Investors with broad-based commodity exposure haven’t had much to cheer about in the year to date. The Bloomberg Commodity Index, for example, was down more than five percent at the end of the year’s first half. The main culprit? Crude oil prices, and the tendency for commodity indexes to be heavily weighted towards the oozy black stuff. That is for good reason: for more than a century, oil has been the world’s most important commodity, the magical elixir powering the modes of transport that arose from the invention of the internal combustion engine. George Bissell, a New York lawyer, in the 1850s succeeded in his obsessive quest to extract the flammable “rock oil” known to reside under the craggy outcrops of western Pennsylvania. Had he not, the world today would know Saudi Arabia merely as a nondescript, likely poor desert kingdom. Nobody would have ever cared about who shot J.R.
While oil continues to struggle with both demand and supply headwinds – the slow pace of global growth on the one hand and the growing importance of non-conventional drillers in supplying the marginal barrel to the market on the other – other commodities in indexes like the Bloomberg are doing just fine, thank you. Precious metals have registered decent single-digit gains, likewise industrial metals like copper and aluminum, and also agricultural staples such as corn and wheat. Of all these, though, there is an interesting larger story about one: copper. It’s not a story for today, as in “what’s hot for my portfolio in 2017?” – but there is a potentially growing narrative around longer term demand trends based on something that is being much talked about this year: the rise of the electronic vehicle.
Copper for EV-er
Electronic vehicles, or EVs, have been in the news recently with chatter around the planned forthcoming roll-out of the Tesla Model 3, the attempt to bring this company’s offerings out of the stratosphere and into the affordability range for the masses. Meanwhile, Volvo has announced its intention to produce only battery-powered or hybrid vehicle by 2019. Scarcely an auto producer in existence has not joined the chorus of paeans to an EV-imagined future.
How soon – and at what cadence – this becomes a reality has major implications for copper. This industrial metal figures into several key parts of the EV manufacturing process including, importantly, the lithium-ion batteries that power the vehicles. Various demand projections for lithium-ion batteries over the coming 10-15 years, assuming certain levels of consumer adoption, show eye-popping ramp-ups that, if remotely accurate, would strain the total volume of commercially mined copper available from current sources. Many of the world’s existing facilities are many decades old, so the race is on for those with wildcatter tendencies to locate new sources in politically stable regions of the world to cope with the potential demand explosion.
Devil Is In the Details
Of course, much of the speculation about the potential role of copper in the brave new world of EVs is just that – speculation. There is no consensus on exactly how much of the metal would be required once the production processes become standardized and cost-efficient along the lines of how automobile factories evolved in the first half of the 20th century. Nor is it at all clear that electronic cars and other vehicles will see the same type of rapid, widespread consumer adoption patterns that we have seen from other technology offerings in recent years.
That being said, one of the important things to always remember about investing is that, over time, the tectonic plates do shift. The past is not prologue to the future – and the storied past hundred years of oil may be a poor predictor of the future for “Texas tea.” It’s worth keeping an eye -- and perhaps a small ante at the table – on copper’s future fortunes.
Some foreign words don’t have English translations that do them justice. Take the German “Schadenfreude,” for example. “Delight at the expense of another’s misfortune” just doesn’t quite pack the same punch. The Russian word “smutnoye” also defies a succinct English counterpart to fully import its meaning. Confusion, vagueness, a troubling sense that something nasty but not quite definable is lurking out there in the fog…these sentiments only partly get at the gist of the word. Russians, who over the course of their history have grown quite used to the presence of a potential fog-shrouded malignance out there in the fields, apply the term “smutnoye” to anything from awkward social encounters, to leadership vacuums in government, to drought-induced mass famines.
Who’s In Control?
We introduce the term “smutnoye” to this article not for an idle linguistic digression but because it seems appropriate to the lack of clarity about where we are in the course of the current economic cycle, and what policies central banks deem appropriate for these times. Recall that, just before the end of the second quarter, ECB chief Mario Draghi upended global bond markets with some musings on the pace of the Eurozone recovery and the notion that fiscal stimulus, like all good things in life, doesn’t last forever. Bond yields around the world jumped, with German 10-year Bunds leading the way as shown in the chart below.
At the time we were skeptical that Draghi’s comments signified some kind of sea change in central bank thinking (see our commentary for that week here). But bond yields kept going up in near-linear fashion, only pulling back a bit after Janet Yellen’s somewhat more dovish testimony to the US Congress earlier this week. And it has not just been the Fed and the ECB: hints of a change in thinking at the apex of the monetary policy world can be discerned in the UK and Canada as well. The sense many have is that central bankers want to wrest some control away from what they see as an overly complacent market. That, according to this view, is what motivated Draghi’s comments and what has credit market kibitzers focused like lasers on what words will flow forth from his mouth at the annual central bank confab in Jackson Hole next month.
Hard Data Doves
In that battle for control, and notwithstanding the recent ado in intermediate term credit yields, the markets still seem to be putting their money on the doves. The Fed funds futures index, a metric for tracking policy expectations, currently shows a less than 50 percent likelihood of a further rate hike this year, either in September or later – even though investors know full well that the Fed wants to follow through with one. Does that reflect complacency? A look at the hard data – particularly in regard to prices and wages – suggests common sense more than it does complacency. Two more headline data points released today add further weight to the view that another rate hike on the heels of June’s increase would be misguided.
US consumer prices came in below expectations, with the core (ex food & energy) CPI gaining 0.1 percent (versus the expected 0.2 percent) on the month, translating to a year-on-year gain of 1.7 percent. Retail sales also disappointed for what seems like the umpteenth time this year. The so-called control group (which excludes the volatile sectors of auto, gasoline and building materials) declined slightly versus an expected gain of 0.5 percent. These latest readings pile on top of last month’s tepid 1.4 percent gain in the personal consumer expenditure (PCE) index, the Fed’s preferred inflation gauge, and a string of earlier readings of a similarly downbeat nature.
Why Is This Cycle Different from All Other Cycles?
In her testimony to Congress this week, Yellen made reference to the persistence of below-trend inflation. The Fed’s basic policy stance on inflation has been that the lull is temporary and that prices are expected to recover and sustain those 2 percent targets. But Yellen admitted on Wednesday that there may be other, as-yet unclear reasons why prices (and employee wages) are staying lower for longer than an unemployment rate in the mid-4 percent range would normally suggest. This admission suggests that the Fed itself is not entirely clear as to where we actually are in the course of the economic recovery cycle that is in its ninth year and counting.
Equity markets have done a remarkable job at shrugging off this lack of clarity. Perhaps, like those Russian peasants of old, they are more focused on maximizing gain from the plot of land right under their noses while ignoring the slowly encroaching fog. Perhaps the fog will lift, revealing reason anew to believe a new growth phase lies ahead. All that remains to be seen; in the meantime, “smutnoye” remains the word of the moment.
Hard to believe it, folks, but Year 2017 has already passed its halfway point. While many are still getting the most out of a holiday-interrupted week, at the beach or in the mountains or anywhere that the Twitterverse cannot find them, we will take this opportunity to contemplate what was, what is, and what may lie ahead in global asset markets.
Sweet and Sour
Perhaps the definitive image of markets for the first six months of the year was a contrast in shapes: the flattening contours of the Treasury yield curve on the one hand, and the upward-sloping progression of the stock market on the other. For much of this time, equity and fixed income investors seemed to be singing off two different hymn sheets: giddy expectations on the one hand and a dour read of the macroeconomic landscape on the other.
Going by the hard data alone, the bond mavens would seem to have the better arguments on their side. Headline data over the first two quarters largely underwhelmed, most notably in the area of prices and wages. Inflation readings, including the Fed’s favored personal consumption expenditure (PCE) gauge, have stayed south of the central bank’s two percent target. The labor market continues to raise more questions than it answers, with the unemployment rate suggesting we are very close to full employment, but tepid wage growth indicating none of the usual pressure that hiring firms experience in a tight labor market. That dynamic was present in this morning’s jobs report as well. Better than expected payroll gains brought the three month average up to 194,000 new jobs, but wage growth again came in below expectations.
Turning Point or Tantrum?
With that soft inflationary context in mind, we consider the recent gyrations in the bond market that has some observers predicting a sea change in yields in the months ahead. The fixed income kerfuffle was ignited by remarks by ECB Chair Mario Draghi last week, suggesting that Europe’s better than expected recovery may warrant moves to start winding down monetary stimulus. Whiffs of increased hawkish sentiment can be detected elsewhere in the central bank world, including the UK and Canada.
With inflation showing no signs of overheating, the Fed will not have a gun to its head to raise rates, nor will the ECB be forced to risk market volatility by accelerating any form of a taper in their bond buying program. But that very volatility is an issue on the table for the monetary mandarins. This week’s release of the June Fed minutes suggests that central bankers are at least somewhat nervous about yet another characteristic of 1H 2017 asset markets: the coexistence of elevated prices with almost no volatility. The Fed’s rate hike in June -- and a possible follow-on increase in September -- reflect at least in part an attempt to wrest control back from complacent markets. That complacency is well-founded; central banks have in recent years gone to great lengths to prop up asset prices. If investors sense an end to the Greenspan-Bernanke-Yellen put, we could expect volatility to return with a vengeance.
Brent Gold, Texas Tea
Another addition to the #thingswelearned category in the first half of 2017 is that OPEC is largely a spent force in exerting influence on oil prices. The cartel’s much-touted meeting last fall that produced a tangible production cut policy initially sparked a recovery in crude prices, but the recovery fizzled away as it became ever clearer that US non-conventional drillers, not OPEC, represent the marginal barrel of production. Supply dynamics suggest a secular trend for the range-based price movements of recent months, with the only question being where the lower end of that range will settle. On the demand side, the continuing reality of below-trend global output signals that the commodity super-cycle of the previous decade is unlikely to return any time soon. Resource companies may be in for an extended winter of discontent.
Much More in Store
These topics are just the tip of the iceberg: we have said nothing here about emerging markets, or risk spreads in investment grade & high yield bond markets, or the strangely underperforming dollar, or sector and geographic rotation among equity asset classes as another season of earnings gets under way. These are all issues of clear and present importance, and rest assured we will be covering them in the weeks ahead.
Meanwhile, enjoy what remains of the holiday week and be ready for interesting times ahead as summer eventually brings us to those tricky fall months that lie in wait.
Investors who like nice, clean narratives keep getting flummoxed by the global economy’s refusal to serve up steady sequences of consistent data points. This was a week, after all, when bond markets around the world took a Super Mario-sized beating in the wake of the ECB chairman’s musings about recovery and reflation in the Eurozone. The bond carnage even spilled into the seemingly Teflon stock market on Thursday. And yet, where did it all end? In the US, the latest reading on personal consumption expenditures (PCE), the Fed’s go-to inflation gauge, posted a weaker than expected year-on-year growth rate of 1.4 percent (both headline and ex-food & energy) on Friday. That same day the latest Eurozone flash CPI showed a 1.3 percent year on year gain, in line with expectations but down from the previous month. Reflation? Or could the bond market just possibly have jumped the gun a tad?
Phillips Curve to Nowhere
The May inflation numbers are, of course, representative of just one month. But there is very little in the longer term trend to suggest that this mythic reflation is anywhere on the horizon. The chart below shows the headline and core (ex-food & energy) PCE along with the US unemployment rate trend for the past five years.
The Fed pays closest attention to the core PCE rate (the green solid line) because it excludes the volatile categories of food and energy, and thus presents a steadier picture of underlying trends. As the chart shows, core PCE has fallen over the past five years from a high of 1.9 percent to the current level of 1.4 percent. Not once during this period has this rate surpassed the Fed’s desired target of 2.0 percent (the headline number was briefly above 2 percent, almost entirely on account of a commensurate rise in oil prices).
While prices have largely gone nowhere over this period, the complexion of the labor market has changed considerably. The unemployment rate (red dotted line) was over 8 percent in June 2012, and currently resides at 4.3 percent. Private nonfarm payrolls have made gains every single month over this period, the longest streak since the Bureau of Labor Statistics started recording this data shortly after the end of the Second World War. Normally, economists would expect this brisk pace of labor market growth to put upward pressure on wages and consumer prices. The Phillips Curve, bane of every Econ 101 student, came into existence to quantify this relationship, but its explanatory powers would appear to have diminished to the point of irrelevance.
Low Growth, Lowflation
When the “reflation trade” theme became the dominant market sentiment at the end of last year we expended a considerable number of words musing about just where all this growth was supposed to come from. Even the most wildly optimistic assumptions about a new bout of pro-growth fiscal policies from Washington, in our opinion, was not likely to change the basic growth equation: declining population growth, a smaller percentage of the population in the labor force and chronically low productivity together comprise a speed limit on how fast the economy can grow. If and when productivity were to return, it would quite plausibly come at the expense of jobs, as nonlinear advances in artificial intelligence and deep machine learning make real inroads into companies’ business operations. Why should we expect to see a major bout of reflation if this is the case?
This week’s bond market activity was significant. We are far from convinced that it marked the start of a paradigm shift away from the low rate environment of the past few years. The Fed may well raise rates again this year – it really, really wants to, and absent a major deviation from headline macro trends it could probably do so without too much risk of collateral damage. But unless some catalyst that we don’t see today shows up to push prices significantly higher, the urgency for the Fed to act again (or the ECB to start tapering) just won’t be there. And we are always just one unexpected market crisis away from the Greenspan-Bernanke-Yellen put coming out of the desk drawer and back into action.
It may be as good a sign of the times in which we live as any: in the space of five business days, Argentina (1) stunned global credit markets with a $2.75 billion 100-year bond (yes, a bond that will come due long after all of us reading this article have gracefully shuffled off this mortal coil), and (2) saw the Argentine peso fall to a record low after MSCI declined to upgrade the country’s equity market from frontier to emerging market status. This seeming contradiction in fortunes comes at a time when emerging market equities hang on as one of the best asset class performers of the year, while investors have plowed more than $35 billion into developing market bond funds. Are there still opportunities here, or is the EM glow due for one of its not infrequent fizzles?
Unlikeliest of Success Stories
Pundits cheerleading the emerging market story were few and far between as 2017 got underway. After the surprise outcome of last November’s US election the asset class fell 6.4 percent through year-end, along with everything else on the flip side of the “Trump trade.” EM assets – debt and equity alike – were imagined to be in for a period of protracted weakness as US interest rates and inflation soared to the fanciful revving up of a $1 trillion tsunami of infrastructure spend. A better square on which to place your growth-and-risk-seeking chips, it would have seemed, was US small cap stocks. As it turned out, though, EM equities, currencies and bond prices all rallied. The chart below shows a 12-month snapshot of the MSCI EM stock index, denominated both in local currency and in US dollars.
Yield: What Matters Most
One of the factors -- not the only one, but key nonetheless -- explaining the updraft in EM equities is currency. After being pummeled by the US dollar more or less constantly since 2015, key emerging market currencies from the renminbi to the Indian rupee, Mexican peso and Russian ruble stepped on the gas after their post-Trump trade declines. That currency strength, in turn, is of a part with the remarkable push by global investors into emerging credit markets. For this there is an easy explanation. The investing world is on a collective, frantic search for yield in a world awash in central bank stimulus. Yield is the Holy Grail of the second decade of the 21st century.
Why was that 100-year Argentine bond deal thoroughly oversubscribed? Because investors could not resist the temptation of a 7.91 percent yield. Same goes for Russia, which unloaded $3 billion worth of 10- and 30-year Eurobonds into the markets this week (4.25 and 5.25 percent yields, respectively). Does it matter that Argentina has defaulted on its debt five times since 2000? Does anyone remember Russia’s bailing on its sovereign debt obligations in 1998, sending the propeller-head mavens of Long Term Capital Management and their backers to the poor house? Not today, not in a world of yield above all else.
Lower for Longer, or Tantrum 2.0?
The punters who scooped up the Russian and Argentine paper this week may well be vindicated for their boldness if the market’s view on the Fed turns out to be right. That view – the opposite of the reflation trade that had everyone so excited last year – is that low inflation and anemic wage growth are here to stay for the foreseeable future, just as they have been for most of the duration of the slow-growth recovery to date. If inflation and wages fail to kick in over the next several months, even with labor market conditions that according to many should suggest full employment, then it is quite possible that the FOMC will hold off even on the one further cut they have in their sights this year. That would potentially keep the dollar from embarking on another punishing rally, and the quest for yield would continue (pushing bond prices ever lower).
Then again, there is an alternative, quite valid argument to make that the low levels of volatility in asset markets today are woefully mispricing the amount of latent risk that could be unleashed at any time. It’s worth noting that many of the EM currencies that have been doing so well of late have run into some headwinds recently. The Brazilian real took a tumble back in May when the newest batch of political scandal headlines hit the wires. The ruble and the renminbi are both well off their recent highs, while the rupee and the Mexican peso are marking time in a relatively narrow corridor. The year’s gains to date have been impressive. Experienced EM investors know that they are anything but certain to last.