Linear Talk – Macro Roundup for August

Is Chinese growth about to falter?

Is Chinese growth about to falter?


Macro Letter – No 83 – 15-09-2017

Is Chinese growth about to falter?

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

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

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


Source: Cantillon Consulting

As Corrigan goes on to say:-

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

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

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


Source: Cantillon Consulting

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

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

Source: Bloomberg

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

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

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

China growth indicators - Bloomberg

Source: Bloomberg

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

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

The authors construct a factor model but find that:-

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

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


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

(Sources: Wind and authors’ calculations.)

Source: Kansas City Federal Reserve

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


Source: Kansas City Federal Reserve

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


Source: Kansas City Federal Reserve

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

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

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

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

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

Why Rebalance When You Can Have Both?

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

Commodities Surprises to the Upside.

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

Away from Markets’ Gaze, Aluminum Shines.

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

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

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

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

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

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

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

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

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

Conclusion and Investment Opportunities

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

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

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

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

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

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

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



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

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

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


Macro Letter – No 82 – 01-09-2017

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

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

Super-cycle theory

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

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

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

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

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

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

From Theory to Practice

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


Source: Economist

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

Since 2008 the Bloomberg Commodity Index has weakened:-


Source: Bloomberg, Financial Times

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

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

The Global Economy and Commodity Demand

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

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

Source: Trading Economics, World Bank

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

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

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

Bloomber Indices 1yr Aug 2017

Source: Bloomberg  

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

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

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

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

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


Source: S&P Dow Jones Indices

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


Source: Trading Economics, Infomine

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


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


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


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

Conclusion and Investment Opportunities

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

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

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

Has Bitcoin come of age?

Has Bitcoin come of age?


Macro Letter – No 81 – 21-07-2017

Has Bitcoin come of age?

  • Bitcoin (BTC) has tripled and then halved since late March
  • Even at BTCUSD 2000 total issuance amounts to $33bln
  • Historic volatility is high (80%) but implied volatility is higher (97%)
  • The introduction of derivatives and an interest rate curve suggest financial deepening

Bitcoin (BTC) came into existence in January 2009. It was not the first ‘cryptocurrecny’ and there are now an estimated 950 competitors, with new ICO’s ‘Initial Coin Offerings’ appearing almost daily.

BTC’s closest rival in terms of coins in circulation is Ethereum (ETH). The chart below shows how these currencies % of total market capitalisations has waxed and waned:-



I want to concentrate on BTC since it remains the market leader with a total circulation of $33bln (reference BTCUSD 2000) whilst the outstanding issuance of its nearest rival ETH is $16bln.

Below is a four month chart of BTCUSD, its price has fallen by almost one third in just over a month:-



The recent price action needs to be seen in a broader context. The price has increased from less than BTCUSD 1000 in late March. On April 1st the Japanese authorities officially recognised BTC for the first time: perhaps, this was the catalyst for its spectacular rise.

The subsequent precipitous decline in price may be related to a proposed software change to be introduced on 21st July, known as SegWit, which is discussed in Cryptocurrency Value: Growing Pains or Something More? By Ryan Shea – here’s the rub:-

SegWit2x software, which introduces SegWit while doubling the block size to 2MB, will be released on July 21. More than 80% of the network hash rate has agreed to run the SegWit2x code, which suggests that the solution to increasing bitcoin’s scalability will be enacted smoothly.

However, it is also possible that the hard fork required to increase the block size leads to a bifurcation of bitcoin into two separate currencies –something that would unquestionably trigger a sharp price correction by undermining the bitcoin brand. (The key date by which a split can be avoided is August 1 when BIP148 activates – this represents the last opportunity for miners to accept Segwit2x and thereby avoid a chain split resulting in the creation of two parallel bitcoins.)

There have been victories and defeats during the evolution of BTC, as it has evolved from an obscure novelty to a serious contender for investors seeking a store of value. The price volatility reflects these uncertainties but it is not demonstrably different from the volatility seen in several commodity markets.

Financial deepening

For a security, commodity or a currency to gain credence, among financial market operators, it needs to offer a store of value, liquidity and convertibility. If can achieve these attributes it should have collateral value, by which I mean, BTC should be capable of being borrowed or lent. This is already happening. Some cryptocurrency exchanges are offering a rate of interest on term deposits and others offer the opportunity for holders of BTC to lend their currency to traders who wish to borrow it, primarily to sell the currency short. Whilst there is not really a ‘risk-free rate’ for BTC an interest rate term structure is beginning to emerge as the table below, derived from a number of exchanges, shows:-


There may well be other exchanges offering a variety of differing interest rates. but this, I hope, provides a snapshot of the current environment.

The other aspect of financial deepening which will help BTC come of age is the development of a derivatives market. I believe the arrival of exchanges for BTC futures and options is a very positive signal.

The futures exchanges include Okex, CryptoFacilties, BitMEX, BitVC, Coinut and Deribit which also offers options – there may be several others. Today (Monday 17th July) I have taken some snap shots of the futures and options pricing from Deribit.

With the BTCUSD spot price at 2027, the July future (expiration 28th July) traded at a discount of $12 ($2015) this is known in futures parlance as a backwardation. The September contract (expiration 29th September) was, by contrast, trading at a premium, or contango ($2070). Because of high demand from leveraged traders to borrow US$ to buy BTC the forward/futures price of BTCUSD normally trades at a premium (contango). The current environment is unusual, the forced liquidation which has fuelled the recent collapse in the price has led to, what is likely to be a temporary, backwardation. John Jansen – CEO of Deribit – explained the anomaly during a recent interview:-

…when the market is bullish, US$ interest rates spike up and BTC interest rates go down: uses want to borrow USD to buy BTC. In other words, short USD and go long BTC…there is an overall tendency for speculators to be long, therefore, the arbitrage traders are short BTC (lending out their USD) or short the future. USD interest rates are, therefore, normally higher than BTC rates which explains the contango in BTCUSD futures prices.

…on BTC platforms, annualized interest rates on US$ are on average maybe 20%…which would imply that the future should trade at a 20% annualized contango. Arbitrage traders take the other side of the trade…but get paid for their trouble.

Over time I expect the BTC market to become more efficient and the natural relationship for BTC futures should (other things equal) eventually become a small backwardation, reflecting the 1.5% differential between lower US$ and higher BTC interest rates. There are a number of arbitrage opportunities for those who want to dig deeper, but remember credit risk, both in terms of counterparties and exchanges, together with risks surrounding convertibility are nuanced. It may not be the free-lunch you perceive it to be.

This brings me to the BTC option market. The prices in the table below are again from Deribit:-

Deribit_-_Bitcoin_Options_prices_-_17-7-2017_-_Spo (1)

Source: Deribit

I regret the resolution this table is less than I’d like but it shows some important features. Firstly, implied volatility is trading at a substantial premium to historic volatility. The chart below shows the evolution of historic volatility and the BTC price over the last three months:-


Source: Deribit

The July option series expires on 28th but the mid-market implied volatility for the September 29th expiration is not significantly lower – implied call volatility stands at 97%, for puts it is 85%. At this stage in the development of the BTC options market, I suspect the majority of the buyers are speculative traders rather than desperate hedgers, but option market-makers are wise to build in a margin of safety given the tendency of the underlying market price to gap lower or higher: delta and gamma hedging is challenging with these price swings. The bid/offer spreads on the options are also wide, another reflection of the nascent nature of the marketplace.

A final measure of immaturity – or perhaps I should say, opportunity – which the option market reveals, may be found in the shape of the volatility surface. The chart below is extrapolated from the mid-market implied volatilities in the table above:-


Source: Deribit

In a liquid options market one would normally expect the lowest implied volatility to be at-the-money – around the $2000 strike price. In the chart above the nadir of volatility is around the $1900 strike, a level breached briefly last weekend.

Conclusions and investment opportunities

Cryptocurrencies have captured the imagination of many new participants, from geeks to gold bugs, but, as BTC achieves greater legitimacy, the market will deepen and mature. The adoption of scalable technology to deal with the exponential increases in trading volume is a part of this process. The acceptance of distributed ledger technology across other parts of the financial services sector will also be supportive.

From a technical perspective the price of BTC has corrected by around 50% – since March it has risen from under $1000 to $3000 and is now back around $2000 (Monday 17th July). In absolute terms it has fallen by just over one third. This is a healthy price correction, typical of the price action witnessed from time to time in more liquid and established commodity markets: US Natural Gas springs to mind.

As an investment, the argument for holding BTC is more tenuous. It is a currency with no government or central bank to underwrite its value, however, the expansion of the BTC monetary base is strictly controlled, making it more like a hard currency, such as we had during the Bretton Woods era, as opposed to the endlessly debased fiat currencies we are inveigled to consider of value today.

Currencies have no implicit yield but BTCUSD currently offers a theoretical positive carry of around 1.5%. As mentioned above, this relationship is currently distorted by the demand to borrow US$ to buy BTC by leveraged traders. Any investment in an asset which has no earnings and pays no dividend/coupon/interest must by its nature be a trading asset. However, strategies such as high frequency, robotic, liquidity provision and long term, trend following, are among a number of exciting trading opportunities for the active BTC operator.

The fundamentals driving BTC investment revolve around: investor distrust in fiat currencies, loathing of government intervention in asset markets and belief in the tenability of cryptocurrencies as a lasting store of value both from a technical and regulatory perspective. These fundamental drivers of valuation have, in the past and will in the future, cause sudden repricing’s. Outside of these seismic episodes, the price of BTC will be driven by capital flows. With liquid currency pairs like EURUSD, the economic fundamentals of both geographic regions are of equal importance. This is unlikely to be the case for BTC for the foreseeable future. BTC volatility eclipses the majority of its developed currency peers; its true value, whilst it is becoming gradually clearer, will remain ephemeral for some time to come.