, Rocky Mountain and Gulf Coast areas.

These changes have been assessed in addition to 49 Tcf of domestic marketed-gas production estimated for the two-year period since the Committee’s previous assessment.

“The PGC’s year-end 2012 assessment reaffirms the Committee’s conviction that abundant, recoverable natural gas resources exist within our borders, both onshore and offshore, and in all types of reservoirs—from conventional, ‘tight’ and shales, to coals,” said Dr. John B. Curtis, Professor of Geology and Geological Engineering at the Colorado School of Mines and Director of the Potential Gas Agency there, which provides guidance and technical assistance to the Potential Gas Committee.

The inherent volatility of Nat Gas prices makes prediction about longer term trends difficult, but, I believe the main factor which will influence US Nat Gas prices longer term will be the development of LNG capacity: and this must be preceded by the issuance of further Nat Gas export licenses by the US  DOE.

Coal

Coal doesn’t appear in the commodity futures table above, but, like Iron Ore and Natural Gas, it is globally important. This chart from Uppsala University – Coal future of China and the World shows how Coal production is still increasing:-

World Coal Production Forecast - 2100

Source: Uppsala University

According to the World Coal Association, China is currently the world’s largest producer but also the largest importer, 81% of its electricity is generated from Coal. By comparison the second largest producer, USA, is the forth largest exporter and uses Coal for only 43% of its electricity generation. The third largest producer, India, is the third largest importer and uses Coal for 68% of its electricity generation.

The World Bank compiles monthly commodity prices including Coal from three of the top six export countries; this shows a similarly subdued pattern to industrial metals. Prices are not far above their 2008-2009 lows :-

Coal Exporter prices 2007 - 2020

Source: Knoema and World Bank

Of the BRIC economies, China, India and Russia are among the top five Coal producers (whilst Brazil is 12th largest producer of Crude Oil). From an energy-security perspective, Coal is a geopolitical palliative since “known reserves” are globally distributed. Prices are far from over-stretched and predictions for “Peak-Coal” are still some decades away. If Coal prices rebound from their current levels it will most likely be due to demand-pull factors. 

Grains and El Nino

Last year Wheat, Corn and Soybeans all declined substantially, but, when viewed over the past decade prices appear to have consolidated and are now beginning to push higher.

US Wheat - monthly 2004 - 2014

Source: Barchart.com

 US Corn - monthly 2004 - 2014

Source: Barchart.com

US Soybeans - monthly 2004 - 2014

Source: Barchart.com

 

US Rice, by contrast, remained broadly stable.

US Rough Rice - monthly future - 2004 - 2014

Source: Barchart.com

To understand the impact on emerging market inflation, however, we need to look beyond the US domestic market. The table below shows Wheat and Rice production for 2013 by country.

WHEAT
Rank Country Production   2013 (mln tons)

1

  China

125.6

2

  India

94.9

3

  United States

61.8

4

  France

40.3

5

  Russia

37.7

RICE
Rank Country Production   2013 (mln tons)

1

China

143

2

India

99

3

Indonesia

36.9

4

Bangladesh

33.8

5

Vietnam

27.1

6

Thailand

20.5

7

Philippines

11

8

Myanmar

10.75

9

Brazil

7.82

10

Japan

7.5

The disruption to grain production in the Ukraine provides significant price support for Wheat (and also Corn) but a more global factor may be brewing in the central Pacific: El Nino. Whilst Wheat and Rice are not substitutes El Nino weather patterns may disrupt production of both commodities. Risks are on the upside.

Last week the NOAA – ENSO (National Oceanic and Atmospheric Administration – El Nino Southern Oscillation) report maintained its forecast of a 50% chance of El Nino developing by summer or fall 2014. For the US El Nino has a number of effects on agriculture as this article from The Southeast Climate Consortium illustrates: –

During El Niño Years

Corn yields are usually lower than historic averages.

Harvests of summer crops such as corn, peanuts, and cotton may be delayed because of increased rains in the fall.

Frequent rains may reduce tilling and yield of winter wheat.

Wheat yields in southern AL and GA are generally higher than average during El Niño.

Frequent rains at the end of August and in early September may increase Hessian fly populations on winter wheat.

For a more global view of the El Nino effect the following map simplifies an otherwise complex picture, droughts in Brazil, India, Indonesia and Australia stand out: –

El Nino Map

Source: PhysicalGeography.net

Last month Reuters – El Nino threatens to return described some of the risks, you will notice they predict heavy rain in Brazil – the El nino effect is a distinctly complex: –

A strong El Nino can wither crops in Australia, Southeast Asia, India and Africa when other parts of the globe such as the U.S. Midwest and Brazil are drenched in rains.

While scientists are still debating the intensity of a potential El Nino, Australia’s Bureau of Meteorology and the U.S. Climate Prediction Center have warned of increased chances one will strike this year.

…Last month, the United Nations’ World Meteorological Organization said there was an “enhanced possibility” of a weak El Nino by the middle of 2014.

The specter of El Nino has driven global cocoa prices to 2-1/2 year peaks this month on fears that dry weather in the key growing regions of Africa and Asia would stoke a global deficit. Other agricultural commodities could follow that lead higher if El Nino conditions are confirmed.

In India, the world’s No.2 producer of sugar, rice and wheat, a strong El Nino could reduce the monsoon rains that are key to its agriculture, curbing production.

“If a strong El Nino occurs during the second half of the monsoon season, then it could adversely impact the production size of summer crops,” said Sudhir Panwar, president of farmers’ lobby group Kishan Jagriti Manch.

El Nino in 2009 turned India’s monsoon patchy, leading to the worst drought in nearly four decades and helping push global sugar prices to their highest in nearly 30 years.

Elsewhere in Asia, which grows more than 90 percent of the world’s rice and is its main producer of coffee and corn, a drought-inducing El Nino could hit crops in Thailand, Indonesia, Vietnam, the Philippines and China.

And it could deal another blow to wheat production in Australia, the world’s second-largest exporter of the grain, which has already been grappling with drought in the last few months.

Between 2006 and 2008 average world prices for Rice rose by 217%, Wheat by 136%, Corn by 125% and Soybeans by 107%. This prompted food riots in India and other emerging market countries. Many commentators blamed developed countries whose institutions had been investing in commodities to diversify their portfolios away from traditional asset classes, but El Nino also had a significant hand in this process.

In December 2013 CFTC proposed amended limits on positions size for 28 US commodity futures markets – not solely to aid the emerging world.  This may restrict some investment activity but is unlikely to reduce volatility. Here is the Harvard Law School Forum review of the proposal.

For emerging economies food prices are more important to CPI. This essay from the St Louis Federal Reserve – Food Prices and Inflation in Emerging Markets sheds more light on the topic: –

Rising food prices contribute more to inflation in developing countries because food is a much higher share of the consumption basket in emerging markets than in wealthier countries. For example, food accounts for 15 percent of the U.S. consumer price index (CPI) basket, but 50 percent of the Philippines’ CPI basket. Compounding the differences, research shows that there is a much more significant pass-through from food prices to non-food prices in developing countries compared with advanced countries, where there is almost none.

Emerging Market Currencies and inflation

The weakening of emerging market currencies since mid-2013 has been widely covered in the financial press. The “Fragile Five” – Brazil, India, Indonesia, South Africa and Turkey – have, among other attributes, above target inflation. How much higher will this become in response to their declining currencies and when will this inflation start to be exported? Assuming there is a lag between changes in commodity prices and CPI, last year’s commodity price declines will still be feeding through in 2014. Lower exchange rates allow these economies to become more export competitive in the near-term, but, once this adjustment has run its course, cost push factors will begin to emerge unless world economic growth suddenly stalls.

In Q4 2013 Societe Generale produced the following chart, this is their forecast for EM currencies after the fall: –

Soc Gen EM Currency Forecasts from March 2014 to Dec 2014

Source: Societe Generale

This would be an export led recovery at the expense of developed markets. Adding commodity inflation into the mix together with higher domestic wage costs, in order to meet higher food prices, could begin a global reflation process. Near-term the impact of the EM currency group will, however, be disinflationary for developed economies. This EM Currency ETF chart high-lights the depreciation since Q1 2013: –

PIMCO EM Currency ETF - 2012 - 2014

Source: Yahoo Finance

Conclusion 

Industrial metal prices remain under pressure due to weakness of demand especially from China. Energy prices continue to tread water but are supported by forecasts of better world GDP growth during 2014 and geopolitical concerns. Grains and other perishable commodity prices are vulnerable to upside pressure should a strong El Nino phase develop in H2 2014.

Stronger world growth combined with higher commodity prices will eventually lead to reflation in developed markets as price increases are exported from emerging markets. These effects may be muted by adverse demographics in some countries but those countries with youth on their side will witness an end to the great moderation and the beginning of a new longer-term inflation cycle.

For equity markets inflation is not a universal good as this article from Detlev Schlichter recounts but many emerging markets already have high interest rates. Whilst these rates may go higher still the fear of higher rates is far less severe in these emerging markets than in developed markets where zero-bound asymmetry predominates. I believe emerging market equities – especially agricultural exporters – are well placed to benefit from the next inflation cycle.

Commodity super-cycles in a fiat currency world

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Macro Letter – No 2 – 16-12-2013  

Commodity super-cycles in a fiat currency world

Notwithstanding weakness in the last six weeks, stock markets have witnessed significant gains during 2013, but commodities – with a few exceptions – have failed to follow suit.

For global investors the advent of investible commodity indices has simplified the commodity allocation process but I have always encouraged my readers to view each commodity on its own merits.

The Goldman Sachs – GSCI Index is constructed on a production weighted basis; the table below is courtesy of Reuters: –

                       2013       2012    Change Vs 2012

 WTI Crude           30.96%     24.71%           6.25%

 Kansas Wheat         0.88%      0.68%           0.20%

 Live Cattle          2.71%      2.62%           0.09%

 Sugar                1.90%      1.85%           0.05%

 Cotton               1.12%      1.07%           0.05%

 Gold                 3.05%      3.00%           0.05%

 Soybeans             2.63%      2.62%           0.01%

 Coffee               0.83%      0.82%           0.01%

 Natural Gas          2.03%      2.02%           0.01%

 Zinc                 0.52%      0.51%           0.01%

 Cocoa                0.23%      0.23%           0.00%

 Nickel               0.58%      0.58%           0.00%

 Silver               0.49%      0.49%           0.00%

 Aluminum             2.12%      2.13%          -0.01%

 Lead                 0.38%      0.40%          -0.02%

 Corn                 4.66%      4.69%          -0.03%

 Feeder Cattle        0.49%      0.52%          -0.03%

 LME Copper           3.24%      3.28%          -0.04%

 Lean Hogs            1.52%      1.58%          -0.06%

 Chicago Wheat        3.04%      3.22%          -0.18%

 Gas Oil              8.11%      8.56%          -0.45%

 RBOB Gasoline        5.02%      5.90%          -0.88%

 Heating Oil          5.13%      6.17%          -1.04%

 Brent Crude         18.35%     22.34%          -3.99%

This highlights the increasing production of WTI Crude (West Texas Intermediate) relative to Brent Crude. It also highlights the substantial index weighting to Energy followed by Metals and then Grains. In this letter I will keep these weightings in mind.

The table below, from barchart.com, shows the year to date performance of the major US futures markets. The price divergence is not atypical.

US Futures YTD - barchart

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Source: barchart.com

As an “asset class” commodities offer among the most uncorrelated returns, but, unlike more traditional assets, they generally have a negative real expected long-term return. In other words, due to human ingenuity, the cost of production falls over time.

Back in 2006 I used the chart below from the Economist as part of a presentation about the dangers of “long-only” investment in commodities. The Economist first published its Industrial Commodity-price index in 1864 due to demand for information on commodity markets resulting from the strong price appreciation during the preceding two decades. The commodity price appreciation was driven primarily by US demand as the country industrialised and then entered into a bloody civil war. Historic data was collected to create a starting level of 100 in 1845. When the raw data is deflated using the US GDP deflator you will observe that the current index is rebounding from a cyclical low of 20.

The Economist industrial commodity-price index

Economist Commodity Price Index - deflated - 1845 - 2005.

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Source: Economist

Today, in a world of fiat currencies, it is more difficult to examine the cause and effect of changes in supply and demand for commodities because their measurement – generally in US$ – is itself a “moving target” rather than a “store of value”. However, given the vagaries of Gold leasing and the plethora of conspiracy theories surrounding the price of Gold, the “gently declining” US$ seems like the most familiar measure of value. This “Dollar Value” is practical in the short-term but in the Long Run the entire commodity cycle may be as much a reflection of monetary policy as supply and demand for the underlying commodities.

The collapse of Bretton Woods in 1971 heralded in a period of inflation, the appointment of Paul Volcker as governor of the Federal Reserve finally reversed this process as he attempted to control the supply of money. The bursting of the “Tech Bubble” and a policy of low interest rates created the conditions for the next “Super-cycle”.

One of the vexing issues with commodity super-cycles is their variability of duration. This paper from the United Nations Department of Economic and Social Affairs – Super-cycles of commodity prices since the mid-nineteenth century – is a useful guide to the difficulties of prediction: –

http://www.un.org/esa/desa/papers/2012/wp110_2012.pdf

Here is the abstract:-

Decomposition of real commodity prices suggests four super-cycles during 1865-2009 ranging be­tween 30-40 years with amplitudes 20-40 percent higher or lower than the long-run trend. Non-oil price super-cycles follow world GDP, indicating they are essentially demand-determined; causality runs in the opposite direction for oil prices. The mean of each super-cycle of non-oil commodities is generally lower than for the previous cycle, supporting the Prebisch-Singer hypothesis. Tropical agriculture experienced the strongest and steepest long-term downward trend through the twentieth century, followed by non-tropical agriculture and metals, while real oil prices experienced a long-term upward trend, interrupted temporarily during the twentieth century.

The paper goes on to point out that these cycles can last between 20 and 70 years. The UN, however, focus on developing country demand, seeing it as the main driver of the cycles; they don’t consider the “money” side of this phenomenon.

The origin of modern economic studies of cycles is thought to have commenced with Nicolai Kondratiev, it was then taken up by economists of the Austrian School, most notably Joseph Schumpter. At this time – 1930’s – other price cycle theories were being developed independently by Ralph Elliott, among others. Elliott’s ideas were published in his book – The Wave Principle – in 1938. Among his influences were the Italian 10th Century mathematician Leonardo of Pisa – otherwise known as Fibonacci.

I believe there is another long-term factor which drives these cycles, beyond economic growth and currency debasement, and that is geopolitical tension. In developing my thoughts on this subject I am indebted to two authors; Marc Widdowson – The Coming Dark Age – The Phoenix Principle – which I must admit I am still reading, you may download it here: –

http://www.scribd.com/doc/63914376/The-Coming-Dark-Age

The other author is David Murrin – Breaking the Code of History – David looks at the history of empires using a wave principle derived from Elliott and the Polish-American mathematician Benoit Mandelbrot’s theories of fractal geometry, here is his website:-

www.davidmurrin.co.uk

In simple terms, David’s observation is that the majority of wars, throughout history, have been driven by resource scarcity. Looking back at the Economist Commodity Price Index you can identify the great conflicts of recent history. However, during the tumults, more often than not, payment in specie was suspended and inflation ensued. Any countries return to the “Gold Standard”, or its equivalent, was likely to precipitate an inevitable period of deflation; as happened to the UK and US after the first world war.

Returning to the factor of debasement, during the “Great Deformation”, as David Stockman describes the post Bretton Woods era (1971 onwards) governments have been operating in an elastic “quasi-war finance” environment. When ever a crisis arrives, governments lean on their respective central banks to backstop the markets with abundant liquidity. As the worlds’ “reserve currency” is the US$, the US government has an advantage – what De Gaulle referred to as the “exorbitant privilege” during the period of the gold exchange standard, remains a  boon today – but other countries have succeeded to a lesser degree by allowing their currencies to decline relative to the UD$.

The prospects for commodities

Looking ahead to 2014 there are a plethora of factors to consider. I will focus on just a few: –

Commodity – Demand

On the demand side of the equation are China followed by other emerging market countries where strong economic growth is expected. Below is the OECD GDP forecast from 20th November 2013: –

Real   gross domestic product – forecasts
‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Australia

2.4

 

1.5

 

2.6

 

2.4

 

3.7

 

2.5

 

2.6

 

3.1

 

Austria

0.9

 

-3.5

 

1.9

 

2.9

 

0.6

 

0.4

 

1.7

 

2.2

 

Belgium

1.0

 

-2.8

 

2.4

 

1.9

 

-0.3

 

0.1

 

1.1

 

1.5

 

Canada

1.2

 

-2.7

 

3.4

 

2.5

 

1.7

 

1.7

 

2.3

 

2.6

 

Chile

3.2

 

-0.9

 

5.7

 

5.8

 

5.6

 

4.2

 

4.5

 

4.9

 

Czech   Republic

3.1

 

-4.5

 

2.5

 

1.8

 

-1.0

 

-1.5

 

1.1

 

2.3

 

Denmark

-0.8

 

-5.7

 

1.4

 

1.1

 

-0.4

 

0.3

 

1.6

 

1.9

 

Estonia

-4.2

 

-14.1

 

2.6

 

9.6

 

3.9

 

1.0

 

2.4

 

4.0

 

Finland

0.3

 

-8.5

 

3.4

 

2.7

 

-0.8

 

-1.0

 

1.3

 

1.9

 

France

-0.2

 

-3.1

 

1.6

 

2.0

 

0.0

 

0.2

 

1.0

 

1.6

 

Germany

0.8

 

-5.1

 

3.9

 

3.4

 

0.9

 

0.5

 

1.7

 

2.0

 

Greece

-0.2

 

-3.1

 

-4.9

 

-7.1

 

-6.4

 

-3.5

 

-0.4

 

1.8

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Hungary

0.9

 

-6.8

 

1.1

 

1.6

 

-1.7

 

1.2

 

2.0

 

1.7

 

Iceland

1.2

 

-6.6

 

-4.1

 

2.7

 

1.4

 

1.8

 

2.7

 

2.8

 

Ireland

-2.2

 

-6.4

 

-1.1

 

2.2

 

0.1

 

0.1

 

1.9

 

2.2

 

Israel 1

4.5

 

1.2

 

5.7

 

4.6

 

3.4

 

3.7

 

3.4

 

3.5

 

Italy

-1.2

 

-5.5

 

1.7

 

0.6

 

-2.6

 

-1.9

 

0.6

 

1.4

 

Japan

-1.0

 

-5.5

 

4.7

 

-0.6

 

1.9

 

1.8

 

1.5

 

1.0

 

Korea

2.3

 

0.3

 

6.3

 

3.7

 

2.0

 

2.7

 

3.8

 

4.0

 

Luxembourg

-0.7

 

-5.6

 

3.1

 

1.9

 

-0.2

 

1.8

 

2.3

 

2.3

 

Mexico

1.2

 

-4.5

 

5.1

 

4.0

 

3.6

 

1.2

 

3.8

 

4.2

 

Netherlands

1.8

 

-3.7

 

1.5

 

0.9

 

-1.2

 

-1.1

 

-0.1

 

0.9

 

New   Zealand

-0.6

 

0.3

 

0.9

 

1.3

 

3.2

 

2.3

 

3.3

 

2.9

 

Norway

0.1

 

-1.6

 

0.5

 

1.2

 

3.1

 

1.2

 

2.8

 

3.1

 

Poland

5.0

 

1.6

 

3.9

 

4.5

 

2.1

 

1.4

 

2.7

 

3.3

 

Portugal

0.0

 

-2.9

 

1.9

 

-1.3

 

-3.2

 

-1.7

 

0.4

 

1.1

 

Slovak   Republic

5.8

 

-4.9

 

4.4

 

3.0

 

1.8

 

0.8

 

1.9

 

2.9

 

Slovenia

3.4

 

-7.9

 

1.3

 

0.7

 

-2.5

 

-2.3

 

-0.9

 

0.6

 

Spain

0.9 

-3.8

 

-0.2

 

0.1

 

-1.6

 

-1.3

 

0.5

 

1.0

 

‌‌

‌2008‌

‌2009‌

‌2010‌

‌2011‌

‌2012‌

‌2013‌

‌2014‌

‌2015‌

Sweden

-0.8

 

-5.0

 

6.3

 

3.0

 

1.3

 

0.7

 

2.3

 

3.0

 

Switzerland

2.2

 

-1.9

 

3.0

 

1.8

 

1.0

 

1.9

 

2.2

 

2.7

 

Turkey

0.7

 

-4.8

 

9.2

 

8.8

 

2.2

 

3.6

 

3.8

 

4.1

 

United   Kingdom

-0.8

 

-5.2

 

1.7

 

1.1

 

0.1

 

1.4

 

2.4

 

2.5

 

United   States

-0.3

 

-2.8

 

2.5

 

1.8

 

2.8

 

1.7

 

2.9

 

3.4

 

Euro   area (15 countries)

0.2

 

-4.4

 

1.9

 

1.6

 

-0.6

 

-0.4

 

1.0

 

1.6

 

OECD-Total

0.2

 

-3.5

 

3.0

 

1.9

 

1.6

 

1.2

 

2.3

 

2.7

 

Brazil

5.2

 

-0.3

 

7.5

 

2.7

 

0.9

 

2.5

 

2.2

 

2.5

 

China

9.6

 

9.2

 

10.4

 

9.3

 

7.7

 

7.7

 

8.2

 

7.5

 

India

6.2

 

5.0

 

11.2

 

7.7

 

3.8

 

3.0

 

4.7

 

5.7

 

Indonesia

6.0

 

4.6

 

6.2

 

6.5

 

6.2

 

5.2

 

5.6

 

5.7

 

Russian   Federation

5.2

 

-7.8

 

4.5

 

4.3

 

3.4

 

1.5

 

2.3

 

2.9

 

South   Africa

3.6

 

-1.5

 

3.1

 

3.5

 

2.5

 

2.1

 

3.0

 

3.7

 

Source: OECD

Resource security has influenced China’s foreign policy for several years. Their increasing presence in Africa is but one example of this approach. Chinese trade negotiations at a bilateral and multilateral level continue apace. China’s latest economic policies are discussed by Jamestown Foundation – Economic Reform in the Third Plenum: Balancing State and Market –  

http://www.jamestown.org/programs/chinabrief/single/?tx_ttnews%5Btt_news%5D=41667&tx_ttnews%5BbackPid%5D=25&cHash=9fc3fb92316d1e463d72d5505fc20884#.UqrHhJRFDMx

The new “market-centric” policy suggests more, rather than less, uncertainty for commodity prices: –

The plenum report calls for the market to play a “decisive role” (juedingxing zuoyong) in the allocation of resources in the economy. This represents an elevation from previous party documents, which assigned the market a “fundamental role” (jichuxing zuoyong) in resource allocation. This change in language reflects a step forward in the continued reduction in the number of official price controls. Areas that are specifically targeted in the report include the prices of water, oil, natural gas, electricity, transportation and information technology.

As the private sector gains traction and State Owned Enterprises (SOEs) diminish, better inventory controls are bound to be implemented. Chinese stockpiles of commodities have been a function of SOEs ability to purchase well into the future. The more cash-flow constrained private sector will need to operate more efficiently and with lower stock levels. During the transition I anticipate some reduction in demand. In the past year a moderate slow-down in Chinese growth, combined with a backing-up of US Treasury yields in anticipation of the tapering of QE has put significant downward pressure on a broad array of industrial commodities. With stronger growth forecast for next year demand may lead to an increase in prices but the structural rebalancing towards the private sector is a strong counter-factor.

Energy – supply

On the supply side, starting with Oil, Gas and Coal are the OPEC members, Russia and USA – though it is worth noting that China is the fifth largest Oil producer. Recent price action in Crude Oil has been puzzling in that the price rallied following the recent Iranian peace deal. The European Council for Foreign Relations – The Gulf and sectarianism – give some insight into the increased risk that the recent agreement has created, however, it goes on to look at Shiite/Sunni tensions throughout the whole middle eastern region: –

No single country is considered to do more to propagate sectarianism than Saudi Arabia. As Andrew Hammond writes in his essay in this issue of Gulf Analysis, the Saudi royal family sees itself as the rightful inheritor and guardian of Islamic orthodoxy. Saudi Arabia’s formal interpretation of Islam is ideologically sectarian, condemning all other traditional schools of Islamic thought and religious communities as heresy. The state and private citizens put millions every year into evangelism (known in Arabic as da’wa), the establishment of schools and mosques worldwide and financial support to print and broadcast media that promote its interpretation of Islam.

As Shiite communities inside Saudi Arabia and around it constitute the largest and most organised group of such “heretics”, it deliberately subjects them to particularly stringent criticism and discrimination. Even before the Arab Awakening, the rise of an Islamist, Shiite Iran, and then a Shiite Iraq had already posed a serious threat to a Saudi and Wahhabi influence over the region.

The full article can be found here: –

http://ecfr.eu/page/-/ECFR91_GULF_ANALYSIS_AW.pdf

The oil price appears to be trapped in a virtuous/vicious circle: a collapse in the oil price will exacerbate sectarian tensions prompting a rise in the price of oil. Only a significant slowdown in global demand is likely to change this dynamic.

Of course, there are other geopolitical flashpoints; Russia – as they approach the winter Olympics – the South China Sea (as discussed last week) but the disruption to energy supplies created by a new Middle Eastern conflict would probably cause the largest immediate damage to global growth.  Returning to the UN paper, the “Oil Cycle” tends to be “contra” to other commodities; rising oil prices are often referred to as a tax on consumption. It may also go some way to explaining the relatively strong performance of oil in 2013 despite significant increases in fracking production and continuous improvement in drilling techniques. The chart below shows the relative strength of oil since the Great Recession began.

WTI - 5 yr chart - infomine

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Source: infomine.com

Natural Gas in the US is a “local” market due to US restrictions on the issue of export licenses and the significant cost of gas liquefaction. In Europe, Russia is the dominant player. Russian gas prices have been relatively stable this year, although they have rebounded more strongly than US Natural Gas since 2008.

The recent surge in US gas prices is a response to regional weather conditions. It’s worth noting that US Natural Gas prices tend to be either non or negatively correlated to the price of WTI. Overall supply is increasing and as the government issues more LNG licenses – longer-term I expect prices to remain subdued.

US Natural Gas - 5 yr chart - infomine US Natural Gas - 6 month chart - source infomine

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Source: infomine.com

Coal has remained subdued in the US and elsewhere during 2013. China is the largest producer followed by the US, India, Australia and Russia. Thermal Coal has rallied recently in response to the spike in Natural Gas but, barring a significant increase in global demand, I don’t envisage a marked increase in prices in 2014.

US Thermal Coal CAPP - 2001 to 2013 - Source Infomine

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Source: infomine.com

Industrial metals – Supply

Among the industrial metals I will focus on Iron Ore/Steel and Copper. These form the basis for a large swathe of industrial activity. The largest producers of Iron Ore are China, Australia, Brazil, India and Russia. By contrast global copper production is dominated by Chile which produces around 5 mln tons (USA is next with just over 1 mln tons).

Iron Ore - 5yr chart - source infomine Copper - 24 yr chart - source infomine

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Source: infomine.com

Iron Ore has reflected the moribund state of global demand since the start of the great recession. Copper has recovered from its 2009 lows but further upside impetus is lacking. This may have been due to the high levels of stock, however, during the last six months these stock levels have started to decline. A small increase in demand could lead to a significant re-rating.

Copper LME warehouse levels - 5 yr - source infomine

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Source: infomine.com

 

Precious Metals – supply

The precious metals complex is dominated by Gold and 2013 has been a difficult year for the “Gold-bugs” as central banks continue adding liquidity but gold prices fail to respond. So much has been written about this subject that I feel I can add little to the debate except to note that the disparity between paper gold (ETFs and Certificate) appear to be at an unusually large discount to physical gold – especially in India and China. For more insights into the arcana of the gold leasing market, I refer you to an excellent article by Gold Money’s Alasdair Macleod – There’s too little gold in the West –  published by the Cobden Centre: –

http://www.cobdencentre.org/?s=There+is+too+little+gold+in+the+West+

Here is his typically bullish dénouement: –

Bearing in mind Veneroso’s conclusion in 2002 that there must be 10,000-15,000 tonnes out on lease and loan from the central banks at that time, one could imagine that this figure has increased significantly. Officially, the signatories of the Central Bank Gold Agreement, plus the U.S. and U.K. own 20,393 tonnes. A number of other central banks are likely to have been persuaded to “invest” their gold, but this is bound to exclude Russia, China, the Central Asian states, Iran, and Venezuela. Taking these holders out (amounting to about 3,000 tonnes) leaves a balance of 8,401 tonnes for all the rest. If we further assume that half of that has been deposited in London, New York, or Zurich and leased out, that means the total gold leased and available for leasing since 2002 is about 12,000 tonnes. And once that has gone, there is no monetary gold left for the purpose of price suppression.

Could this have disappeared since 2002 at an average rate of 1,000 tonnes per annum? Quite possibly, in which case, the central banks are very close to losing all control over the gold price.

Meanwhile the trend continues lower.

Gold

Gold - 2yr chart.

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Source: Tradingcharts.com

Agricultural commodities – supply

With the agricultural sector demand is broadly constant although secular trends such as China’s increasing consumption of meat are structurally important. Within the agricultural sector I will review Wheat, Corn and Soybeans. No pork bellies, frozen concentrated orange juice and none of the softs – not because these markets don’t matter but in the interests of brevity.

In June 2013 the Food and Agriculture Organisation (FAO) published their long-term forecast for agricultural production.  Here is their press release: –

Global agricultural production is expected to grow 1.5% a year on average over the coming decade, compared with annual growth of 2.1% between 2003 and 2012, according to a new report published by the OECD and FAO today.

Limited expansion of agricultural land, rising production costs, growing resource constraints and increasing environmental pressures are the main factors behind the trend. But the report argues that farm commodity supply should keep pace with global demand.

The OECD-FAO Agricultural Outlook 2013-2022 expects prices to remain above historical averages over the medium term for both crop and livestock products due to a combination of slower production growth and stronger demand, including for biofuels,

The report says agriculture has been turned into an increasingly market-driven sector, as opposed to policy-driven as it was in the past, thus offering developing countries important investment opportunities and economic benefits, given their growing food demand, potential for production expansion and comparative advantages in many global markets.

However, production shortfalls, price volatility and trade disruption remain a threat to global food security. The OECD/FAO Outlook warns: “As long as food stocks in major producing and consuming countries remain low, the risk of price volatility is amplified. A wide-spread drought such as the one experienced in 2012, on top of low food stocks, could raise world prices by 15-40 percent.”

China, with one-fifth of the world’s population, high income growth and a rapidly expanding agri-food sector, will have a major influence on world markets, and is the special focus of the report. China is projected to remain self-sufficient in the main food crops, although output is anticipated to slow in the next decade due to land, water and rural labour constraints. 

Presenting the joint report in Beijing, OECD Secretary-General Angel Gurría said:  “The outlook for global agriculture is relatively bright with strong demand, expanding trade and high prices. But this picture assumes continuing economic recovery. If we fail to turn the global economy around, investment and growth in agriculture will suffer and food security may be compromised. (Read Mr. Gurría’s speech)”

“Governments need to create the right enabling environment for growth and trade,” he added. “Agricultural reforms have played a key role in China’s remarkable progress in expanding production and improving domestic food security.”

FAO Director-General Jose Graziano da Silva said: “High food prices are an incentive to increase production and we need to do our best to ensure that poor farmers benefit from them.  Let’s not forget that 70 percent of the world’s food insecure population lives in rural areas of developing countries and that many of them are small-scale and subsistence farmers themselves.”

He added:  “China’s agricultural production has been tremendously successful. Since 1978, the volume of agricultural production has grown almost five fold and the country has made significant progress towards food security. China is on track to achieving the first millennium development goal of hunger reduction.

While China’s production has expanded and food security has improved, resource and environmental issues need more attention. Growth in livestock production could also face a number of challenges. We are happy to work with China to find viable and lasting solutions.” 

Developing countries to gain

Driven by growing populations, higher incomes, urbanization and changing diets, consumption of the main agricultural commodities will increase most rapidly in Eastern Europe and Central Asia, followed by Latin America and other Asian economies.

The share of global production from developing countries will continue to increase as investment in their agricultural sectors narrows the productivity gap with advanced economies. Developing countries, for example, are expected to account for 80 percent of the growth in global meat production and capture much of the trade growth over the next 10 years. They will account for the majority of world exports of coarse grains, rice, oilseeds, vegetable oil, sugar, beef, poultry and fish by 2022.

To capture a share of these economic benefits, governments will need to invest in their agricultural sectors to encourage innovation, increase productivity and improve integration in global value chains, FAO and OECD stressed.

Agricultural policies need to address the inherent volatility of commodity markets with improved tools for risk management while ensuring the sustainable use of land and water resources and reducing food loss and waste.

Specifically in the US, droughts and extreme weather conditions have been the principal factors influencing supply. Water remains a scare and undervalued resource but improvements in technology and farming methods are ongoing. Nonetheless, prices for irrigated farm land have been making new highs during the year. Below are a series of Ten Year monthly charts of Wheat, Corn and Soybeans. The price spike of 2008 is evident in each case and the subsequent rally of Corn and Soybeans to make new highs in 2012. However, during 2013, despite another year of droughts, prices have remained subdued. Nonetheless, prices appear to be near to the base of their long-term up-trends.

Wheat

Wheat - 10yr chart

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Source:Tradingcharts.com

Corn

Corn - 10yr chart

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Source: Tradingcharts.com

 

Soybeans

Soybeans - 10yr chart

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Source: tradingcharts.com

The latest USDA reports (December 2013) can be found here: –

Wheat

http://www.ers.usda.gov/publications/whs-wheat-outlook/whs-13l.aspx

Projected 2013/14 supplies are raised 10 million bushels this month to 3,008 million bushels. Production and carryin stocks are unchanged, but imports are raised to 10 million bushels to 160 million bushels with expected higher hard red spring (HRS) and soft red winter (SRW) imports from Canada, up 5 million bushels each.

Corn

http://www.ers.usda.gov/publications/fds-feed-outlook/fds-13l.aspx

Projected 2013/14 corn use is increased 100 million bushels this month, split evenly between fuel ethanol and exports. Margins have been very favorable for ethanol mills, with higher ethanol and distillers’ dried grains (DDG) prices on the revenue side combined with lower corn prices on the input side. Exports have benefitted from lower corn prices and increased global consumption. Increases in use are offset slightly by a 5-million-bushel increase in projected imports. Production and feed and residual are unchanged. Projected carryout is tighter by 95 million bushels, at 1.8 billion bushels, but still double last season’s estimate of 824 million. The 2013/14 season-average farm price for corn is projected 10 cents lower at the midpoint of $4.40 per bushel, with the range narrowed to $4.05 to $4.75 based on prices reported to date.

World coarse grain production for 2013/14 is projected higher this month led by increases for Canadian corn and barley, Australian barley, and Ukrainian corn. Global coarse grain use prospects increase slightly more than production increases, trimming expected global ending stocks.

Soybeans

http://www.ers.usda.gov/publications/ocs-oil-crops-outlook/ocs-13l.aspx

USDA raised its 2013/14 forecast of U.S. soybean exports this month by 25 million bushels to 1.475 billion. Similarly, 2013/14 exports of soybean meal were forecast 250,000 tons higher to 10.5 million short tons, which prompted an expected increase in the domestic soybean crush by 5 million bushels to 1.69 billion. An improved demand outlook lowered the forecast of season-ending soybean stocks by 20 million bushels this month to 150 million. USDA raised its forecast range for the season-average farm price by 35 cents this month to $11.50-$13.50 per bushel.

For Argentina, area reductions for corn and sunflowerseed led USDA to raise its 2013/14 soybean area estimate by 300,000 hectares this month to 20 million. As a result, Argentine soybean production is forecast 1 million tons higher to 54.5 million metric tons. Additional output of Argentine soybean meal may push exports of the commodity in 2013/14 to a record 29.4 million tons. Yet, Argentine soybean stocks could be higher by next September to 28.5 million tons.

None of these forecasts looks excessively constrained and the proximity to trend-line support makes me cautious in the near-term, a breakdown through the ten year up trend could see a retracement of the entire cycle.

A longer term factor which may yet change this dynamic dramatically is the effect of the “Eddy Minimum”.

For some general background on sunspots and climate, this Princeton University website is a useful resource: –

http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Maunder_Minimum.html

The argument in favour of a cooling of global temperature is not new but for the latest comments on this subject the following website is informative: –

http://wattsupwiththat.com/2013/07/24/newsbytes-sunspot-enigma-will-inactive-sun-cause-global-cooling/

Conclusion

Throughout 2013 I waited for a resumption of the commodity bull-trend, expecting that the pick-up in economic activity, combined with the provision of central bank liquidity, would fuel the next leg of the super-cycle. It never materialised. Global growth remained subdued, China switched to a policy of “quality not quantity” and “taper terror” in the US, increased deflation expectations: and revealed weaknesses in a number of emerging markets. Even in the agricultural sector, weather related stress failed to materially reverse the downward pressure on prices.

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!”

I’ll be back in mid January. With best wishes for the festive season and New Year. Col