Bonds & Interest Rates
While higher stock prices are often cited as the biggest beneficiary of the Fed’s several rounds of quantitative easing (QE), a lesser cited beneficiary has been overall market volatility and the credit markets. With each round of QE and/or “Operation Twist” we’ve seen measures of financial stress in the credit markets (like the Ted Spread or BBB corporate bond yields to 10yr UST yield spreads) contract as seen below. Similarly, whenever we’ve seen the cessation of QE we are treated to a spike in financial market stress and with the ending of the Fed’s recent QE program in October of 2014 we are already seeing the first signs of stress in the corporate bond market as BBB spreads to 10yr UST yields rise. In fact, they have risen so much that they have retraced all of the improvement seen since QE3 began.
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Throughout my years on Wall Street and to this day, one question has always bothered me. I have never got a good explanation as to why the price of crude oil and the strength of the USD move in negative correlation. I’ve heard many different arguments but none are foolproof. I’ve even read that there is no causality in the relationship, that’s it’s all in our minds.
The main argument seems to be that as most commodities, including crude, have historically been priced in dollars, if the dollar strengthens, it takes less dollars to buy a barrel of crude, and vice versa, hence the reverse correlation. This seems to make sense, but is it just the dollar that drives the relationship? Can an increase or decrease in the price of oil be the determining factor as well? Many explanations have focused on the economic impact of interest rate changes and the possible associated demand implications they would bring. But what about supply? What if, like today, the supply of oil is plentiful and growing due to geopolitical changes in the production of crude? Will this drive a stronger dollar as well? Or is it the stronger dollar that has pushed the oil price lower?
For supply and demand related solutions to this investment quandary, wouldn’t there be a lag time to a direct causality? For example, if interest rates rise, wouldn’t it take a while for this to hit the demand side of the equation and impact the oil price? Historically the correlation has been much more immediate. Is it the case that the market is just looking forward to these economic consequences?
Another wrench could be thrown into the discussion. Now that many countries are trying to remove the USD as the commodity trading currency and replace it with their own domestic currencies, how will this impact the USD/crude relationship? Will the yuan and/or the euro or ruble begin to act in the same manner in conjunction with commodity prices? This remains to be seen.
As we have seen recently with the severe drop in the price of crude, the dollar has strengthened accordingly, confirming the historic negative correlation we have been discussing. The question in my mind is, with all of the geopolitical changes in the production of crude, will this relationship exist in the future? One can foresee a situation where the United States will not import much oil at all in a decade or so, maybe sooner. Will oil and the dollar still react in the same way then?
Perhaps we should limit the conversation to a very short-term horizon. Oil is at a multi-year low. The dollar is at a multi-year high. Demand for crude is falling due to an economic slowdown outside the United States. The supply of crude is at very high levels with no end in sight as American fracking keeps pumping and OPEC refuses to cut production to shore up the price. What will happen when this dynamic changes. What if 500 rigs come off line like T. Boone Pickens forecasts? What if Saudi Arabia decides to help out its OPEC friends and cut production? What if global economic activity shows signs of life and the price of crude starts to rise?
The high probability is that the historical negative correlation between the price of oil and the strength of the USD will remain in place, regardless of whatever reason you attribute to this causality. That means the USD will weaken. It’s a matter of when, not if. Which will be good news for the Loonie which has been firmly tied to that barrel of oil for the last 6 months.
Loonie and Oil, sinking together
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L Todd Wood
L Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is a contributor to Fox Business, Newsmax TV, and others as well as Agility Forex.
When China celebrates its new year next month, we will transition into the Year of the Ram, also known as the Year of the Goat or Sheep. If you believe in luck, this could be a good sign. The ram comes eighth in the 12-zodiac cycle, and in Mandarin, “eight” sounds very similar to the words meaning “prosper,” “wealth” or, in some dialects, “fortune.” As you might imagine, the Chinese consider the number to be very lucky.
But of course successful investing involves so much more than luck. In a time when not only China but much of the rest of the world is trying to get its groove back, it’s important to be cognizant of the factors that shape the markets, including changing government policy. We often say that government policy is a precursor to change, so it’s important to follow the money.
With that in mind, I asked Xian Liang, portfolio manager of our China Region Fund (USCOX), to outline a few of the most compelling cases to remain bullish on the Asian giant.
Below are some highlights from our discussion.
A Healthy Balance Between Monetary and Fiscal Support
Back in October, I pointed out that one of the main contributors to the European Union’s sluggish growth is its inability to balance its monetary and fiscal policies. It has been eager to tax everything and everyone who moves. Waiting for European Central Bank (ECB) President Mario Draghi to act often feels a little like waiting for Godot. Investors’ patience is wearing thin.
China, on the other hand, is much more responsive and actively committed to making full use of both policies in its arsenal to spur its cooling economy.
On the monetary side, according to Xian, are interest rate cuts and a loosening of reserve requirements for certain deposits. The goal is to ease access to loans for businesses and individuals seeking to purchase big-ticket items such as homes. As a result, Chinese entrepreneurs have increasingly been able to start more businesses.
Jobs growth has been so robust, in fact, that the government has managed to attain its job creation target outlined in its current Five-Year period ahead of schedule and by a wide margin. The country has grown millions of jobs with great efficiency, even as GDP sags.
Although the Chinese housing market has stagnated in recent months, these new monetary measures will help it pick up steam. Already we’re seeing some improvement, with home property stocks moving higher.
Regulations are an indirect taxation of the economy, whereas deregulation unleashes entrepreneurial spirit.
On the fiscal front, the government is reportedly planning to spend $1.6 trillion over the next two years on infrastructure projects in various industries—300 separate infrastructure programs, to be exact, according to BCA Research.
As I pointed out last month, many of these projects will largely involve high-speed rail,both domestically and abroad. China has already secured multiple construction deals with countries ranging from Brazil, South Africa, Nigeria, India, Russia, the U.S. and others.
Government to Remain Accommodative
There are a couple of reasons the Chinese government has accelerated support to capital markets, according to Xian: “One, a significant deflationary threat has been driven by slumping energy prices. And two, there are potentially lower exports to commodity producing nations.”
Indeed, sluggish global demand has contributed to China’s weak December purchasing managers’ index (PMI), which dropped to an 18-month low of 50.1. China has been quick to respond to lower PMI data with a drop in interest rates.
But Where There’s Bad News, Good News Is Often Not Far Behind
The silver lining to falling commodity prices is that since China is a net-importer of raw materials—crude oil especially—the country has been able to save tremendously on its oil and gas bills. Back in November, I reported that for every dollar the price of a barrel of oil drops, China’s economy saves about $2 billion annually. From its peak in June, crude has slipped close to $50—you do the math. This has served as a major wealth transfer from oil-producing countries into China’s coffers.
Oil Sinks, Airlines Take Flight
Speaking of crude, declining oil prices have been good for airlines, Chinese companies included. As you can see, there’s been a clear inverse relationship between crude oil returns and airline stocks.
China is the largest investor in U.S. government bonds. The country has accumulated close to $1.3 trillion, so a strong dollar and falling oil prices benefit its economic flexibility.
More middle-class Chinese might be able to afford to travel abroad, specifically here to the U.S., where inevitably they will spend their money.
According to Carl Weinberg, founder and chief economist of High Frequency Economics:
Chinese President Xi Jinping has estimated that there will be more than a half-billion Chinese tourists traveling to the West in the next 10 years. You can work out the impact if all of them came to New York and spent $2,000 or $3,000 each. That would be enough to add a half-percentage point to U.S. GDP every year over the next decade.
Reasonable Stock Valuation
Chinese stocks are currently valued below their own historical averages as well as those among other global emerging markets, making them both attractive and competitive.
“Odds favor mean reversion to continue,” Xian says. “The better the Chinese markets perform, the more global liquidity they might attract.”
Chinese stocks, as expressed in the MSCI China Index, are currently a much better value than those in the S&P 500 Index, trading at 10 times earnings whereas the U.S. is trading at 18 times.
A-Shares Still a Huge Draw
Chinese A-Shares surprised the market by breaking out last summer, having delivered 66 percent for the 12-month period. It looks like a breakout from the long-term bear market.
What’s more, the upside is unlikely to have been exhausted. Although they aren’t as stellar of a bargain as they once were, they’re not yet overvalued, and retail and institutional investors might accumulate on pullbacks.
For the A-Shares market, USCOX has recently added exposure to A-Shares to capture more attractive valuation. In today’s environment, we believe the safer bets are investable H-Shares, which are driven by A-Shares and, in 2014, returned 15.5 percent. H-Shares comprise the vast majority of the fund’s exposure to Chinese equities, with further exposure gained through A-Shares exchange-traded funds (ETFs).
To the right you can see merely a sampling of the ever-popular emerging markets periodic tables, which will soon be available exclusively to subscribers of our award-winning Investor Alert.
The Ram Is the New Bull
As GARP (growth at a reasonable price) hunters, we’re prudently optimistic about the upcoming year and anticipate great things out of the world’s second-largest economy. China’s government and central bank are committed to jobs and manufacturing growth as well as policy easing. Its stocks are reasonably valued, and low commodity prices should continue to offset slowing global demand.
As Xian eloquently put it last month:
China’s leadership appears to be delivering on the promises it made in November 2013 at the Third Plenary Session, specifically the liberalization of the financial sector and reform of the role capital markets play in allocating resources. This leadership is determined and committed to putting China on the right path.
A Special Announcement
Please mark your calendars for January 21, as we will be conducting our first webcast of the year. We will be discussing the state of commodities, and as a loyal subscriber, you’ll be first to receive the registration this week. We’ll be following up with an emerging markets webcast on February 18 that will focus on China and Emerging Europe.
Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by
Past performance does not guarantee future results.
Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. By investing in a specific geographic region, a regional fund’s returns and share price may be more volatile than those of a less concentrated portfolio.
The HSBC China Services PMI is based on data compiled from monthly replies to questionnaires sent to purchasing executives at more than 400 private service-sector companies.
The MSCI China Free Index is a capitalization weighted index that monitors the performance of stocks from the country of China.
The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.
Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is also known as historical volatility.
Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. Holdings in the China Region Fund as a percentage of net assets as of 9/30/2014: Air China Ltd. 0.00%, China Eastern Airlines 0.00%, China Southern Airlines Co. 0.00%.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.
The oil industry has experienced boom and busts before, but the depths to which oil prices have plunged have surprised everyone. Could the bust now persist much longer than many think?
It is not just oil that has seen a bust. Over the last decade and a half, the global economy has witnessed a massive commodity boom, with prices rising for all sorts of raw materials, including gold, iron ore, oil, gas, copper, wheat, corn, and more. But the commodity “super-cycle” appears to be over, with vast new supplies having come online in the last few years.
As prices rose through the 2000’s, multinational companies extracting all sorts of commodities planned billion dollar projects. With new mines, new oil and gas fields, and other commodity supplies hitting the market at the same time, a bust has ensued.
Related: Gains From Low Oil Prices Could Be Wiped Out This Year
“Supply has been outstripping demand not because demand has been particularly weak, but because there was too much supply,” Stephen Briggs, a commodities analyst at BNP Paribas SA, told The Wall Street Journal. “It looks like this won’t change anytime soon.”
The oil bust has captured worldwide attention in a way that crashing coal and copper prices have not. And for now, the bust may here to stay, at least a bit longer than many anticipated.
For example, Goldman Sachs sharply downgraded its assessment for crude oil prices. The investment bank now says that it sees Brent trading at around $42 per barrel over the next few months, down from its previous forecast of $80 per barrel. It also says that WTI will fall to $41, a downward revision of its previous $70-per-barrel prediction.
Many market watchers have predicted a “floor” in prices at each key threshold – $70 per barrel, then $60, then $50. But crude prices have ignored these forecasts, plunging to fresh lows each week over the past few months. Just last week, major hedge fund manager Andrew J. Hall said $40 would be an “absolute price floor,” another threshold that is within striking distance.
Saudi Prince Alwaleed bin Talal threw cold water on the markets even further with his recent comments.
“If supply stays where it is, and demand remains weak, you better believe it is gonna go down more. But if some supply is taken off the market, and there’s some growth in demand, prices may go up. But I’m sure we’re never going to see $100 anymore,” he said in an interview with USA Today.
Also, there is excess storage capacity that is allowing producers to continue to pump. Some companies are even storing oil on unused tankers at sea, betting that they can sell the volumes later at higher prices.
Finally, as oil prices fall, so do the costs of production. The cost of materials, along with the rates drillers pay to rent out rigs, deflate with the price of oil. That makes breakeven cost projections a bit of a moving target.
Related: Canada: A Microcosm Of The Ultimate Effect Of Low Oil Prices?
“To keep all capital sidelined and curtail investment in shale until the market has rebalanced, we believe prices need to stay lower for longer,” Goldman Sachs wrote in their latest report.
Speculators don’t know what to make of the oil markets right now. Some are pouring money into bets on prices rising, while others are wagering that prices have further room to fall.
We will learn more about the state of the U.S. oil and gas industry over the next few weeks as fourth quarter earnings are released. For the energy sector as a whole, profits are expected to fall by 19.1 percent. Some companies will be in worse shape than others, which could give us an indication of where production levels are heading, and with them, how long oil prices will stay low.
By Nick Cunningham of Oilprice.com
We have so far analyzed the current situation in the oil market, suggesting that falling oil prices can indicate another recession in the not so distant future. So the obvious question arises: would it be positive or negative for the gold market? The answer depends on whether gold is pro-cyclical or not. Some economists believe that gold, as oil, rises in a boom and falls during the bust. We consider that opinion too simplified. However, there are indeed strong arguments that commodity prices are strongly affected by the monetary policy responsible for the business cycle. Let’s analyze some data.
Usually commodity prices were booming during inflationary times: in the first years of 1920s, 1970s and 2000s. On the other hand, commodity prices were not performing well after the contraction of the money supply 1929-1933 and in the 1980s and 1990s due to the significant tightening of monetary policy implemented by Volcker (see chart 2). Commodity prices also fell significantly after Lehman’s collapse in 2008. Similarly, it seems that the recent drop in commodities prices means a popping of another inflationary bubble because of real or (just) perceived Fed’s monetary tightening. Although the U.S. interest rates did not really rise in 2014, investors are thinking ahead and shifting out of commodities today in anticipation of future higher interest rates in the next year.
Graph 2: IMF All Commodity Price Index from 1992 to 2014
Why do we think that the bull market in commodities is over? Undoubtedly variability of commodity prices is not an unusual thing; however a recent supercycle was rather unique in terms of length and scope. Usually high prices do not last too long, because they encourage larger production. High prices are the only cure for high prices, the adage says. And usually the prices of commodities do not surge together. Why would we have supply shortages across the full range of commodities?
According to the popular theories, the rapid development of emerging markets, mainly China and India, was the real cause behind the commodities boom. Surely, this economic growth should not be neglected. However many analysts consider easy-money policy as a much more important factor explaining rising commodities prices. For example, according to this paper, growth of commodities was caused mainly by excess liquidity and not by demand from emerging economies.
So, how did it all start? The commodity boom began in late 2001, just as the Fed cut interest rates to counteract the recession after the bursting of the high-tech bubble. Lower interest rates encouraged banks to expand their lending. In turn, cheap funds induced entrepreneurs to extend their operations and investments, which stimulated demand for raw materials. Moreover, new and easy money entered commodities as the new “hot” investment destination for money managers. They were in a bear market since the early 1980s, but the growing demand from emerging markets called investors’ attention to this asset class.
Investors should also note that commodities were negatively correlated with the falling stock market at that time and low interest rates decreased the opportunity cost of investing in commodities. Professor Frenkel points out that the Federal Reserve cut real interest rates sharply in 2001-2004, and again in 2008-2011, which lowered the cost of holding inventories thereby contributing to an increase in demand. According to him, low real interest rates also increase the price of storable commodities by increasing the incentive for extraction tomorrow rather than today.
It is still not the full story. In that time the government deregulated pension funds, which started to diversify their portfolios by investing in commodities. Also, first commodity ETFs facilitated investments in that asset class. Professor Randal Wray calls this process the financialization of the commodities market and considers it as the main reason behind the commodity super cycle. Similarly, according to Yanagisawa, the speculative money inflows were one of the main factors explaining the rapid rise in oil prices. Now, if you add bubbles in emerging markets (alongside the real growth), the falling of the U.S. dollar and rising expectations of inflation stimulated by QE programs (in the second phase of the commodities bubble), you get a full picture of why and how a commodity boom was created.
We have talked so far about commodities in general. But what about gold? Does this all apply also to the yellow metal? For sure, gold in many ways behaves like all other commodities. The inverse relationship with U.S. dollar is the most important feature in common with other commodities. However, gold is not only the commodity; it also behaves like a currency. This is why the gold is so unique. Among the commodities considered in the above-mentioned analysis, only gold was not affected very significantly by the severe liquidity squeeze in 2007 and 2008, “implying that gold acted as a safe haven during the period of international financial dysfunction”. Therefore, although commodities in general are to a large extent pro-cyclical, gold breaks out of this simple scheme.
Thank you.
The above article is based on the January issues of our Market Overview reports. We invite you to stay updated on the latest developments in the commodity market and global economy by joining our gold newsletter. It’s free and you can unsubscribe in just a few clicks.
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