FYI | Feb 10 2011
GaveKal offered the following observations this week:
The most striking event on the markets over the last couple of weeks has probably been the sell-off in bonds. Taken together with the fact that OECD equities have pushed higher, it would imply that portfolios have briskly adjusted to a growth scenario (as opposed to a 'double dip' scenario). Yet the PBoC's interest rate hike yesterday is a reminder that the recent shifts in asset allocations, as hectic as they seem, might not yet fully reflect the reality of a solid recovery in the developed world set against slowing momentum in emerging markets. In particular, one wonders if commodities and commodity-related assets (such as the AUD) have priced in the fact that:
1) QE3 is obviously no longer on the table, which should take some "financial investors" out of the energy and commodities markets (particularly with carry-trade costs remaining high). This is backed up by multiple US data points, including stronger payrolls and personal income, rising consumption, rising business bank loans, bottoming credit card debt, improving small business sentiment and signs of returning pricing power.
2) Developing market growth is less commodity-intensive than emerging market growth, which is heavily geared towards infrastructure investment. Which brings us to the next point…
3) China is the largest global consumer of key commodities-including coal, iron ore, manganese alloys, copper (see p. 2)-and a marginal mover of the energy markets. And in light of money-supply growth at +20% (as expected for January), spiking food CPI and worrying asset price inflation, the PBoC tightening cycle has surely only just begun. Meanwhile other major emerging markets, such as Brazil, India and Indonesia, are also fairly early in their tightening cycles. Demand growth from these nations will still be solid, but the rate of growth is probably set to slow. And because markets are made on the margin, this is bound to have a significant effect on prices.
4) Technical factors indicate a top in commodity indices, while recent weather-related shocks, such as the La Nina effects on wheat, corn and sugar production, or the Australian-floods effect on coal supply, should recede. It is also interesting that oil prices weakened this week, even as more Egyptian protestors poured into the streets, and despite further signs of rising global growth.
In our most recent Quarterly, we argued that strong global growth would make QE3 (and any other subsequent QE programs) far less likely. The question was then how commodities would react: Would prices fall because of less easy money or would this effect be negated by a stronger global growth environment? It is a tough call, but with tightening in Asia (especially China) also weighting in, two out of three factors are moving against commodities. Of course, it is still too early to draw any long-term conclusions, but we would not be surprised to see the commodity rally continue to fizzle. And in turn, this poses a number of additional questions.
Most notably, we cannot help but wonder whether the AUD/USD can really maintain its strength (after all, it is 32% overvalued on a PPP basis)? Looking beyond the FX markets, would any potential roll-over in commodities, be initially interpreted as a) good news for equities, or as b) a sign that risk assets are correcting? Our long-term view is that weakness in commodities would allow many corporates to have their cake (stronger growth) and eat it too (steady margins). But in the short term, equities do look a little overbought-and meanwhile, we have had some big moves in bonds! Since mid-October months US 10-year yields have moved up some +130 basis points (see p. 2), Germany +115bp, France +100bp and Singapore +80bp, the Philippines +120bp and Indonesia +170bp. Granted, OECD bonds were immensely overvalued a few months ago, as we long complained. And while we remain cautious on OECD bonds, with commodities looking toppy, it is hard not to wonder if some of the more solid emerging market bonds (e.g., Indonesia) will not start finding more of a bid.
The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.
GaveKal is a financial services firm that offers institutional investors and high net worth individuals fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.
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