Last year (2008) saw indiscriminate declines in stock markets around the world with virtually all major indices declining 35% to 50%. The first half of 2009 saw sizable rebounds for a number of stock indices in the Asia-Pacific region. The markets that outperformed were either tied to Asian growth (China, Japan) or were highly tied to natural resources (Australia, Canada).
The divergence between the markets of the East and West began in mid to late March about the same time the U.S. Federal Reserve announced its multi-trillion dollar quantitative easing program. At that point major markets were down an additional 15%-25% in 2009. The program worked to put a floor under global equity markets. I should say the psychology of the program worked, not so much as the mechanics of it.
However, that psychology also had a negative side affect in terms of outsized inflation expectations by the time financial stability began to return to the markets in April and May the “reflation trade” was on.
Money poured back into the markets such that the U.S. and European markets recovered to about flat (or slightly negative) for the first half of 2009. Four major markets, in particular, did better than breakeven, posting gains that ranged from 6% for Australia to 28% for the Hang Seng Index. Part of this could be attributed a greater market rebound in China and Japan which had performed worse than most in 2008.
However, looking back it becomes clear that the market had begun to pick winners (China, Canada, Japan, and Australia) from losers (US, Germany, UK, and France) by mid to late March.
The key question though is: why are Canada and Australia included in the outperform category. The answer is natural resources.
The logic of the reflation trade goes as follows:
The US and other western governments are printing money to keep their economies afloat, albeit less so in Continental Europe.
Western government budget deficits (Europe included) are rising so fast that their sovereign credit is at risk.
Few paper currencies are a good long term store of value; even the Swiss are actively debasing (weakening) their currency.
Yields are sure to rise so it is good to be short US Treasury’s
It is critical to invest in commodities to hedge against the coming inflation
The fundamentals never supported the reflation trade. Then again, fundamentals are never a requirement of a trade. It was as if traders from Wall Street to Canary Warf to Nihonbashi (Tokyo’s financial district) were all on the same page for the reflation trade from March through June. Fundamentals may now be catching up to the market. Since I first wrote on weak oil fundamentals, supply and demand curves have only widened further:
Oil demand continues to weaken. With the abrupt fall in oil prices over the holiday weekend, that trade may be over. The International Energy Agency (IEA) is now forecasting that a net increase in oil demand (above 2008 levels) won’t be seen until 2012 at the earliest. Unemployment is still rising, keeping labor costs in check. Recent Treasury auctions have been well oversubscribed.
For all the talk of Chinese distaste for U.S. debt, there is really no alternative as long as China runs a trade surplus with the U.S. and it does not want its currency to appreciate.
Lastly, most all the money that Federal Reserve has supposedly printed is being parked back at the Fed in terms of bank deposits and not finding its way into circulation.
Inflation will surface one day. The problem is that inflation is still a long way away. Inflation is a medium term story (about two or three years) recently embraced by folks with short term investment horizons. Thus, it is likely that the market will correct before inflation becomes a reality.
Sure there will be the rare mutual fund managers that will actually hold their positions in oil ETFs (NYSEARCA:OIL) or (NYSEARCA:USO) until oil consumption overtakes supply in a few years. The rest will be equally likely to take a short position as soon as the technicals confirm a reversal of trend direction. My guess is that just about the time oil demand is back to 2008 levels, banks will be bullish enough to pull most of their funds out from the Fed to chase the next big investment wave. The question at the FOMC in early 2012 would then be whether they should set the Fed Funds Rate at 7% or 8%.
Commodities other than oil are just as weak. Composed more than two-thirds of minerals and agriculture, Australia’s exports are a good proxy for the non-oil commodities market. As discussed in the past, Australian exports to China have boomed this year thanks to stimulus and stockpiling. However, this was not a reflection of underlying demand in the global market; that somehow the emerging markets had decoupled from the OECD (developed nations).
Chinese demand for commodities may have peaked in the short term. In June, though, Chinese officials began to signal that the commodities stockpiling is now over. Even with the stimulus and stockpiling, Australian exports were continuing their overall decline. That means demand growth is now up to the OECD and other emerging markets.
Demand growth outside of China is nowhere to be found. As the marginal buyer of commodities or the marginal provider of growth, China has a powerful presence. However, in the presence of contracting global demand for resources, China’s added growth is just a fraction of that being subtracted by developed economies (represented by the OECD) and the rest of the world. This is true whether you look at Australia or Canada. It is true whether you look at minerals or oil. Consumers buy less, global trade slows, manufacturing is reduced, industrial production declines, and demand for resources evaporates. It takes multiple years for demand to fully contract and will take multiple years for demand to fully return.
Declines to continue as prices reset lower. Two major components of Australian exports are coal and iron ore. These two commodities differ from gold, oil or copper in that prices are set through annual contracts. Mining giants BHP Billiton (NYSE:BHP) and Rio Tinto (RTP) are reaching the conclusion of their tense contract negotiations with steel mill and public utility customers. Rio and BHP conceded price reductions in iron ore to 33% while coal prices dropped more than 50%. Key contract negotiations with Chinese mills (which are holding out for even steeper discounts) are not yet concluded but for BHP, Rio and Vale (NYSE:VALE) of Brazil the best case is the discounts quoted above retroactive to April 1st. As expected this is now bringing about the full brunt of the global recession to resource intensive economies like Australia and Canada.
The past quarter has been marked by a strong rally based on an Asian growth story and inflation fears. While the Chinese economy remains the best growth story in the world, the extrapolation to net global demand for commodities is unrealistic. A correction, necessary to come more in line fundamentals, may be upon us.
Disclosure: Short position in the inverse oil ETF (NYSEARCA:UCO) that I will soon exit.