- Commodities are in a 'normalisation' process that will drive their prices more in line with their marginal cost of production. We expect this to be a 'one-off' process.
- Lower commodity prices are in effect a tax cut and will go a long way to offset the US fiscal drag. Expect the world economy to show more strength in the second half of the year
- Gold will not see the previous highs, perhaps not in this decade.
- Oil has moved very quickly and violently and it is time to reduce short positions.
- Though we are not experts in equities we would suspect that lower input costs will assist prices in the long run.
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A lot of has happened in the last few trading sessions and confusion reigns. We thought it wise trying to put forward our ideas and highlight the sectors and asset classes which will likely be winners, losers as well as how to take advantage of them.
We, here at Archbridge Capital (and we suspect our readers), have survived the moves with little impact. Regular readers will know we had short commodity positions (spreads and outright) especially in energy, which overall offset the adverse moves against us (for instance in the JPY) in those troubling days.
Let us analyse the markets one by one.
Energy:
We have already shared our view that the underlying demand-supply balances favour lower energy prices (see 'I have too much energy' Dec 21, 2012 and 'Anchors Away' Mar 21, 2013) and how to play this theme. We argued, for instance, that, China is becoming a more domestic demand-driven economy and that this would result in her not being 'the same benefactor to commodities as she once was' and why the markets are beginning to move to a more sustainable price level, in line with their marginal cost of production.
The gold market collapse has caused or at least assisted in a lot of the other markets showing extreme moves, as investors have reduced unrelated positions in order to satisfy the margin clerks for their unexpectedly large gold losses. So it was also for energy, where the move in gold has added to the speed and voracity of the move we were expecting - enough so that we have substantially reduced our short oil positions in recent days. (We have done so also in light of refineries coming out of their maintenance season and our expectation that Chinese restocking will commence in the month ahead).
Other Commodities:
It seems as if most view this downward move in commodities as a prelude to a much much slower growing world economy or even a world-wide recession. We do not adhere to this view.
We still believe that growth will pick up in the second-half of the year in the USA, China and even in Europe. In fact we believe this will happen partly because of the commodity price adjustment that is in full swing at the moment, as it represents, in essence, a lowering of taxes. Let us explain:
Most commodities have substantially traded above their marginal cost of production (and their supply-demand balances) for some time. They have been able to do so due to the massive amounts of QE that was injected into the system since 2009. This liquidity fuelled rally has kept commodity prices at unsustainable levels and has correlated commodities, that in essence should not be.
Over the last months we have seen these unfounded correlations break-down, we have seen a more predictable future for QE especially in the USA, we have seen the underlying economy in the US pick-up (with increased bank lending, consumption and a more buoyant housing market). Though these economic strengths have been diminished somewhat by the fiscal drag the US economy is experiencing, we believe that the effective tax cut vial lower commodity prices will go a long way to offset this.
In short, we do not believe that commodities will fall for long enough to create a deflationary spiral, instead we see this move (so far) as part of a 'normalisation' process with which commodity prices will begin to trade more in line with their marginal cost of production.
On gold collapse:
According to our analysis the gold market performs well when real interest rates are negative and expected to either get more negative or stay negative. Since QE is probably not going to be increased in the US it is reasonable to assume that real rates will begin to become positive over time and herewith ending the 10-year gold bull market. We, here at Archbridge Capital do believe that this will indeed occur and that rates will begin rising as we have discussed in "There is treasure in them Treasuries" Apr 4, 2013. We also believe that inflation will not pick up in the foreseeable future and hence we do expect that real rates in the forwards will begin to turn positive as the economies gradually strengthen. We would expect that gold does not see the previous highs in a very long time, perhaps even in this decade.
What does this mean?
If QE was expected to continue or increase while inflation rates remain at the current levels, then real rates would remain negative for the foreseeable future and gold prices should have substantial support. The move in gold, however, indicates that markets do not believe that real rates will remain negative for the next 10 years (as is currently priced). This is in line with our thinking and reporting to date.
However, real rates could turn positive in one of two ways and it is important to note the distinction:
a.) deflation could take hold and even with rates at zero % we could have positive real rates - like in Japan
b.) economic growth takes hold, and gradually drives interest rates higher, starting with longer maturity rates, while inflation takes its time to feed into the system only once capacity utilisation rates and output gaps are overcome.
We are squarely in the b.) camp as we do believe that the amount of ongoing QE in the USA will heal the underlying economy over time and to the extent that economic growth will continue to expand (2-2.5% GDP growth), despite the fiscal headwinds thrown at it - especially with lower energy prices which are in effect a tax reduction and increase disposable income.
We also find a little solace in the knowledge that deflation is what the world's central banks are doing their best to avoid and especially the Fed has clearly stated that they will do everything in their power to avoid deflation, i.e. avoid becoming Japan (in fact even Japan is trying to avoid being its former self (see "Big in Japan" Apr 16, 2013). In other words we would see more QE before we would see sustained deflation in the USA.
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We, here at Archbridge Capital, are not equity traders and only comment on equities at our investors request:
US companies especially have become very efficient in the last few years and their main profit growth has come from cost cutting, which they have done to the bone. The second wind for equities could come from lower input costs and slowly by increased revenues from higher consumption due to higher disposable income.
Though we believe the above holds in the longer term there are some worrying aspects in the short-term for equities as John P. Hussman points out (www.hussmanfunds.com/wmc/wmc130422.htm):
1) There is a highly elevated level of margined investment in the equity markets, close to levels at which previous price corrections occurred.
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2) Anecdotal evidence suggests that when equity targets are on the front page of major magazines one is closer to a correction than one thinks, especially when market surveys clearly indicate extreme bullishness
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