President Trump took a few jabs this past week at his Fed chairman appointee, Jerome Powell, for spoiling his tax plan economic boost by continuing to increase interest rates. How dare the chairman and his cohorts do their job, especially when it prevents the Almighty Dollar from being, well, a little less almighty. A weaker dollar translates into greater export trade volume and, at the end of the day, greater GDP growth, as well. It is also quite beneficial for commodities, whose prices are quoted in USD, as a rule.
Trump’s jawboning antics, both in public interviews and within his Tweet-osphere, did have the desired effect – The USD index dipped below 95.4, finishing the week at 94.4. It has been vibrating about this 95-parallel for weeks, attempting to break through resistance one day, only to be repulsed by trade concerns the next. Fundamentals still mean something in the forex sector, and, at present, the Fed is the only central bank on the global map that is actually normalizing rates and its bloated balance sheet.
For Trump to bash monetary policy at this juncture is a bit facetious, as well. Interest rates, while they may be headed north according to plan, are still well below what would normally pass as acceptable for the present level of growth in the economy. The global economy has been on an upswing, if commodity prices are used as our best measure of success. Trends had been very favorable for 2018, but Mr. Copper, the harbinger of global economic activity, suddenly took a nosedive in June, as the chart below reveals:
Commodity prices in general have also reflected a similar “June Swoon”, but for 2018, overall price levels still exceed averages at the end of 2017, not a 16.6% decline as with Copper. In the long run, a weaker U.S. Dollar will be bullish for commodity prices, but for the time being, the potential for massive disruptions in international trade balances is taking its toll on growth prospects for basic resources. These moves are further confirmation that yield curves are flattening and that global economic growth is slowing.
What has been the story for commodities over he past year?
Let’s start with a chart:
What’s not to like about this chart, except for the final two months? Year-to-Date 2018 is still positive, perhaps, only by a hair, but this sector of the market has performed quite well, if a 27% run is worthy of praise in your book. There are several indices that track commodities, but if you get behind the numbers and make a few adjustments, one can discern that Copper is truly trying to tell us something. After backing out energy components (Oil prices have rocketed upwards of nearly 20% this year), the remaining items show a decline of 6.5%, more inline with Copper, but trailing, as one would expect.
Long gone are the Herculean days that followed the millennium, when consumers in the developing countries of the world desired to emulate their brethren in more developed economies. The resulting demand pressed commodity prices through the roof. No end was in sight, but this was wishful thinking. The Great Recession came and went, as did commodity price points. Investors, the ones that bought and held, were trapped in a downward spiral from 2011 to 2016, which included a return of the USD to prominence. The return over that period was a negative 55%.
A formidable bottom did form, and investors, gun shy to be sure, slowly returned in numbers. Returns have been positive, a healthy 21% for eighteen months, and strong fundamentals have returned to a once depleted arena. Trade war fears are a recent phenomenon, but you do not have to look far to find confirming evidence that Mr. Copper (Dr. in some quarters) is ahead of the wave. The equity markets have struggled with the notion of tit-for-tat tariffs across the planet, but, once again, if you look behind the numbers, the story is not as pretty, as one might suspect. The chart that follows segregates Industrial equities and compares their performance with the entire market portfolio:
Industrials are definitely underperforming and have been doing so, as if driven by the signals emanating from the Copper sector. Lastly, it is a given that commodity prices fluctuate to the whims of the U.S. Dollar. The impacts are more pronounced when a trade-weighted version of an index for the USD is reviewed, as with this chart:
The jump in the greenback, however, only accounts for roughly half of the decline noted earlier in Copper. The conclusion: The global economy is slowing, maybe more than is apparent at the moment. Analysts have followed recent declines in the Chinese Yuan and have come away believing that the Chinese economy is slowing, as well. As the largest consumer of commodities, a pullback in China could send shockwaves across the globe. JPMorgan also recently noted, “Global Manufacturing Growth At 11-Month Low In June.” Reasons abound for a flattening yield curve, which suggests a perceived decline in future growth prospects.
Taking all of these measures into account, one analyst summarized the current situation as follows: “The diagnosis made by Dr. Copper appears to be something worth paying attention too. There are starting to be widespread declines in the commodities complex. Most evidence continues to point to a global growth slowdown leading into 2019. It remains unclear how the slowdown will resolve, a soft landing or a hard landing, but based on the way money moves around the economy, it is very unlikely that the combination of commodity prices, the underperformance of growth-linked sectors and the yield curve has lost its ability to forecast future growth prospects.”
Will investors heed the message of Dr. Copper and depart in droves?
Since the financial crisis, our financial markets have performed admirably, but one always had the sense that demand had been manipulated, either by central bank machinations, corporate tax cuts, or corporate buybacks. If an expanding money supply is no longer a viable option, then how will equity markets withstand the current prognostications of Dr. Copper or the continuous negativity arising from the doomsayer crowd? There are opposing camps on this issue, each with logical arguments.
“Pro” – Market Sustainability
Central bank accommodative policies may be on the wane, but their impacts have more than been replaced by stock buyback programs and improved earnings. Consider this recent quote: “Corporate America threw Wall Street a record-shattering party last quarter. Flooded with cash from the Republican tax cut, U.S. public companies announced a whopping $436.6 billion worth of stock buybacks. Not only is that the most ever, it nearly doubles the previous record of $242.1 billion, which was set during the first three months of the year.” The “Corporate Bid”, as it is called, will not dissipate soon. It will be a gift that keeps on giving, even if and when a sell off occurs.
And then there is corporate earnings growth, boosted in large part by recent tax cuts and the freedom to repatriate foreign profits at substantially reduced rates. Goldman Sachs recently published that, “Despite valuation risk, strong corporate profitability continues to support equity prices. S&P 500 return on equity (ROE) increased by 36 basis points to 16.6% in 1Q, its highest level since 2011. Profitability is even more impressive excluding Financials. ROE ex-Financials rose by 44 basis points to 19.9%, the highest level on record except for 4Q 1997.”
“Con” – Market Sustainability
Arguments from the opposite camp posit that the two drivers described above are ephemeral, at best. Stock buybacks were not supposed to be the overriding reactions to tax plan incentives. The original thinking, despite entreaties to the contrary, was that extra cash would lead to more capital investment, which has always led to increased employment, better wages, and more disposable income. Unfortunately, if there was investment, it was done overseas. Foreign returns trump domestic ROEs at every turn. As a result, long-term benefits will not materialize, and buybacks will taper for lack of additional incentives.
The earnings argument falls flat, as well, as soon as new tariffs wreak havoc on margins. Per one analyst: “It’s entirely possible that corporate profitably has either peaked or is close to peaking. Eventually, margin pressure is going to show up, and if trade frictions end up denting the outlook for growth and prompting guidance cuts from management, well then, the earnings tailwind could abate, even if it doesn’t disappear entirely.”
Are there other measures, which support this opposing view? Analysts carefully watch fund flows in and out of bond and equity ETFs and Mutual Funds to assess if investors are actually putting their money where their mouths are. The following diagram is not what you want to observe in this arena:
The “Wait-and-See” attitude that commenced in February has carried over, buffeted perhaps a bit by tax refunds, but more telling are newly-released figures for June that are nearly zero for both equities and bonds. What about institutional investors and professional hedge funds? The strategies employed by these folks typically revolve around momentum signals, volatility measures, and trend following systems, and the jury here is that markets are too muddied up to offer traditional trading opportunities.
These players are also taking the same “Wait-and-See” approach, as summarized by a recent quote from Societe General: “Markets are pulled by the promises of late stage economic growth boosted by monetary and fiscal stimulus. They are also contending against the risks of rising geopolitical tensions and the likelihood of potential recession. So they end up moving up and down with no clear direction. Such sideways markets are challenging for convex strategies such as trend following systems.”
Whether it is Mr. or Dr. Copper, this well-accepted leading indicator of global economic activity deserves our attention and respect. President Trump can tweet and jawbone to his heart’s delight, but economic facts are not fake news. Investors seek their own measure of the truth and are rarely swayed by dogmatic rhetoric, when it comes to their private decision-making.
Something is brewing in the background with each passing day. The evidence is piling up, and attempts to deny its existence can only delay the inevitable. The perception of reality may work its magic for a time, but, eventually, economic truth will find a way to control the narrative, once again. What do you do in times like these? Reduce your level of risk, for one. In addition to defensive strategies, prepare your future plan for how to take advantage of a dramatic shift in volatility.
When change comes, it will be abrupt. Patience will be rewarded!