The Bull Market is Not Dead.

“Bulls do not win bull fights. People do.” – Normal Ralph Augustine

 

 “Stocks fluctuate, next question.”Alan Greenberg, former CEO and Chairman of the Board of Bear Stearns, in response to questions about the crash, October 22, 1987

 

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle

 

November last year, in Volatility Selling and Volatility Arbitrage Ideas Using Equities, we wrote:

 

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are underweighting as opposed to overweighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

 During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year.  The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.

 

Poorly structured short-volatility products and the limited – almost non-existent – down-side risk to going long volatility has, in our opinion, led to the emphatic short-squeeze in volatility witnessed over the last ten days or so. The tail has well and truly wagged the dog. That is, higher volatility has led to the sharp correction in the market. Not the other way round. The late-afternoon equity sell-off on Monday 5 February is indicative of as much.

S&P 500 Index on 5 February, 2018SPX 5 FebSource: Bloomberg

XIV, SVXY and other products of their ilk are not the first, and are almost certainly not going to be the last, poorly conceived investment products to blow-up. Think back to portfolio insurance, synthetic collateralised debt obligations (CDOs) and CDO-squared as a reminder. There has been plenty of commentary, and no shortage of memes, lambasting regulators of and speculators in short-volatility products alike – many of the critics make valid arguments that should give regulators pause for thought. For investors the time, however, is not to reflect on the flaws of these products but rather to focus on whether the blow-up of these products can lead to a contagion into adjacent markets or is this just a shake-out of weak hands.

The most convincing argument for the recent correction being a shake-out of weak hands comes from the US corporate bond market. US corporate spreads have been benign in the face of the recent spike in volatility – a first in a very long-time.

US Corporate Yield Spreads vs. VIX IndexCorporate yields and VIXSource: Bloomberg

The narrative of rising inflation expectations leading to the correction in equity market has taken hold in some quarters. Firstly, looking at the USD 5-year, 5-year inflation swap rate, there has not been a sharp increase in market-based inflation expectations. In fact, the increase in inflation expectations was much sharper immediately after Trump won the election than at any time during the last year. Secondly, high inflation does not negatively affect equities. If inflation is high but stable, it is nominally positive for equity markets and is unlikely to cause any damage to the real economy. Moreover, historical data suggests that the highest levels of price-to-earnings multiples are witnessed during periods when inflation ranged from 2 to 3 per cent.

 

An unexpected acceleration in inflation followed by unanticipated changes in monetary policy, however, can have significant negative consequences for the economy. The Fed, to date, has not shown any signs of panic. As long as the Fed continues on the path of slow and steady rate hikes, we do not expect Fed rate hikes to derail the economy or the equity market. If, however, the US economy overheats in response to the recently passed tax reforms and the tight labour market, the Fed may be forced to react aggressively, which could be catastrophic for both the economy and equity markets.

USD 5-Year, 5-Year Inflation Swap Rate5Y5YSource: Bloomberg

The one change coming out of the recent sell-off, in our opinion, is that volatility has made its secular low. We suspect that retail investors are unlikely to return to short volatility in droves. We also have a hunch that private banks and wealth managers will not be offering short-volatility products to their high-net worth clients any time soon. Volatility, therefore, should stabilise closer to its longer-term average – we do, however, expect volatility to be structurally lower than the past due to the increased prevalence of passive and systematic strategies, which implicitly dampen volatility during a stable market environment.

A necessary corollary of higher volatility is that investors have to be more discerning in security selection.  Active management may soon be back in vogue.

 

 

Investment Perspective

 

In the after-math of the recent market sell-off we have heard market legends claim that “macro is back” or that it is an “exciting turn for macro trading”. At the same time, we have heard old hands speak of the trauma of 1987 and how it shaped their approach to markets going forward. What we do not hear or read of enough though is that as traumatic as 19 October, 1987 was, it was also the buying opportunity of a generation. The S&P 500 compounded at an annualised rate of 18.9 per cent over the next ten years.

We do not expect returns from equity markets for the next ten years to be like those witnessed between 1987 and 1997. We, however, also cannot ignore that global equity markets had a major break out last year.

 

MSCI All Cap World IndexMSCI ACWISource: Bloomberg

We have one simple, singular thought when it comes to equity markets today. Until we come across evidence to the contrary, we think investors should figure out what they want to own and buy it with both hands.

 

 

 

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. 

China’s Strategic Gains

“Let a hundred flowers bloom; let a hundred schools of thought contend” – Chinese poem that inspired the name for Mao Zedong’s Hundred Flowers Movement

“Everything is relative in this world, where change alone endures.” – Leon Trotsky

“Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.” – Winston Churchill

Democracy, according to Freedom House, peaked in 2005. Between the years 1970 and 2005 democracy flourished greatly. As recently as 1973, countries such as Spain, Portugal and Greece were dictatorships, and only forty-five out of the world’s then 151 countries were counted as  free democracies by Freedom House. Driven by massive social change at a global level, the number of free democracies had grown to 120 nations by the end of the twentieth century.

Over the last decade, however, democratic institutions have experienced a significant decline. And 2017 saw this trend accelerate. The reversal in fortunes of democracy has emboldened the likes of China and Russia to push for increasing acceptance of the ideologies underpinning their respective brands of governance across the developing world.

The Trump Administration’s inward looking policies and hostility towards pluralist international agreements have opened the door for China to replace the United States as the key power broker in Asia and the developing world. Take, for example, Trump’s decision to withdraw the US from the Trans-Pacific Partnership (TPP), which was followed up by Xi Jinping’s rousing support for globalisation at Davos in January 2017 and again at the Belt and Road Forum in Beijing in May 2017. And it is not just bravado; China is pushing for greater integration amongst Asian economies by driving negotiations for the Regional Comprehensive Economic Partnership (RCEP) – a proposed 16-nation free trade agreement that includes the ten member states of the Association of Southeast Asian Nations (ASEAN) and Australia, China, India, Japan, South Korea and New Zealand.

Chinese efforts to wrestle away US influence in Asia are not limited to the RCEP alone.

In May 2014, Xi called for an “Asia for Asians” – a security concept encouraging Asian nations to step up and assume leadership in administering regional order. Xi’s words were provocative at the time but are progressively coming to reflect the emerging reality in Asia.

The China-Pakistan Economic Corridor (CPEC) – a collection of infrastructure projects under development across Pakistan valued at USD 62 billion – is a formalised strategic alliance that will connect landlocked parts of China to the port of Gwadar on the Arabian Sea and gives China substantial influence over Pakistan.

China has also deepened ties with countries, such as the Maldives, Sri Lanka and Nepal, that have traditionally fallen in India’s sphere of influence. Leveraging its position as the Maldives’ biggest debt holder, China has entered into a free trade agreement with the Maldives in November last year and also received the government’s endorsement for its “Maritime Silk Road” plan. Sri Lanka too has capitulated under the burden of Chinese debt and has handed over the strategic port of Hambantota to China on a 99-year lease. Chinese firms also control a container terminal in Sri Lanka’s capital Colombo. In Nepal the Left Alliance, a pro-China and communist party, propelled by China’s pledge to invest over USD 8 billion in developing Nepal’s infrastructure won the recent elections by a landslide and will take power in March 2018.

China’s deepening ties within Asia, while true to Xi’s “Asia for Asians” mantra, form part of its much larger vision: the Belt and Road Initiative. The Belt and Road Initiative, at times dubbed the Chinese Marshall Plan, is an ambitious economic policy centred on international infrastructure development. It will span four continents and encompasses the construction of two broad networks:

– The “Silk Road Economic Belt” a land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and

– The “Maritime Silk Road” a network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

Scepticism, when the Belt and Road Initiative was unveiled by Xi Jinping in October 2013, ran high. For all its ambition, the fact remains that there are few countries that trust China. The US retreat and the promise of new infrastructure, however, have seen bottlenecks and political roadblocks fall by the wayside and the initiative has started to gather momentum. Quoting from Caterpillar Inc.’s fourth quarter earnings call (emphasis ours):

“Lastly, we expect to see continued growth in Asia Pacific, led by China. Our forecast is for China to remain strong through the first half of the year, and then slow in the second half, which reflects normal seasonality. In addition to China, we expect most other countries in Asia Pacific to grow, largely driven by investments in infrastructure.

Equipment manufacturers such as Caterpillar are seeing increased demand out of China and the Asia Pacific. Excavators and loaders, such as those produced by Caterpillar, are amongst the most commonly used earthmoving equipment at construction sites. The increase in orders for such equipment from China and the Asia Pacific are tell-tale signs that the Belt and Road Initiative is underway.

While sceptics will remain and there will be many hurdles along the way, the importance of the Belt and Road Initiative to China cannot be overstated. It is seen as being so important by Chinese leadership that during the Communist Party of China’s 19th National Congress, the following statement was deemed to be a necessary addition to the Chinese constitution:

“Following the principle of achieving shared growth through discussion and collaboration, and pursuing the Belt and Road Initiative.”

Some have speculated that because the Belt and Road Initiative is inseparably connected to Xi Jinping, the inclusion of the above statement into the constitution is a means by which Xi will extend his leadership beyond his term. We, however, think that this objective was already achieved by the enshrining of “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” into the constitution. The Belt and Road Initiative is China’s path to rebalancing its economy, creating ripe markets for its “Made in China” policy to be a success, and moving up the manufacturing value chain.

China’s expanding influence in Asia comes at the cost of increasing insecurity amongst Japan, India, and the US. The Trump Administration, while being irreverent towards globalisation, contains amongst its ranks deep-seated China sceptics – Director of the White House National Trade Council Peter Navarro and Trade Representative Robert Lighthizer chief amongst them – we think it is unlikely that the US will forfeit its position within the global order without a fight.

India, wary of the Chinese-Pakistani alliance, too, is trying to up the ante. Indian Prime Minister Narendra Modi has signalled a USD 250 billion revamp of India’s armed forces by 2025 and 2017 saw India entering into new defence deals with Israel, Russia and the US. At the same time, India is trying to shore up relations with its neighbouring countries. It extended USD 4.5 billion in project financing to Bangladesh to support infrastructure development, committed USD 500 million in investment for the Chabahar Port in Iran, and also entered into an estimated USD 2 billion agreement with Iran for cooperation in the rail sector.

While China is unlikely to win over western democracies, Japan or India anytime soon, the overtures of Chinese money-fuelled infrastructure projects are likely to prove too tempting for most developing nations. And this, we think, is the reason the Belt and Road Initiative should continue gathering momentum.

Investment Perspective

Equity markets globally have started 2018 with a bang. This year’s most eye-catching market action, in our opinion, however, occurred on 2 January at the Karachi Stock Exchange in Pakistan. Why? Well, for starters, Trump’s first tweet of the year:

“The United States has foolishly given Pakistan more than 33 billion dollars in aid over the last 15 years, and they have given us nothing but lies & deceit, thinking of our leaders as fools. They give safe haven to the terrorists we hunt in Afghanistan, with little help. No more!” – @realDonaldTrump

Given that Pakistan was to receive over USD 255 million and USD 900 million in security assistance from the US for 2016 and 2017, respectively, the freezing of these disbursements subsequent to the US President’s tweet was bad news for Pakistan. Yet the Pakistani stock market went up and has continued to go up since.

 

Karachi Stock Exchange 100 IndexKSE100.png

Source: Bloomberg

Two days after President Trump’s tweet against Pakistan, China unveiled that its second overseas military base would be built in Pakistan.  The base will be built at Jiwani, a port close to the Iranian border on the Gulf of Oman and will be a joint naval and air facility for Chinese forces.

China’s growing influence in Asia is real. The Belt and Road Initiative is gathering momentum. The investment implications of these developments may prove to be profound over the next decade. For now, it is a signal that China wants to increase its influence in Asia. Stability is a necessary condition in order to achieve further influence. For this reason, as we noted in Our Thoughts On and Investment Ideas for 2018, China bears stand to be disappointed in 2018.

An added corollary is that one should not be shorting the stocks of construction equipment providers.

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. 

 

Our Thoughts On and Investment Ideas for 2018

“No one’s ever achieved financial fitness with a January resolution that’s abandoned by February” – Suze Orman, American author, financial advisor, motivational speaker, and television host

 

“Nobody wants a prediction that the future will be more or less like the present, even if that is, statistically speaking, an excellent prediction.” – Nathan Myhrvold, formerly Chief Technology Officer at Microsoft

 

“It requires a very unusual mind to undertake the analysis of the obvious” – Alfred North Whitehead, English mathematician and philosopher

 

The start of a new year is as a good time as any to take stock of one’s portfolio and by extension the investment views underpinning it. Having undertaken the exercise internally, we take this opportunity and share some of our thoughts and investment ideas for the year ahead.

The ideas we present here are amongst our top convictions based on a 6 to 12 month investment horizon. As ever, we remain flexible and should circumstances and / or the data change our investment views too may change.

 

  1. Japan continues to outperform

We issued a piece on Japan last month, where we argued that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle. This view is predicated on the fact that Japan is already at the forefront of the robotics revolution and has a demographic profile that makes it uniquely sheltered from the potentially negative socio-economic consequences of the increased proliferation of artificial intelligence. Moreover, Japanese companies are flush with cash – cash holdings of companies listed on the Tokyo Stock Exchange are now more than 140 per cent of Japan’s GDP – that they can use to invest in robotics and automation.

Long iShares MSCI Japan ETF ($EWJ).

 

  1. A bull market in uranium

 “The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

– Excerpt from Capital Returns Investing Through the Capital Cycle: A Money Manager’s Reports 2002 -15 edited by Edward Chancellor

 

When it comes to uranium sector, plenty have cried wolf over the years as the commodity’s price crashed following the Fukushima Daiichi nuclear disaster in March 2011. When prices fell below the cash cost of the marginal producer, many felt the bottom was close. Instead, prices continued falling and even dropped below the cash cost of the most efficient producer.

Uranium 308 Physical Spot Price UraniumSource: Bloomberg

Uranium miners cut capital expenditures in response to the decline in price. Some producers even went as far as buying from the spot market to fulfil their deliveries as it became cheaper to buy in the market than to produce. Despite the struggles, supply cuts were few and far between – given tepid demand, the lack of capacity curtailment became a major impediment to any improvement in prices. That is, until recently. In January, 2017, KazAtomProm, the national operator of Kazakhstan for import and export of uranium, announced plans to cut production by 10 per cent – representing approximately 3 per cent of global uranium production. Spot prices rallied in response to the announcement but faded due to slow implementation of the cuts while demand also remained tepid. This past November, Cameco Corporation ($CCJ) – the world’s largest publicly listed uranium company – announced that it would suspend production at two of its mines, representing approximately 9 per cent of total global production,  for ten months by end of January, 2018. Less than a month later, Kazakhstan announced that it would cut 20% of its production for the next three years. These announcements sparked a yearend rally in uranium prices.

Our analysis suggests that the announced production cuts, without any improvement in demand dynamics, are sufficient to bring the uranium market into balance over the course of the next 18 months. If demand picks up, however, the market could quickly fall into a deficit, which would push prices up to much higher levels.

Long Global X Uranium ETF ($URA).

 

  1. US inflation, wage growth and velocity of money all pickup

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WG

Sources: Bureau of Labor Statistics, National Federation of Independent Business

This discrepancy is largely due to headline figures masking the underlying trend. The outsized impact of a handful of industries distorted the average. Based on the data from the Bureau of Labor Statistics (BLS) wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

 Annualised Wage Growth by Industry (2014 to 2016) Wage Growth IndustrySource: Bureau of Labor Statistics

As the oil and gas extraction industry is no longer a drag on headline wage growth, there is increasing evidence of wage growth picking up. Based on a recent article, “In Cities With Low Unemployment, Wages Finally Start to Get Bigger”, in the Wall Street Journal:

“Workers in metro areas with the lowest unemployment are experiencing among the strongest wage growth in the country. The labor market in places like Minneapolis, Denver and Fort Myers, Fla., where unemployment rates stand near or even below 3%, has now tightened to a point where businesses are raising pay to attract employees, often from competitors.”

Rising wages in the US will have disproportionately higher impact on the disposable incomes of low and lower-middle class households. As poorer households’ disposable income increases, they are more likely to increase consumption as opposed to increasing savings, especially when compared to upper and upper-middle class households. Moreover, the spending patterns of poorer households are starkly different to those of richer households – for one they are more value conscious. Retailers and quick service restaurants catering to lower and lower-middle income households are likely to be amongst the greatest beneficiaries of higher wages.

The inevitable corollary is the rising wages will place increasing pressure on businesses to improve productivity. This coupled with the incentives within the new US tax bill for increasing capital spending – cutting the corporate tax rate from 35 to 21 per cent and a capital expensing provision – we expect capital expenditures in the US to pick up during 2018.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex Plans

 Source: National Federation of Independent Business

The combination of increased capital expenditures and higher wages means corporate cash piles will start turning away from financial engineering and toward investment. Flows out of Wall Street and into Main Street should translate into velocity of money picking up ergo higher inflation.

Long Wal-Mart Stores ($WMT), Dollar General ($DG) and Dollar Tree ($DLTR).

 

  1. Industrial commodities continue to rally

In our last post of 2017, we outlined our bullish view on industrial commodities. To summarise, on the demand side we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China which, given the Chinese Communist Party’s goal to make housing more affordable and transform rural residents into urban residents, should remain strong over the course of the year. The second is US capital investment, which we expect to pick up in 2018 given the incentives for capital investment created by the new tax bill. On the supply side, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results of these reforms thus far have been largely positive. Given the supply and demand dynamics, we are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

Long Vale SA ($VALE) and United States Steel Corporation ($X).

 

  1. Emerging markets: Oil exporters outperform oil importers

The sharp drop in oil prices in late 2014 has been a welcome windfall for oil importing emerging markets. Money that was previously being used to pay for oil imports has gone into productive investments as well as increasing consumption. Since the number of oil importing nations far outstrips the number of oil exporting nations, the drop in oil prices has supported the synchronised global economic recovery that we are enjoying today.

As the old saying goes, “Low prices, cure low prices”, the synchronised pickup in global economic activity caused in part by lower oil prices is resulting in demand for oil exceeding expectations. At the same time Russia and OPEC are maintaining high levels of production discipline. Moreover, our analysis suggests that the likes of Mark Papa and Harold Hamm are correct in calling out the Energy Information Administration (EIA) for its optimistic projections for shale production. We think that shale production will disappoint leading to higher oil prices in 2018.

Higher oil prices should lead to oil exporting emerging markets outperforming at the expense of oil importing emerging markets.

Long iShares MSCI Russia ETF ($ERUS) and long iShares MSCI Saudi Arabia ETF ($KSA).

 

  1. Robotics and artificial intelligence adoption accelerates

 At a human level, the pace of adoption of robotics and artificial intelligence, while being cognizant of the possibilities for human advancement, concerns us. We worry that the blind, unchecked development of artificial intelligence could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe. The business case for artificial intelligence adoption, however, is very strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive. Companies have no choice but to invest in robotics and artificial intelligence.

Our advice: learn a foreign language. If you have children, encourage them to learn a foreign language too. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

Long ROBO Global Robotics and Automation Index ETF ($ROBO).

 

  1. The first trillion dollar company

While this may not materialise in 2018, we think before this bull market is done we will have witnessed the world’s first publicly listed trillion dollar company. It could be one of tech giants – such as Apple, Amazon or Google – or it could be the successful listing of Saudi Aramco. Either way, we think a trillion dollar company will ring the bell at the market top.

 

  1. China bears disappointed

 After the botched currency devaluation efforts of 2015 and 2016, the Chinese government has deftly managed its economy by balancing between fiscal stimulus, risk management within the financial system, and supply-side reforms on the industrial side. While there have been hiccups, such as the gas supply crunch witnessed late last year, the economy has continued to grow smoothly. We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot. We expect China bears to have little to celebrate in 2018.

 

  1. Onslaught of cyber-attacks

 In 2017, cybercrime came of age:

  • US-based consumer credit reporting agency, Equifax, suffered a massive data breach compromising the data of over 143 million of its customers
  • WannaCry a ransomware was unleashed in May 2017 and targeted computers running Microsoft Windows by encrypting data and demanding ransom payments in the Bitcoin cryptocurrency
  • NotPetya ransomware attack forced shipping giant Maersk to halt operations at 76 port terminals around the world, which translated into an estimated financial cost of USD 300 million
  • Television network HBO was hacked in late July. A group of hackers claimed to have stolen roughly 1.5 terabytes of information from the company, including scripts and episodes of popular TV show Game of Thrones

The above are but a few examples of the cyber-attacks that took place in 2017. In an increasingly hyper connected world, we expect the scale and frequency of cyber-attacks will only increase.

Long Cyber Security ETF ($HACK)

 

  1. Household consumer stocks underperform

 We wrote about avoiding household consumer names in October last year – namely constituents of the Consumer Staples Select Sector SPDR ETF ($XLP). We maintain this view for 2018 as we consider their valuations to be stretched for businesses that are increasingly susceptible to disruption and shifting consumer preferences towards more niche brands.

 

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. 

Industrial Commodities: A Sustainable Bull Market?

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

– Excerpt from Xi Jinping’s speech at the 19th Communist Party of China National Congress

 

“Commodities tend to zig when the equity markets zag.” – Jim Rogers

 

“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise

 

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx

 

Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial IndexCRB

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

  Ratio of China Money Supply M1 to China Money Supply M2M1 to M2 China

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy.  As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

CRB US Spot Raw Industrial Index vs. China M1 YoY Growth (Lagged 6 Months)M1 YoY China vs CRB Industrial Metals

Sources: The People’s Bank of China, Commodity Research Bureau

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The government is clearly very serious about developing the rental housing market. And key private sector participants are responding to the government’s signals. Not long after the National Congress, China Construction Bank – one of the big four banks in China – launched a loan product for home renters.  China Vanke, a leading residential real estate developer in China, indicated that it aims to provide up to 100,000 apartments for long-term leases, up from the 24,000 rental units operated currently. AliPay, Alibaba’ mobile payment platform, announced that it would enable users across eight cities and based on their credit history to rent residential properties through the platform without having to pay deposits.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

  1. Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
  2. Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.

 

Investment Perspective

 

Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market?  What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.  

 

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 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.