US
equity markets had continued to benefit from export driven bottom line
growth, but are now sagging on hesitancy about the US domestic economy ahead
of QEII buoyancy drying up in June.
The Dollar decline that allowed export strength has also boosted US
import costs. This could mean a modest US summer driving season unless recent
declines in oil prices continue.
China’s
inflation concern has taken up more of its policy. The tighter Yuan policy isn't showing
up in the inflation rate but it will have some impact and mean that growth
engine downshifts. On top of that
the vagaries of nature and street crowds continue to add uncertainty.
We
began the year with an “expect the unexpected” stance. May began with the death of bin Laden,
which caused only the barest ripple of market applause. We stir entrails this time of year on
whether to look for bargains early in the northern summer, or not — a
tough call this year.
The
sector we focus on has been consolidating after doing very well. This downward move accelerated
recently, which could hasten the start of a buying period. The recovery of the broader equity
market after March events seems to be stalling after new highs again in the
past couple of weeks. Its not
looking comfortable though, and volumes are low. Are the market’s about to repeat
last summer’s pause?
“Events”
have been hard on the algorithmic.
The muddle of just-in-time manufacturing waylaid by tsunami wasn't
expected, but adjustments can be made for it. It’s possible to program varied
responses to currency and bond or inflation related policy shifts. However, aging powers having to choose
between the old buddy system or newly emboldened Arabic Street is quite
variable rich.
Despite
these weakening events, inflationary pressure would be the most likely cause
for a pause. Its not the G7
economies that are the big concern for us. The real pressure is in the growth
economies that the high income economies still need for export support. This pressure comes from resource
price gains, and most worryingly from high food prices and simple demand
growth across many local markets.
This again is event related.
Weather
events have been getting a lot of ink lately, the most recent being the
unusually heavy and deadly North American storm season. Our sympathy goes out to the victims
of the southern US tornado onslaught, but it is slower motion events that
concern markets. Weak crops and
high food inflation are becoming a plague. Those still looking for a second
market collapse and double dip recession will remind us the ‘30s dust
bowl deepened the Depression.
Markets run on perception so analogies like this can have an impact.
Perception
aside, the problem is a real and serious one. The chart above, courtesy of the Food
and Agriculture Organization of the UN, shows their food price index hitting
new all-time highs, in both nominal and real terms. The price measure is already well
above the levels reached in 2008.
The one cause for optimism is that the commodity rout going on the
past few sessions is driving speculative money out of grain and other
“soft” markets too.
This helps, but speculators aren’t the main cause of price run
ups. Its supply and demand, and
there is no obvious easy fix.
Brazil
has temporarily halted rice exports.
Drought in China’s wheat region may have the country importing
grain for the first time this century.
There is also news that China wants to import more sugar due to
declining domestic supply and because imported sugar is cheaper. The need to import food may finally be
pushing aside the weak Yuan policy.
Not the best reason admittedly, but still better for overall balance
in the exchange rate system.
A
stronger Yuan won’t stave off rural unrest in China by itself. It would however help with broader
inflation and increase purchasing power for imported goods which could ease
the transition for the poorer regions of China.
Talk
about a stronger Yuan comes on
top of a concerted tightening policy that is finally impacting oil and metal
prices. The most recent
statistics out of China include weaker Purchasing Manager Indices and
inflation numbers that appear to be peaking. The move out of commodities based on
these is now fully underway.
Weakening
metals and energy prices are a necessary consolidation that we have been
looking for, which offers some relief for weak economies. It doesn't help other, poorer
economies deal with their food issues though. These keep piling up. Whatever the direct political causes
might be, the rash of street protests in the world have an underlying concern
about soaring food costs.
Certainly
there are some dire predictions for this year’s weather, but we
won’t wade in on them.
Rather, we will point out that changing crop conditions have had as
much impact on history as kings or bishops. Early signals over the next few months
of crop potential in the north may have a larger than usual impact on equity
markets. We add that watch to the
waiting game on QEII’s end.
Rising
food costs could (and should) hasten a reduction in the global farm subsidy
system. This may be wishful
thinking politically, but higher market prices and demand suggest the time is
ripe to try. The subsidy system
in wealthy economies has hurt capital input elsewhere and closed some markets
to developing world farmers. Now
that shortage is on the table and prices are high across the board this will
be a talking point. It should be
kept track of.
The
currency mix will also be important to this. Liquidity created to hold the Yen down
for 20 years was combined with protected high-cost food producers. Japan could take advantage of Yen
strength that liquidity and low external debt now bring to rethink that food
subsidy system. Tokyo certainly
has better places to spend the money after the tsunami.
The
EU has always had a transfers system around agriculture. It’s a smaller fraction of the
budget than it used to be and is being reformed, but is still there. The will to push reform further
as part of a global realignment may be in place. It would need to recognize the debt
realities of EU members, but the ECB focus on inflation positions the
Eurozone to refocus trade.
The
US situation is similar but arguably tougher to deal with right now. Reducing direct subsidies would be
small change against the Federal deficit. Like most industrialized democracies
the rural vote has a large impact.
The Fed’s loose money policy is making US export of all
commodities more viable, and sensible.
It should be taking this export gain, but it shouldn't need to subsidize
to do that.
The
subsidy system has been such that other big, wealthy exporters like Canada
and Australia compete, but not
too heavily. In the low
income world subsidy tends to be for inputs like power and soil additives,
which have also moved up in price.
The problem with that has been a skewing of capital allocation to
farming. Sound familiar?
Some
blame global warming for shortage, while others say the Malthusian equation
is simply setting in. We think
it’s another case of a century of technological based cost reductions
working through to their end.
Food has rejoined metals and energy in reverting to a larger slice of
a global economy that has been prosperous enough to add hugely to the population
base.
Investment
from the Mid-East and East Asia in Africa is changing that. How well that feeds locals is now the
issue. There will be more unrest
in more places if some solutions don’t get found. Food is not an issue that can be put
off.
Another
issue shared by the US and China is income disparity. In the US this is taking a back seat
to debt. China has been trying to
work through that by creating non-rural payrolls, with great success so far. But now urban workers are demanding
higher wages to better inflation and that is eating up the country’s
competitive advantage.
China
is one country where higher food prices (if they are allowed) could be an
added boon for a very large rural population hoping for better living
standards. The export of low wage
manufacturing from China means the next Wal-Mart will do its shopping in
places like Viet Nam, Indonesia, Pakistan and Nigeria. How does the US compete with
that?
Strictly
speaking, it can’t. There
is no point trying to outdo developing countries on low wage manufacturing. Quality, innovation and productivity
are the only realistic competitive advantage for a country like the US. This worked for Germany after
all, and no one would classify it as a low wage country.
That
means the US accepts that it needs to resume the hard goods export model it
had before it became a global investor. That has been happening, with
last month’s exports reaching an all-time high. It’s one more reason why strong
dollar talk in Washington is just that.
Export sectors have been the real wealth and job creators lately and
no one in Washington will mess with that.
That
notwithstanding, last month we laid out what may eventually turn the US$ back
up as a cautionary tale on when precious metal prices could top. At the same time we have been
reordering the list a bit to reduce exposure in silver relative to gold.
Silver
continued its strong price run until the end of April and came just
shy of making a new notional high. It was a very short lived spike and the
metal has been falling since.
Silver has now given back all the move that began in March. Margin requirements for futures
traders were raised several times during the move up which silver bugs are
pointing to as the cause of the fall.
Futures markets attract speculators that use maximum leverage and may
have sold rather than put up more margin. Similar steep down moves were seen in
the oil market when margin requirements were upped there in recent sessions.
However,
the margin changes mainly reflected increased contract size as prices
rose. Traders with sufficient
conviction could have put up more margin. The fact they chose to sell rather
than do that indicated there was plenty of short term money in these
markets. Momentum traders that
had taken over the tape in some trades cut and ran when the trend changed.
Similar
moves have been seen across the commodity space during the past couple of
weeks. We want to be clear
here. We are not saying that
internal market issues like margin requirements are the reason for the price
pull backs. They might have
hastened the moves in a couple of the most overdone markets, but only because
traders had already decided it was time to take profits.
We
don't think the US$ bear has left the woods yet, nor do we think the longer
term commodity bull cycle has suddenly evaporated. We do think that growth economy
central bankers are starting to succeed in slowing their economies. That success, plus ongoing concerns
like QEII, European debt squabbles and US debt ceiling smack downs has traders
blowing the froth off metal and other commodity markets. It’s what they
do.
Copper
has finally made the move back below the $4 mark we have been expecting for
months. Copper’s move can
be more directly attributed to signs of slowing in China, though it too had a
speculative component that needed to be dented. Now that the spell has been broken
there may be a bit more downside left before the red metal is again ready to
base and provide another sustained up leg in price again.
We
are still focused on market warehouse stocks to time the red metal, and so
far they are not suggesting it’s time to go long. The Shanghai total is down some, so we
may be approaching the “right” price soon.
Similar
moves have been seen across the base metal space. For the most part, the scale of the
current pull backs has been in direct relationship to earlier upward price
moves. In short, the larger
the late 2010-early 2011 price increase in a particular metal the bigger the
resulting correction. This
is what would be expected in a market where prices were being reset to match
lowered expectations or greater concerns.
Gold
has been an exception so far.
In percentage terms the pullback has been small. This reflects gold’s status as a
quasi-currency and its insurance value. We expect that to continue and
gold to be one of the stronger metals as the markets settle.
During
silver’s 1980 run many wondered where the buying came from and lined up
with grandma’s silverware to cash in. No such line ups are seen this time
even though the recent run up looked pretty bubbly by the time it
peaked. Again, this points to the
current price moves in commodities being corrective, not a “sky is
falling” scenario.
Now
that traders are lightening commodity positions and markets are easing, the
question is when and where to we find a bottom. At a macro level, the big risks
are growth economies slowing too much, QEII ending with a bang not a whimper
and politicians in Europe and the US letting gridlock keep them from
negotiating debt deals.
China
has proven adept at managing growth so far. Likewise, for all the handwringing
about QEII the bond markets are acting a lot less worried than people who talk
about bond markets. Both of these
situations may end well, but it will be at least a couple of months before
that is known. That points to a
bottoming during mid-summer and charts that may yet look a lot like last
year’s. We plan to position
accordingly.
Ω
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