Commodities | Sep 12 2006
By Greg Peel
In a rather alarmist report published today entitled “The US moves to red alert”, Macquarie equity strategists have looked at a US yield curve that has turned strongly inverse and seen an abyss. Since 1970, notes Macquarie, every time the US yield curve has turned negative (such that 10-year bond yields are lower than 3-month treasury yields) a US recession has followed.
The culprit in the equation is the US housing market, which after about six months of threatening to be “soft”, has now started to look rather “stuffed”.
The reason why the US housing market is such a big problem is twofold. Firstly, like Australians, Americans place great stake in the value of their house. If it is increasing then they feel happy to go and spend the increased (but uncrystallised) value today. They might, like Australians, even remove some of the equity gain by refinancing or borrowing against the value, through means encouraged by banks.
Secondly, US mortgage rates are measured against the 30-year bond rate, unlike Australia where they are determined by the overnight cash rate. Call me a fool, but thirty years for a mortgage seems far more sensible than overnight.
US housing values and new housing starts have suddenly collapsed a lot quicker than even the sceptics were expecting. This has implications down the economic line, from resources such as copper, to building materials, to consumer spending on, say, a new car, which then affects steel, and so on and so on. What’s bad for US housing is bad for the economy as a whole. And if new mortgages are not being sought, the 30-year bond rate falls.
In the meantime, front end inflation pressures (particularly from oil) have also served to curb spending, while labour costs have been rising ahead of productivity gains. This is why the front end of the curve is now above the back end. (Note that the curve is effectively deemed to begin at three months, as anything earlier is influenced by more volatile measures of immediately available funds).
When the back end is lower than the front end the effect is that there’s little value to work towards and the economy grinds to a halt. Or it recedes. This is what the Macquarie strategists are looking at. And when the rot sets in it is very unlikely the curve will suddenly flip back again.
The Fed could take the step of saving the economy by easing rates, but then that would leave inflation to run wild and that’s exactly not what the Fed wants happen. So the Fed is stuck on the horns of a dilemma. In order to prevent spiralling inflation it must let the economy suffer.
While the US has its problems, the rest of the world is now beginning to rethink monetary policy tightening. China is already trying to slow its economy, Europe has realised thoughts of an economic awakening may have been too soon and Japan has similarly realised the great break from the zero interest rate policy may take a while yet. Economies across the world are slowing.
The first things to go in such circumstances are resources stock prices, and already the suggestion is that’s starting to happen. The irony is that investment banks across the world have just entered into another round of commodity price forecast increases, but one has to remember that analysts run well behind actual spot prices.
This is why Macquarie has made the urgent call to cut resources stock exposure, and in Australia the strategists have come up with a very simple means of doing so – sell Rio Tinto (RIO).
Why single out Rio? What about the world’s biggest diversified miner, BHP Billiton (BHP)? Over to Macquarie:
“We have removed Rio Tinto from the portfolio given its negative EPS growth forecasts for 2007 and 2008. It has an inferior spread of commodity exposures compared to BHP with far fewer new projects to sustain growth.”
Macquarie’s market portfolio only contains significant market cap companies, not smaller, more volatile spec stocks. Hence BHP is the only stock now left in its mining sector allocation. The likes of a Zinifex, Oxiana or Minara do not feature. (Nor is there a single gold stock for that matter).
Macquarie’s portfolio is seriously weighted towards banks (which, at 33% weighting, make up the entire cyclical component), property trusts (18%) and growth non-cyclicals (18%) such as Woolworths (WOW). Mining is still significant (14%) but that’s a lonely BHP.
Macquarie has also reduced its holding in Woodside Petroleum (WPL) despite its strong growth prospects, because energy is now out of favour.
What a difference a month makes, hey? Remember when Israel was bombing Lebanon, Iran was thumbing its nose at the UN and memories of Katrina were keeping small children awake at night? Well apparently there’s no longer anything at all to worry about. US$77/bbl might well have just been a nightmare.
What’s actually happened?
On a micro scale, Israel has gone backing its box, and is now even talking about reinstating peace talks with Palestine. (Heard that one before and nothing will make me believe I won’t be hearing it for a long time yet). Iran has offered to stop proceeding with its plans to enrich uranium, for at least a couple of months, to see whether the UN can’t be convinced that the government’s intentions are simply peaceful, and not bellicose. There’s been nothing but light rain in the south of the US and we’re already at least halfway through the hurricane season.
Any of those could turn on a dime at any moment. More significant are the macro developments. Firstly, there has been a big discovery of oil some 9km under the Gulf of Mexico – perhaps some 3 billion barrels of oil and maybe 15 billion barrels of oil and gas. I consider this a macro development because it’s not really a surprise – there’s obviously a lot of oil under the Gulf and it was only a matter of time before deep-sea drilling technology developed sufficiently to exploit it.
What this does show is that the world is trying harder to find oil, and investing in new ways to extract it. The law of averages suggests there will still be more found. However, I don’t believe the answer to a lower oil price lies in more oil.
The answer to a lower oil price lies in substitution. Substitution has already been developing at a rapid pace – take ethanol as an example. After a few years of rising oil prices the world has said it’s time to stop relying on the stuff, as who knows what might happen in the Middle East or anywhere else. But side from that consideration is the consideration of global warming.
There are still many who believe global warming is nonsense, but most of them are paid to say so by oil companies. Yet other scientists believe that as the Earth has been naturally cooling and warming, cooling and warming for eons, and we’re simply in another warming phase. That’s all well and good but blanketing the atmosphere with pollution and trapping green house gases isn’t exactly going to help. Most now accept, to some degree, that global warming is a problem.
If the governments of the US and Australia are happy to be pariahs then so be it. The rest of the world is moving to reduce the burning of fossil fuels. Even China knows it can’t go on the way it is. And if it’s not happening at a government level, it’s happening at a household and community level.
The bottom line of all of this is yes, oil prices are going to fall. As to whether the move from US$77/bbl to US$65/bbl in one month signals the beginning of the end for oil then I believe that’s just wishful thinking. US$100/bbl is merely a blink away, given certain circumstances. Don’t count the chickens just yet.
Anyway, if the oil price does start heading towards US$50/bbl once more then suddenly inflationary pressures will take a dive and economic recessions will seem less likely. (And the US yield curve may even revert).
Which provides me with a pre-planned segue – does everyone agree with Macquarie?
No.
There has been talk among the technical analysts and related tea-leaf readers that US equities look weak, weak, weak. But it wouldn’t be the first time that’s happened with no result. There is a large segment of the investment community that has been saying for a while that weakness will prevail towards the end of the year and then everything will be positive for equities again. Once inflation is under control, the Fed may even cut interest rates.
The AMP’s Shane “El Toro” Oliver puts it thus:
“We remain cautious on share markets for the next couple of months. Inflation concerns are still raising their head periodically, worries about a housing driven US hard landing are likely to intensify, China is still intent on slowing its economy which will contribute to a rough ride for commodity prices and political uncertainty is likely to weigh on US (and hence global) shares in the run up to this year’s mid-term Congressional elections.
“However, shares are likely to provide reasonable returns on a six to 12-month view as the market focus will shift towards the prospect that the US Federal Reserve is moving towards interest rate cuts and as it becomes apparent that economic growth is not heading for a hard landing”.*
So there you have it – the two opposing views in a nutshell. Oliver’s views are backed by many including those who can’t believe no one can see that the China/India story simply means boom times, particularly in commodities, for years to come.
FN Arena’s friends at global investment consultants GaveKal believe that “US equities are poised to generate great returns for their shareholders in coming years”, based on their extensive work into the changing nature of capitalism, and the rise of the platform company. *
For certain we are facing uncertain times. This is evident in the polarisation of views that have existed since everything went a bit awry in May. To say one view is correct is to be extremely foolish. Investors can only approach 2007 with an air of caution.
*Shane Oliver’s reports can be found in John Bedson’s The Australian Investment Guide as published in FN Arena’s “Sources of Wisdom” section. Therein readers may also find opposing views. GaveKal’s theories are explained in the FN Arena series “Brave New World” available in the “Special Reports” section.
Note from the editor: the call to remove Rio Tinto from the portfolio was made by Macquarie equity strategists. The broker’s fundamental analysts have not altered their positive investment view on the stock over a twelve month horizon, as can be seen in our Stock Analysis section.