Rudi's View | Nov 17 2011
By Rudi Filapek-Vandyck, Editor FNArena
It is easy to think the October-November rally for global equities is nothing but a temporary correction from oversold levels following the carnage in August and September. After all, who really believes the European problems will be solved in a short matter of time? And is the US really out of trouble? We now have local governments in the US filing for Chapter 11 bankruptcy protection!
However, look beyond the day-to-day media headlines and it would appear the underlying trend for risk assets is improving, in particular for natural resources.
It has been a long wait but investors who held on to their shares in companies such as Fortescue Mining ((FMG), Gindalbie ((GBG)) and BHP Billiton ((BHP)) post the April peak in investor risk appetite this year might finally have something more positive to look forward to. (Something more than just a correction on the back of temporary relief from macro-sovereign matters).
First, let's have a look at what has acted as a headwind for natural resources (and for share prices of resources companies) since April:
– economic growth the world around, but in particular in China, the US and in Europe proved less robust than hoped for
– the US dollar stopped weakening
– global liquidity shrank as China continued tightening, the Federal Reserve's QE2 program ended and European banks moved into balance sheet survival mode
– overall risk appetite disappeared
– investment funds flowed out of risk assets into cash and defensive assets
The first observation is that commodities do not just trade on supply and demand factors alone. A second observation is that some of these headwinds seem to have started reversing trend.
I am far from the only one who has observed that economic data in the US have been surprising to the upside since September. Admittedly, some of these data mark improvements from beaten down reference levels but still, genuine improvements are always preceded by flimsier improvements. At the very least, more robust looking economic data from what is still the world's largest economy suggest less chances of a double-dip recession, which is and will be a positive for overall risk appetite going forward.
What is further boosting confidence is that economists seem increasingly confident that both the US and China will be able to remain on a positive path even with Europe sinking into the inevitable recession. Why has Europe's recession become unavoidable? Because after months of scary news headlines and tumultuous price movements on financial markets, consumers and business leaders across the continent have bunkered down and stopped spending. At the same time, European banks started hoarding cash and assets to safeguard their liquidity and balance sheets amidst extreme uncertainty about what will happen for owners of government bonds from countries such as Greece, Italy and Spain.
We don't need to add anything else, that's already sufficient to confidently predict Europe will experience a recession. The good news is the rest of the world will feel some impact (Europe is in economic terms of similar size as the US), but it won't automatically translate into a global meltdown. At least, not if European leaders can prevent their banks from shutting up shop and so dragging the rest of the world into a Lehman Bros Part 2 experience. This is why the political aspect of Europe's euro union remains a key threat to global growth and risk appetite, and why genuine relief from euro-politics will have a profound effect on the price of equities and other risk assets the world around.
We're not there yet, as we all can read from news updates every day, but it is hard to deny there is some progress being achieved on the European continent.
At the same time speculation is returning about the Federal Reserve starting QE3 in 2012. The main motivation behind this is that Fed Chairman Ben Bernanke has already hinted unemployment cannot remain at 9% for too long because that will transform something that's supposed to be of cyclical nature into a structural matter. While recent employment data have been encouraging, they are by far not enough to reduce unemployment by significant steps in the short to medium term.
This doesn't mean QE3 in 2012 is a given. The Federal Reserve might wait to see whether the Obama administration can perform a surprise act in this matter, but what are the chances?
QE3 will without any doubt put heavy downward pressure on the US dollar, which will push up prices of USD-priced hard assets, such as natural resources. It will also flood the world with excess US dollars, which leads us to the third factor that has been holding back prices of commodities and share prices of resources companies since April; global liquidity. Commodity analysts at UBS(*) recently confessed their analysis shows commodity prices have a much closer relationship to global liquidity than they have to global economic growth.
Surprise, surprise. Those same UBS analysts switched to a more positive view on investing in commodities and resources stocks in mid-October. Their main consideration was an anticipation that Chinese authorities would stop tightening and change their focus to loosening a little here and there. This process has already started. Chinese authorities have issued relief measures for smaller sized companies who don't have easy access to funding like their bigger competitors. October lending data also suggests Chinese banks have again expanded their loans, and in significant fashion.
The waiting is now for official inflation data to fall back to annual growth of 4% and lower, which economists anticipate will occur during the first quarter of 2012. China doesn't have to necessarily open the stimulus tap again, like Beijing did in 2009, but a loosening in its monetary policy will automatically create a more accommodative environment for commodities after the gradual and stringent tightening that took place this calendar year.
Note that last month UBS mentioned a few other, key considerations for its change in view:
– a large unwinding of the short USD/long commodity trade
– overall market positioning which had become extremely defensive by early October
– cheap valuations for resources stocks
– the inventory cycle in Western economies
– dollar fund flows
It is not difficult to see as to how relief from Europe and a more accommodative stance in China, even without extra monetary stimulus from the US, can lead to less risk aversion, triggering increased funds inflows which then translates into higher prices.
There are, however, a few holes in the road that will, at some point, present themselves. One is the close correlation between equities, risk appetite and crude oil. West Texan Intermediate (WTI) is back near US$100/bbl while economists seem confident that relief from high gasoline prices earlier this year provided the platform for firmer than anticipated US consumer spending in recent months. What does this mean for US consumer spending in early 2012?
In a worst case scenario, it probably means QE3 is definitely on the agenda.
There is also still a genuine risk that we are underestimating the direct economic fall-out from a recession in Europe. Economists at National Australia Bank reviewed their forecasts for the Asian Tiger economies this week. These countries combined represent 20% of all Australian exports, roughly matching China, and slower exports are already taking their toll, concludes NAB. The economists anticipate GDP numbers for countries such as Taiwan, Malaysia, Singapore and Hong Kong will slow down further into 2012. Already, observe NAB economists, central bankers in the region have given up on their tightening bias and Indonesia, for one, is already loosening quite aggressively.
More bad news that can ultimately end up becoming a positive. The same principle applies to countries Brazil, Russia and India. If developments do take a turn for the worse, all have room to insert stimulus into a slowing economy.
Remember, the RBA also started loosening this month.
All of this does not take away the fact that "Europe" can still turn itself into an all-destructive force and on this account euro-politicians remain the biggest threat to themselves as to the well being of the rest of the world. Consider, for example, the fact that governments keep insisting their banks mark down distressed assets to better ascertain capital-raising requirements. While this may seem logical inside the present political climate on the continent, analysts at GaveKal remind us this is exactly what unleashed the Doomsday Machine in the US in the midst of the Lehman crisis.
Says GaveKal: "Most rational actors would think lessons had been learned here yet amazingly, three years later, European policymakers may be setting in motion the same potential death spiral."
Under a worst case scenario, European authorities are effectively forcing their banks to massively reduce the size of their balance sheets through selling assets and at the same time refusing to write new loans for the foreseeable future. Did I mention already that Europe is definitely going to have that recession, and that European politicians remain their own worst enemies, as well as ours?
(*) I wrote about UBS's change in view on commodities on the 18th October in "Commodities: All About China Policies"
P.S. Here's an excellent interview with Dave Rosenberg, the Market Bear Du Jour, with a surprise positive ending: http://www.zerohedge.com/news/david-rosenberg-depression-ecb-mf-global-canary-coalmine-all-surprise-ending
(This story was written on Monday, 14 November 2011 and published in the form of an email to paying subscribers on that day)