Posts Tagged ‘Commodities’
Wednesday, May 22nd, 2013
Gold’s been on a wild ride. After reaching a peak of $1,920 an ounce in September 2011, gold has tumbled 28% to the current ~$1,380 level forcing John Paulson to take a 47% loss in his gold fund during the first four months of this year, according to Bloomberg.
Unlike Paulson who maintained his positions in gold, other big players like George Soros and BlackRock cut their gold ETF holdings, while Goldman Sachs issued a sell recommendation on gold right before the yellow metal plunged 13% through April 15, the biggest drop in three decades. And by looking at the futures curve (chart below), market does not seem to expect gold to come back roaring any time soon.
Chart Source: S&P Capital IQ
QEs Not Hitting the Real Economy
Historically, gold is regarded as a good inflation hedge and store of value, typically thriving in an environment of high inflation, and/or weak U.S. dollar (currency debasement). With U.S. Federal Reserve’s three rounds of QE, the never-ending debt crisis in the Eurozone, hyperinflation and dollar debasement seem inevitable and supportive of gold for the long run, right?
Theoretically, Fed’s QE and near zero fed funds rate is supposed to encourage borrowing and spending from the private sector thus injecting money into the real economy. However, theory and reality don’t always see eye to eye.
Since the 2008 financial crisis, banks have significantly tightened the credit standard and are reluctant to lend. On the other hand, corporations are making money mostly from “streamlined” headcount and structure, but instead of the intended wealth distribution effect expected by the Fed such as investing back to the economy, or increase employee pay which would in turn increase consumer spending, most corporations are hoarding cash or use profits for dividend, share buybacks, or mergers & acquisitions with limited impact on the real economy.
Copper & Oil Indicating Weak Demand
The weak demand is also reflected in part of the commodity market fundamental. WTI crude oil inventory climbed to 82-year high and copper inventory at LME hit a 10-year high in April, while Goldman Sachs cut its “near-term” outlook for commodities.
Although some have argued oil and copper have lost their significance primarily due to increasing domestic oil production, and“temporary” excess copper supply. While the abundance of domestic shale oil production may have distorted the historical supply and demand relationship, but with the U.S. becoming the world’s largest fuel exporter, the fast and furious oil inventory build is nevertheless still an indication of a weak world economy. And I can’t imagine how the “temporary” buildup of copper inventory is not a sign of weak global economic condition?
Further Reading – Oil Market Manipulation Reaches Absurd Levels
Massive QEs, Limited Inflation?
On top of the overall weak spending and demand in the private sector, most of the developed countries are undergoing some shape or form of austerity with reduced government spending. China, the growth engine of the world, is having some problems of its own. The old-fashioned massive infrastructure building QE program got China through the 2008 financial crisis, and was the main driver behind commodity prices. But Beijing can’t afford another QE due to inflation concern (plus China has probably run out of things to build). Low wage levels means China consumers can’t really pick up the spending slack, coupled with bad credit problem (i.e., NPL: Non-Performing Loans), andrecent capital flight, which had many analysts worried enough to downgrade China’s growth prospect.
The simultaneous pullback from both the private and government sectors in U.S. Europe, and China is a major factor why Fed’s massive QEs have resulted in only limited inflationary pressure and increasing signs of deflation.
Dollar and Carry Trade Kills Gold
Nonetheless, when compared with Europe, China or any other regions in the world, the U.S., seems relatively more stable, and has been able to retain the “safe haven” status despite its own debt problem. With investors pouring money into U.S. equity and bond propping up the dollar, and weak demand suppressing inflation, two of the main conditions for a strong gold price — high inflation and a weak US dollar — are basically non-existent in the current macro environment. Furthermore, there was already a bit of disconnect between gold and the other commodity prices such as copper, and oil. So eventually, gold had to come to grip with the macro reality.
Another major factor against gold right now is that gold has no yield and is out of favor with the huge yield-seeking yen carry trade crowd (borrowing yen to invest in higher yield options) since bond and equity now are offering much better returns. Unless there’s a shock to the system such as a war breaking out in the Middle East, or an eventual debt crisis in Japan when people start seeking safety, there’s not much upside momentum for gold.
Gold’s Volatility Game
For now, the prevalent view is that the Fed will slow or exit QE3, and gold is out of favor under the the current macro trend. For example, Lim Chow Kiat, the chief investment officer of the Government of Singapore Investment Corp (GIC), thinks gold still looks overpriced as the usage of gold for industrial or consumer products doesn’t quite justify the prices. GIC is one of the world’s largest sovereign wealth funds.
As long as dollar maintain its strength and inflation remains tame, gold prices most likely will see considerable volatility swinging between rumors and speculation (e.g., some central banks may need to unload some of their holdings due to debt crisis), and Asia retail buying on the dip (South China Morning Post reported that many shops in Hong Kong were running out of the precious metal for the first time in decades.)
Technically speaking, gold’s next support level should be $1,330 range with $1,320 as the major support when most physical retail buyers would rush in. If gold breaks below $1,300 hard, expect a major liquidation when even Paulson could be forced to sell and everybody piles in.
©EconMatters All Rights Reserved
Thursday, April 18th, 2013
Below we provide our trading range charts for ten of the most widely followed commodities. For each chart, the green shading represents between two standard deviations above and below the commodity’s 50-day moving average. Moves to the top of or above the green zone are considered overbought, while moves to the bottom of or below the green zone are considered oversold.
We’ve seen an absolute bloodbath in the precious metals recently. As you can see below, gold and silver have both “fallen off a cliff” over the past few trading days in what has been a remarkable move. Platinum and copper are both oversold as well, but to a much lesser extent.
Oil has also been hit hard this week, and it’s as oversold now as it has been in nearly a year.
One commodity that has bucked the recent move lower is natural gas. As shown, natural gas is actually remains in a very nice uptrend and at the top of its trading range. In recent years, it had been gold and oil going higher while natural gas couldn’t buy an up day. Now the complete opposite is occurring.
Copyright © Bespoke Investment Group
Sunday, April 14th, 2013
April 12, 2013
How a Landslide Shifts Copper Supply
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
The U.S. mining industry was dealt a devastating blow as Kennecott Utah Copper’s Bingham Canyon Mine experienced a pit wall failure causing a massive landslide with rocks and dirt covering the bottom of the mine pit. It’s a miracle no one was hurt due to the vigilance of its owner, Rio Tinto.
Brian Hicks, portfolio manager of the Global Resources Fund, is very familiar with the mine, having visited it often. He also has personal ties as both of his grandfathers were once employed by the mine. When Brian saw the photo of the landslide posted on the web, he said the substantial destruction of the collapsed wall and falling rock was apparent, yet the tremendous scale and magnitude of the mine cannot be captured in pixels.
Bingham’s immense size is a powerful sight to witness firsthand. It is one of the largest open-pit copper mines in the world, it’s the second largest copper producer in the U.S., and it’s been in operation for more than one hundred years.
The mine supplies about 1 percent of copper to the global market, says research firm Paradigm Capital. In the fourth quarter, the mine produced 59,000 tons and 163,000 tons in 2012. Because of the landslide, analysts expect there to be a huge decline in the overall copper output from Bingham this year.
This is a short-term setback for Rio Tinto, as the mine is one of four main copper assets for the company, but Nomura sees an additional shift in the copper market, “where this could take a market where many observers felt a meaningful surplus was about to emerge, back to remaining quite tight” in 2013.
Copper production had been rising to a new high, as you can see below. Credit Suisse charts the rising supply of copper coming out of Canada, Chile, China, Mexico, Peru and Zambia, which represents 60 percent of global supply. In the fourth quarter of 2012 only, copper in the top 6 countries increased 8.5 percent on a year-over-year basis.
With production higher, copper has moved from a deficit to a balanced market, which is typical, but “this is not to say that persistent growth of new mine supply is not problematic for a variety of technical and other reasons,” says Credit Suisse. In addition to the setback from Brigham, the new mines under development, including one in Mongolia, might not come on line as quickly as one thinks.
Copper mining has always been dealt more than its fair share of challenges: We’ve discussed labor disputes in the past, such as the massive strike in Grasberg in Indonesia, which significantly reduced production from a pre-disruption level of about 500 to 700 tons to 136 tons in a year, says Credit Suisse. Political issues and weather catastrophes have also hurt copper supply in recent years.
The good news is that demand for copper persists. With four babies born every second, a growing population along with rising urbanization will continue to drive the need for copper.
The red metal is also the most widely consumed base metal, dominated by wire and cable and used in anything that is electrical or electronic. Credit Suisse estimates that about 20 percent of overall copper is made into building wire and construction uses make up almost 30 percent of the world’s copper use.
Another growing use of copper comes from hybrid and electric cars. Many countries, including China which already uses 40 percent of the world’s copper, have been encouraging residents to purchase hybrid and electric cars via subsidies. These fuel-efficient cars consume substantially more copper than an automobile run on gasoline. Whereas a gasoline-fueled car uses 50 pounds of copper, an electric car can consume triple that amount, says the Copper Development Association. I often say, there’s no free lunch on the commodities table: If more hybrids fill the roads, more copper will inevitably be needed.
The landslide in Utah is just one example of how quickly and unexpectedly the supply and demand factors facing the red metal can shift, which I believe underscores the need for nimble active management.
A New Penalty for Playing by the Rules
Taxpayers who save and invest may soon be punished for doing the right thing and investing successfully. In President Barack Obama’s budget proposal, he wants to limit an individual’s total balance in tax-favored retirement accounts to $3 million for someone retiring in 2013. The president feels the need to “define for everyone what is ‘needed’ for a ‘reasonable’ retirement,” says the Wall Street Journal.
For years, the financial industry has been actively educating and encouraging investors to take full advantage of their tax-advantaged 401(k)s and IRAs. “Now He’s After Your 401(k)” says the WSJ, as its headline draws attention to the contradictory message the government is sending to investors. Rather than incentivizing and rewarding hard-working Americans, the policy penalizes “people who work for decades and abstain from buying the bigger house or the new car so they can contribute the maximum to their 401(k)s or IRAs.”
Having the will and thrill to invest is part of the fiber that makes America great. The proposal “undermine[s] a key national priority—helping Americans prepare for a secure retirement,” says the Investment Company Institute in agreement.
I believe the government hindering savers and investors is the equivalent to a referee kicking Miami Heat’s LeBron James out of a game after he’s scored a “reasonable” number of points.
If you have been dutifully paying your taxes, scrimping and budgeting to save and invest in your future, voice your opinion on the budget proposal. Contact your representatives in Washington and tell them to refuse a strategy similar to the socialist policy wonks in Europe who implement anti-saving and investing policies, oblivious and insensitive to the unintended consequences that hurt savers and investors.
Thank You for Sharing Your Best Investment Advice
A few weeks ago, I talked about my best investment advice in a blog post and asked readers to share the best investment advice they ever received. The responses were overwhelming!
Many people shared their learnings from relatives or professors. Others have heeded the advice of well-known investors, such as Warren Buffett. I was heartened by the fact that many of our readers share our belief in the importance of diversification and accepting the concept of balancing risk and reward as these ideas will serve them well over the long term.
To those readers who took time out of your day to send us your thoughts, thank you. If you’d like to share advice that made you a better investor, email us at firstname.lastname@example.org.
Friday, March 22nd, 2013
by Dambisa Moyo, author, most recently, of Winner Take All: China’s Race for Resources and What it Means for the World, via Project Syndicate
SEOUL – The commodity super-cycle – in which commodity prices reach ever-higher highs, and fall only to higher lows – is not over. Despite the euphoria around shale gas – indeed, despite weak global growth – commodity prices have risen by as much as 150% in the aftermath of the financial crisis. In the medium term, this trend will continue to pose an inflation risk and undermine living standards worldwide. For starters, there is the convergence argument.
via Project Syndicate:
• As China grows, its increasing size, wealth, and urbanization will continue to stoke demand for energy, grains, minerals, and other resources.
• the US consumes more than nine times as much oil as China on a per capita basis. As more of China’s population converges to Western standards of consumption, demand for commodities – and thus their prices – will remain on an upward trajectory.
• although the case for copper seems straightforward, given that it is a key input for wiring, electronics, and indoor plumbing, a strong bid for iron is not as obvious, given the Chinese infrastructure boom that already has occurred in the last two decades.
• unless China’s commodity intensity, defined as the amount of a commodity consumed to generate a unit of output, falls dramatically, its demand for commodities will be greater this year than it was last year.
• As long as China’s commodity demand grows at a higher rate than global supply, prices will rise.
• China’s need to prevent a crisis of legitimacy – places a floor under global food, energy, and mineral prices.
• As the composition of China’s economy continues to shift from investment to consumption, demand for commodity-intensive consumer durables – cars, mobile phones, indoor plumbing, computers, and televisions – will rise.
• By implication, if nothing else, global energy, food, and mineral prices will continue to be buoyed by seemingly insatiable emerging-market demand, which commands much higher reserve prices.
• If people feel rich and enjoy growing wages and appreciating assets, they are less inclined to cannibalize other spending when commodity consumption becomes more expensive. They just pay more and carry on.
• Supply side challenges – It is not just that global supplies of resources are increasingly scarce, but also that supplies are increasingly falling into inefficient hands.
• Around the world, governments are taking greater control of resources and imposing policies that hamper global production and ultimately force prices higher.
• There is a perennial temptation to focus on – even to overemphasize – the short-term, tactical drivers of commodity-price movements, at the expense of giving longer-term, structural factors their due.
• While short-term factors – for example, political instability, weather-related disruptions, and speculative activity – are important determinants of prices, they tell only part of the story.
• In practical terms, this means that oil prices, for example, are more likely to hover near $120 per barrel over the next decade, rather than $50; and we are unlikely to see a $20 barrel of oil ever again.
Copyright © Project Syndicate
Friday, February 1st, 2013
Via John Aziz of Azizonomics blog,
What does it mean that China is making a lot of noise about the Federal Reserve’s loose monetary policy?
A senior Chinese official said on Friday that the United States should cut back on printing money to stimulate its economy if the world is to have confidence in the dollar.
Asked whether he was worried about the dollar, the chairman of China’s sovereign wealth fund, the China Investment Corporation, Jin Liqun, told the World Economic Forum in Davos: “I am a little bit worried.”
“There will be no winners in currency wars. But it is important for a central bank that the money goes to the right place,” Li said.
At first glance, this seems like pretty absurd stuff. Are we really expected to believe that China didn’t know that the Federal Reserve could just print up a shit-tonne of money for whatever reason it likes? Are we really expected to believe that China didn’t know that given a severe economic recession that Ben Bernanke would throw trillions and trillions of dollars new money at the problem? On the surface, it would seem like the Chinese government has shot itself in the foot by holding trillions and trillions of dollars and debt instruments denominated in a currency that can be easily depreciated. If they wanted hard assets, they should have bought hard assets.
As John Maynard Keynes famously said:
The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.
But I think Keynes is wrong. I don’t think China’s goal in the international currency game was ever to accumulate a Scrooge McDuck-style hoard of American currency. I think that that was a side-effect of their bigger Mercantilist geopolitical strategy. So China’s big pile of cash is not really the issue.
It is often said that China is a currency manipulator. But it is too often assumed that China’s sole goal in its currency operations is to create growth and employment for China’s huge population. There is a greater phenomenon — by becoming the key global manufacturing hub for a huge array of resources, components and finished goods, China has really rendered the rest of the world that dependent on the flow of goods out of China. If for any reason any nation decided to attack China, they would in effect be attacking themselves, as they would be cutting off the free flow of goods and components essential to the function of a modern economy. China as a global trade hub — now producing 20% of global manufacturing output, and having a monopoly in key resources and components — has become, in a way, too big to fail. This means that at least in the near future China has a lot of leverage.
So we must correct Keynes’ statement. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed; owe him £1 trillion, and become dependent on his manufacturing output, and the position is reversed again.
The currency war, of course, started a long time ago, and the trajectory for the Asian economies and particularly China is now diversifying out of holding predominantly dollar-denominated assets. The BRICs and particularly China have gone to great length to set up the basis of a new reserve currency system.
But getting out of the old reserve currency system and setting up a new one is really a side story to China’s real goal, which appears to have always been that of becoming a global trade hub, and gaining a monopoly on critical resources and components.
Whether China can successfully consolidate its newfound power base, or whether the Chinese system will soon collapse due to overcentralisation and mismanagement remains to be seen.
Thursday, January 31st, 2013
I have recently been quite busy with other matters and I am sure that my lack of presents has been noticed somewhat. However, my focus returns back towards the blog in February, so I will be doing quite a few more posts than I normally have done in recent months. Expect quite a lot of material in coming weeks and months. Today, we start of with a recent update from Merrill Lynch Fund Managers Survey. I will include just some of the more important charts, because it would take too long to go through the whole thing. If you have any questions about other specifics covered in the survey, while not on the blog, just drop a comment and ask – I will be glad to answer it!
Chart 1: Risk taking moves to extremely high levels
Source: Merrill Lynch
Merrill Lynch Fund Managers Survey, which surveyed an overall total of 254 panellists with $754bn AUM, in a period between 4th to 10th January 2013 showed that investors bullishness surged to extremes. The chart abodes shows that risk appetite is the second highest in surveys history. Current readings should be a worry for bulls, and they are just about everywhere these days. On previous two occasions of appetite reaching these extremes, in April 2010 and February 2011, the market eventually suffered a crash (flash crash and US debt downgrade respectively). Merrill Lynch summarises the mood by stating that:
“Investors enter 2013 as bullish as they have been in two years. Growth and risk metrics are at multi-year highs and, most glaringly, investors are OW bank stocks for the first time since 2007.”
Source: Merrill Lynch
Fund managers remain extremely bullish on the global economic prospects, especially when it comes to China. The survey writes:
“Growth optimism surged to a 33-month high. Optimism on Chinese growth remains robust. A net 63% expect a stronger Chinese economy over the next 12 months, the second highest reading on record.”
On the other hand, fund managers are taking “larger-than-normal” risk (shown in the Chart 1), while the number “taking out market protection” fell to the lowest reading since the survey question was introduced. Once again, similar readings were wittiness in April 2010 and February 2011, and eventually markets corrected meaningfully. Bulls better hope that economy and earnings picture really picks up to justify this much greed, otherwise a lot of investors might be in for a disappointment. I hold my doubts.
Source: Merrill Lynch
Each month, the survey tracks managers opinions on business cycle progression – one of my favourite indicators as a longer term investor. The chart above shows that “a net 65% of investors view the economy as mid to late cycle in maturity. The % of investors that think the economy is currently in recession has retreated back to 6% (from 12% last month).” The economic data continues to hold up for now, but in investing the goal is to anticipate the future, not discuss the present. Majority of investors agree that we are very late in the cycle and therefore near the end of the bull market, which started in March 2009. Therefore, nasty surprises are definitely awaiting us as the secular equity bear market is not yet finished.
Chart 4: Dramatic shift out of cash & bonds, into equities
Source: Merrill Lynch / Short Side Of Long
Equity allocations are also the highest since early parts of 2011. Merrill Lynch writes:
“Bullish expectations on growth, profits and margins have finally translated into higher equity allocations. A net 51% of investors are OW equities, most bullish since February 2011.”
At the same time, “allocation to bonds fell to lowest level since May 2011″. Furthermore, cash levels fell for “the sixth consecutive month and are now the lowest since April 2011″ (last major top in risk assets). The Merrill Lynch Fund Managers Survey title is “The Bears go into hibernation” and there is a very good reason for it. It is very difficult to find a bear amongst fund managers, just as MSCI World Index approaches a major resistance level.
Chart 5: Disinterest in commodities remains in place
Source: Merrill Lynch / Short Side Of Long
Interestingly, despite high risk appetite and overly-bullish growth expectations (especially in China), fund managers allocation towards commodities remains underweight. Furthermore, the survey also reports that managers remain underweight Energy & Materials as well (two most disliked sectors in couple of last quarters). Merrill Lynch states that:
“The commodity complex is very much the forgotten asset class thus far in 2013.”
I believe there is an above average possibility commodities are now building a basing pattern. Therefore, disinterest in commodities by global fund managers is music to contrarians ears, if you ask me!
Thursday, January 31st, 2013
This is the way the world ends…
Not with a bang but a whimper.
They say that time is money.* What they don’t say is that money may be running out of time.
There may be a natural evolution to our fractionally reserved credit system which characterizes modern global finance. Much like the universe, which began with a big bang nearly 14 billion years ago, but is expanding so rapidly that scientists predict it will all end in a “big freeze” trillions of years from now, our current monetary system seems to require perpetual expansion to maintain its existence. And too, the advancing entropy in the physical universe may in fact portend a similar decline of “energy” and “heat” within the credit markets. If so, then the legitimate response of creditors, debtors and investors inextricably intertwined within it, should logically be to ask about the economic and investment implications of its ongoing transition.
But before mimicking T.S. Eliot on the way our monetary system might evolve, let me first describe the “big bang” beginning of credit markets, so that you can more closely recognize its transition. The creation of credit in our modern day fractional reserve banking system began with a deposit and the profitable expansion of that deposit via leverage. Banks and other lenders don’t always keep 100% of their deposits in the “vault” at any one time – in fact they keep very little – thus the term “fractional reserves.” That first deposit then, and the explosion outward of 10x and more of levered lending, is modern day finance’s equivalent of the big bang. When it began is actually harder to determine than the birth of the physical universe but it certainly accelerated with the invention of central banking – the U.S. in 1913 – and with it the increased confidence that these newly licensed lenders of last resort would provide support to financial and real economies. Banking and central banks were and remain essential elements of a productive global economy.
But they carried within them an inherent instability that required the perpetual creation of more and more credit to stay alive. Those initial loans from that first deposit? They were made most certainly at yields close to the rate of real growth and creation of real wealth in the economy. Lenders demanded that yield because of their risk, and borrowers were speculating that the profit on their fledgling enterprises would exceed the interest expense on those loans. In many cases, they succeeded. But the economy as a whole could not logically grow faster than the real interest rates required to pay creditors, in combination with the near double-digit returns that equity holders demanded to support the initial leverage – unless – unless – it was supplied with additional credit to pay the tab. In a sense this was a “Sixteen Tons” metaphor: Another day older and deeper in debt, except few within the credit system itself understood the implications.
Economist Hyman Minsky did. With credit now expanding, the sophisticated economic model provided by Minsky was working its way towards what he called Ponzi finance. First, he claimed the system would borrow in low amounts and be relatively self-sustaining – what he termed “Hedge” finance. Then the system would gain courage, lever more into a “Speculative” finance mode which required more credit to pay back previous borrowings at maturity. Finally, the end phase of “Ponzi” finance would appear when additional credit would be required just to cover increasingly burdensome interest payments, with accelerating inflation the end result.
Minsky’s concept, developed nearly a half century ago shortly after the explosive decoupling of the dollar from gold in 1971, was primarily a cyclically contained model which acknowledged recession and then rejuvenation once the system’s leverage had been reduced. That was then. He perhaps could not have imagined the hyperbolic, as opposed to linear, secular rise in U.S. credit creation that has occurred since as shown in Chart 1. (Patterns for other developed economies are similar.) While there has been cyclical delevering, it has always been mild – even during the Volcker era of 1979-81. When Minsky formulated his theory in the early 70s, credit outstanding in the U.S. totaled $3 trillion.† Today, at $56 trillion and counting, it is a monster that requires perpetually increasing amounts of fuel, a supernova star that expands and expands, yet, in the process begins to consume itself. Each additional dollar of credit seems to create less and less heat. In the 1980s, it took four dollars of new credit to generate $1 of real GDP. Over the last decade, it has taken $10, and since 2006, $20 to produce the same result. Minsky’s Ponzi finance at the 2013 stage goes more and more to creditors and market speculators and less and less to the real economy. This “Credit New Normal” is entropic much like the physical universe and the “heat” or real growth that new credit now generates becomes less and less each year: 2% real growth now instead of an historical 3.5% over the past 50 years; likely even less as the future unfolds.
Not only is more and more anemic credit created by lenders as its “sixteen tons” becomes “thirty-two,” then “sixty-four,” but in the process, today’s near zero bound interest rates cripple savers and business models previously constructed on the basis of positive real yields and wider margins for loans. Net interest margins at banks compress; liabilities at insurance companies threaten their levered equity; and underfunded pension plans require greater contributions from their corporate funders unless regulatory agencies intervene. What has followed has been a gradual erosion of real growth as layoffs, bank branch closings and business consolidations create less of a need for labor and physical plant expansion. In effect, the initial magic of credit creation turns less magical, in some cases even destructive and begins to consume credit markets at the margin as well as portions of the real economy it has created. For readers demanding a more model-driven, historical example of the negative impact of zero based interest rates, they have only to witness the modern day example of Japan. With interest rates close to zero for the last decade or more, a sharply declining rate of investment in productive plants and equipment, shown in Chart 2, is the best evidence. A Japanese credit market supernova, exploding and then contracting onto itself. Money and credit may be losing heat and running out of time in other developed economies as well, including the U.S.
If so then the legitimate question is: how much time does money/credit have left and what are the investment consequences between now and then? Well, first I will admit that my supernova metaphor is more instructive than literal. The end of the global monetary system is not nigh. But the entropic characterization is most illustrative. Credit is now funneled increasingly into market speculation as opposed to productive innovation. Asset price appreciation as opposed to simple yield or “carry” is now critical to maintain the system’s momentum and longevity. Investment banking, which only a decade ago promoted small business development and transition to public markets, now is dominated by leveraged speculation and the Ponzi finance Minsky once warned against.
So our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time. When does money run out of time? The countdown begins when investable assets pose too much risk for too little return; when lenders desert credit markets for other alternatives such as cash or real assets.
REPEAT: THE COUNTDOWN BEGINS WHEN INVESTABLE ASSETS POSE TOO MUCH RISK FOR TOO LITTLE RETURN.
Visible first signs for creditors would logically be 1) long-term bond yields too low relative to duration risk, 2) credit spreads too tight relative to default risk and 3) PE ratios too high relative to growth risks. Not immediately, but over time, credit is exchanged figuratively or sometimes literally for cash in a mattress or conversely for real assets (gold, diamonds) in a vault. It also may move to other credit markets denominated in alternative currencies. As it does, domestic systems delever as credit and its supernova heat is abandoned for alternative assets. Unless central banks and credit extending private banks can generate real or at second best, nominal growth with their trillions of dollars, euros, and yen, then the risk of credit market entropy will increase.
The element of time is critical because investors and speculators that support the system may not necessarily fully participate in it for perpetuity. We ask ourselves frequently at PIMCO, what else could we do, what else could we invest in to avoid the consequences of financial repression and negative real interest rates approaching minus 2%? The choices are varied: cash to help protect against an inflationary expansion or just the opposite – long Treasuries to take advantage of a deflationary bust; real assets; emerging market equities, etc. One of our Investment Committee members swears he would buy land in New Zealand and set sail. Most of us can’t do that, nor can you. The fact is that PIMCO and almost all professional investors are in many cases index constrained, and thus duration and risk constrained. We operate in a world that is primarily credit based and as credit loses energy we and our clients should acknowledge its entropy, which means accepting lower returns on bonds, stocks, real estate and derivative strategies that likely will produce less than double-digit returns.
Still, investors cannot simply surrender to their entropic destiny. Time may be running out, but time is still money as the original saying goes. How can you make some?
(1) Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth, and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don’t fight central banks – anticipate them by buying what they buy first; look as well for offshore sovereign bonds with positive real interest rates (Mexico, Italy, Brazil, for example).
(2) Get used to slower real growth: QEs and zero-based interest rates have negative consequences. Move money to currencies and asset markets in countries with less debt and less hyperbolic credit systems. Australia, Brazil, Mexico and Canada are candidates.
(3) Invest in global equities with stable cash flows that should provide historically lower but relatively attractive returns.
(4) Transition from financial to real assets if possible at the margin: buy something you can sink your teeth into – gold, other commodities, anything that can’t be reproduced as fast as credit. Think of PIMCO in this transition. We hope to be “Your Global Investment Authority.” We have a product menu to assist.
(5) Be cognizant of property rights and confiscatory policies in all governments.
(6) Appreciate the supernova characterization of our current credit system. At some point it will transition to something else.
We may be running out of time, but time will always be money.
Speed Read for Credit Supernova
1) Why is our credit market running out of heat or fuel?
a) As it expands at a rate of trillions per year, real growth in the economy has failed to respond. More credit goes to pay interest than future investment.
b) Zero-based interest rates, which are the result of QE and credit creation, have negative as well as positive effects. Historic business models may be negatively affected and investment spending may be dampened.
c) Look to the Japanese historical example.
2) What options should an investor consider?
a) Seek inflation protection in credit market assets/ shorten durations.
b) Increase real assets/commodities/stable cash flow equities at the margin.
c) Accept lower future returns in portfolio planning.
William H. Gross
* The terms “money” and “credit” are used interchangeably in this IO. Purists would dispute the usage and I would agree with them, arguing for the usage for simplicity’s sake and the evolving homogeneity of the two.
† Outstanding credit includes all government debt as well as corporate, household and personal debt. Does not include “shadow” debt estimated at $20-30 trillion.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Commodities contain heightened risk including market, political, regulatory and natural conditions, and may not be suitable for all investors.
The views and strategies described herein are for illustrative purposes only and may not be suitable for all investors. The information is not based on any particularized financial situation, or need, and is not intended to be, and should not be construed as investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Investors should consult their financial advisor prior to making an investment decision. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
Tuesday, January 29th, 2013
Financial Thought Leader, Andrew Lo, renowned professor of finance at MIT and hedge fund manager says the markets are more complex and challenging than ever before. He shares strategies to survive and prosper.
Andy Lo’s “The One Investment”
“The One Investment…”
A managed futures product that includes commodities & financials
“I think that for the coming years, probably some kind of managed futures product, something that involves commodities, but also financials. But that are futures contract based, so that they’re betting on trends as well as dynamically readjusting their risk to take into account some of these macro factors… Managed futures has often been called crisis alpha, because they tend to do well when there are big shocks in the marketplace. Now, they didn’t do well last year when the S&P was up 16%.I think managed futures may have been down five or ten percent. But that’s just the point. The point is that they do well when the stock market doesn’t, and so they provide a nice counterweight to the traditional stock-bond investments.”
- Andrew Lo
Sunday, January 27th, 2013
Energy and Natural Resources Market Radar (January 28, 2013)
• Commodity-hungry China showed more signs of a strengthening economy this week with the HSBC flash PMI for January rising further to 51.9 in January from 51.5 in December which suggests growth momentum continues to improve in the first quarter.
• Energy stocks led the S&P 500 to multi-year highs this week with a gain of nearly 2.5 percent as crude oil gained about 50 cents on the week to finish at $96 per barrel for WTI.
• Palladium closed the week at a 15-month high price of $740 per ounce on continued mine disruptions in South Africa.
• Bloomberg reported that Vale has suspended construction at its Rio Colorado potash project in Argentina. The Rio Colorado project was expected to represent approximately 4.3 million tons of annual production at full run-rates, with our forecasts assuming production starting up in 2016. Capex was estimated at $5.9 billion with approximately $1.6 billion already invested. Wednesday’s news follows previous reports that Vale had officially postponed its $3 billion potash project in Saskatchwan, Canada (Kronau) and separately was looking for potential investment partners in the Rio Colorado project.
• This week saw the release of December’s global crude steel and pig iron production data by Worldsteel. The data show continued weakness in ex-China output at the end of 2012, rounding off what was a difficult year for the global industry. 2012 saw global steel output rise 1.2 percent year-over-year, although after stripping out the reported 3.1 percent growth in Chinese output, ex-China production fell 0.4 percent, with most of the weakness coming in the second half of the year.
• CNBC.com wrote that the slowdown in the world’s largest economies last year, particularly in China, led to warnings that the end of the commodities super-cycle was near, as prices of key resources plummeted. However, a flood of government stimulus unveiled in recent months has reversed that trend, prompting one expert to say the commodities bull run that began in 2002, is here to stay. “(The super cycle) is still intact. The combination of the economic recovery, especially with China powering ahead, and continuing support from central banks…It’s going to be a good year for commodities,” Eugen Weinberg, global head of commodities research at Commerzbank told CNBC on Friday, pointing to the Bank of Japan’s commitment to open-ended easing this week.
• According to a new study by IHS, in the United States alone, the direct, indirect and induced effects of the surge in nonconventional oil and gas extraction have already added 1.7 million jobs (with 3 million expected by 2020) and $62 billion to federal and state government coffers in 2012 (with $111 billion expected by 2020). For the first time in many decades, a number of large global chemicals companies have announced plans to build or expand facilities in North America for exports—capital expenditures totaling around $95 billion in the next decade, focused primarily on ethylene production.
• The Russian central bank will continue to buy gold as it seeks to diversify its foreign reserves away from paper assets it views as risky, First Deputy Chairman Alexei Ulyukayev said on Thursday. The bank has also been a bullion buyer and the share of gold in its reserves is approaching a medium-term target of 10 percent.
• The global copper market faces a surplus of the metal that may push down prices toward the end of the year, according to Codelco CEO Thomas Keller. “Maybe there will be a certain element of downward pressure, albeit very slight, toward the end of the year when there will be a small surplus,” Keller said.
• Bloomberg news reported that Barclays commodity traders believe iron ore will almost erase the past two months’ rally and fall 19 percent in the second quarter as weather stops disrupting supply and Chinese restocking ends.
• According to media reports Farc rebels in Colombia blew up two southern oil pipelines, including the Transandino pipeline (a 48,000 barrels-per-day pipeline from Putumayo to the Pacific Coast) after a two month cease-fire ended on January 20 with no extension.
Monday, January 21st, 2013
by Daniel J. Loewy, AllianceBernstein
Daniel J. Loewy and Brian T. Brugman
The odds of the market staying in risk-on, risk-off mode are lower than they were a few months ago, in our view—but still too high to take a highly aggressive stance.
Market volatility has plunged over the last two weeks, as concerns over a European breakup have abated, China’s economy showed signs of recovery, and an eleventh-hour agreement kept the US from going over the fiscal cliff. Is this just another phase of the risk-on, risk-off (RORO) market that has whipsawed investors for three years—or the beginning of a more lasting positive market environment?
In a RORO environment, markets repeatedly shift between fear and euphoric relief, typically in response to news regarding the dominant issue of the day. Unusually high variability in perceived risk leads to unusually high variability in levels of market volatility.
RORO behavior reached historic high levels in recent years, driven by concerns about subpar macroeconomic growth, deleveraging, and political gridlock over key policy issues, as shown by the display below. This behavior is not unprecedented: in the early 1980s, concerns about inflation spiraling out of control drove similar, albeit lower, RORO behavior. The display is based on a proprietary RORO metric that we developed; it incorporates many market volatility measures.
RORO environments tend to persist: the current RORO environment began with the financial crisis five years ago. But by our metric, RORO behavior has declined steadily over the last year, which suggests that we may be on the cusp of a prolonged period of stability. In a more stable environment, we’d expect investor concerns about growth and deflation to abate, and take a back seat to industry and company fundamentals.
We would also expect risk aversion to ebb in periods of stabilization. As a result, risk assets such as equities (particularly high-beta segments such as emerging-market and smaller-cap equities) would deliver strong returns. We’d also expect real assets, such as commodities, to do well as accelerating economic growth generally leads investors to anticipate a pick-up in inflation.
But our metric also shows that RORO behavior remains well above average and recently registered a small up-tick, which raises the possibility that this latest risk-on phase will be short-lived.
Clearly, there are fundamental risks that could drive volatility up. Europe is likely to adopt more painful austerity measures. The US has yet to deal with its deficit and faces the near-term specter of automatic spending cuts and political deadlock over the debt ceiling. And both Japan’s and China’s new leaders may make big policy shifts.
Given these mixed signals, we think it may make sense to add to equities and real assets, but to hedge those bets. Here are three tools to consider:
- Adding income-generating strategies such as credit, which tend to do well in a low-growth RORO world;
- More frequent rebalancing after market rallies or dips; and
- Opportunistic purchases of equity put options as a hedge against a spike in volatility.
The recent drop in market volatility has made options a relatively cheap form of insurance. That may not last.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Daniel J. Loewy is Co-Chief Investment Officer and Brian T. Brugman is Portfolio Manager of Dynamic Asset Allocation services at AllianceBernstein.
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