A short follow-up to our piece earlier this week.
Commodities Follow Up
In our piece earlier this week, we were trying to convey the sense that the deflationary era of the last 3+ decades may well be coming to an end. This is in part due to the large-scale monetary stimulus enacted by the major global central banks in response to the COVID-19 pandemic. And also, at the enhanced prospect of fiscal stimulus in the US, Europe and Japan. Moreover, as the world gradually opens up (whatever the hiccups in the process), there is potential for a burst of short-term growth.
Following the protectionist turns in the UK and the US, markets have also begun to price in the longer-term impact of changing directions on globalisation. While the risk of a reversal in globalisation is now well acknowledged, the focus on the global pandemic means that the risks of globalisation are probably not fully reflected in asset prices.
We are certainly guilty of not having focused on the risks arising from a reversal in globalisation in recent months.
The Short-Term
The sharp up-turn in the USD in March and the resulting drop-off in economic activity led to a sharp reduction in capital investments, pulling down US and global growth.
The bottoming and, more importantly, the stabilisation of commodity prices reduces default risk across the commodity complex, especially in the oil & gas sector. And, we are starting to witness a cyclical upturn in new durable goods orders, excluding transportation. This indicates that US corporations are once again willing to put capital to work and investment spending should rise. That seems to be giving a boost to the US economy and could well be a factor more globally.
The near-term risk to the short-term up turn is the oil and gas sector.
In June, there were 20 very large crude carriers (VLCCs) in queue at the Qingdoa port in China. This has forced VLCCs arriving at the port to wait for up to three weeks before being able to discharge their cargoes. If these queues lead to a shortage in availability of tankers, oil producers will have little choice but to dump production on to the spot market, which would cause another sharp drop oil the price of crude.
As long as OPEC and Russia continue to adhere to production quotas agreed with President Trump, we do not expect this risk to materialise.
The Long-Term
We look once again at the chart above of new durable goods orders and the spot price of crude, we can see the drop in oil and commodity prices in 2014 was quite severe. The severity of the drop led to dislocations in commodity producing sectors. Today commodity prices are much lower. This means any sell off in commodities, due to a strengthening US dollar or worsening macro environment, is likely to prove less disruptive to global growth than in the recent past.
That is, a strengthening of the greenback makes it more likely that the US exports inflationary pressures abroad as US growth strengthens on the back of record monetary and fiscal stimulus. That’s very different from the 2014/2015 US dollar rally which was associated with rising deflationary dangers — that rally generated fears of the Fed tightening too much, too fast and of a collapse in commodity prices and commodity production. We do not see that scenario to be relevant today.
The one exception to this, and an important one, is if a trade war once again takes centre-stage. If the US pushes for more tariffs on foreign produced goods, then this reduces the extent to which the US exports reflation and instead keeps the bulk of the stimulus benefit within the domestic US economy. This would create a relative growth story, and argues for another episode of US equity out performance relative to the rest of the world.
Even so, in circumstances of US fiscal stimulus, we think the imposition of tariffs would be unable to thwart inflationary pressures. This forms the basis for the idea that the most robust trade is buying either commodities or international equities and positioning for an uptick in longer term US breakeven inflation rates.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.