Monthly Roundup
There have been some nasty sell offs in Octobers past, so we should be grateful we made it through without a 1987-style crash, but there was still some marked softness around financial markets. Amid the political hullaballoo on both sides of the Atlantic as well as a spike in military activity in the middle east, we saw two dominant themes this month: a resurgence of commodity prices and more bond yield rises. The combination of those themes saw weakness in the high yielding stocks, which have been star performers for the past few years, offset by surging resources stocks, which had been so poor.
Commodity prices: not quite free markets
Oil
Since the oil price peaked at over $114 per barrel in 2011 we’ve become kind of accustomed to hearing of it falling, and falling – until it bottomed out at just over $27 per barrel in February of this year from which point it shot up to almost double in four months. Talk about a roller coaster, as you can see from the chart below.
Oil prices – quite a ride!
Source: IRESS
The reason for the most recent rally is OPEC announcing production cuts in late September, but then quite predictably we started to hear of countries that didn’t want to play along. Iran and Russia have both said they don’t want to reduce their output and Venezuela simply can’t afford to.
At the same time, over the last 18 months US shale oil producers have lowered their breakeven price by a remarkable $19 down to $51 per barrel; now that’s ingenuity for you. Given the rise in oil prices, not surprisingly the number of oil rigs being deployed in the US has risen for the past eight weeks in a row, but it’s still almost 30% less than 12 months ago. In other words, that sound you hear is the whooshing of more oil supply coming down the pipes.
This is an interesting example of markets at work: OPEC interferes in the price mechanism by reducing supply, which causes the price to rise, which causes US producers to re-enter the market, which will cause supply to go up, which drives the price back down. Perhaps the chart below provides some further perspective: it shows oil prices over a 30 year period. It’s very clear the effect an industrializing China had from the early 2000’s, and likewise the effect of a slowing China since 2012. You can’t help but wonder if there’s not the resumption of a long-established trend slowly playing out.
The long term oil price – spot ‘the China effect’
Source: Index Mundi
Coal
The other extraordinary commodity price move over the past month has been coal prices, both thermal (which is used for producing electricity) and coking (which is used in steel production). Once again though, it’s more a story of market interference causing a reaction.
The chart below says it all – coking coal prices have risen more than 240% from the lows seen late last year. But an almost vertical price rise is rarely due to natural market forces and more often than not is followed by a return to earth.
Coal prices – unnatural market forces
Source: Platts, Bloomberg, CBA
So what happened? Earlier this year the Chinese government tried to boost economic growth through its favorite trick of increasing fixed asset investment and construction, which requires lots of steel. The problem was the government had previously tried to rein in both steel and coal production and part of that was by cutting the number of days coal mines were allowed to produce from 330 days per year to 276 – not far off a 20% cut. Overall it’s estimated China’s coking coal production has fallen by 30% in the past few years.
But just as the shackles were being taken off the Chinese mines, a series of supply disruptions due to floods and safety outages conspired to reduce the amount of coal being shipped both internally within China as well as from Australia. Although China recently announced that imports of coking coal in September had increased by 40% year on year, it’s estimated the Chinese authorities have given the go ahead to an extra 60 million tonnes per annum.
And it’s been pretty much the same story for thermal coal as well, where prices rose by 27% in the first three weeks of October alone. Again, however, supply is responding. So a sharp increase in demand combined with a supply disruption and voila!, prices go nuts. But reintroduce mothballed supply and watch what happens then.
Overall it’s a fascinating example of how markets work and don’t work; the unforeseen consequences of the Chinese government trying to control one market results in another one going stratospheric. It’s also an illustration of how difficult it can be to invest in resources stocks with a high degree of confidence. The prices of their end products are way beyond their control and can indeed be subject to the whims of mother nature and governments – two of the least predictable market forces.
Bonds
There are two things that are sure to get bond yields going up: rising interest rates and concern about inflation. Remember, when a bond’s yield (the interest rate it pays) goes up, that means its price has gone down. In a world starved of safe yield, a rise in bond yields can be tempting.
Since early July the bellwether US 10 year bond yield has risen from 1.36% to 1.85%. Now 50 basis points (or 0.5%) may not sound like much, but on a relative basis, that’s a 36% increase in just a few months – see the chart below. And the same has been happening all around the world: Europe, Japan, even Australia.
US 10 year bond yield
Source: IRESS
One of the effects the rising yields have had is a sell off in the ‘bond proxy’ stocks, those stocks with what are seen as reliable dividend yields. We’ve seen the property trust index down 15% from its recent peak and a similar story across infrastructure stocks as well.
Why have bond yields been going up? Firstly because markets are factoring in a 70% likelihood the US Fed will raise interest rates in its December meeting: unemployment is less than 5%, annual GDP growth was reported last week at 2.9%, wages growth seems to have finally picked up, and crucially signs of inflation are popping up. All in all, it’s tough to see the Fed knocking back an opportunity to give itself some more monetary policy wriggle room by increasing the cash rate by another 0.25%, to a still very, very low 0.75%.
It could well be the inflation part that’s keeping bond markets up at night. Standard measures of inflation are trending upwards as the charts below indicate – they may not be positive yet, but it’s the direction that’s important. In these charts the grey lines are the separate elements that go into making the overall number in black.
US Consumer Price Inflation (CPI)
Source: Deutsche Bank
US Producer Price Inflation (PPI)
Source: Deutsche Bank
US wage inflation
Source: Deutsche Bank
However, one of the problems is that consumer spending in the US, which accounts for about two thirds of GDP, has been growing at a much slower rate. The cautious argue that if you put interest rates up it may send consumption into a complete stall. However, as the chart below shows, the lower interest rates have gone in the past few years the less people are inclined to spend, so, counterintuitively, maybe a rate rise will spur more spending.
US preference for saving vs. spending
Source: Gallup
It’s the classic economic argument of “on the one hand” and “on the other hand” until you run out of hands. At the end of the day though, it still appears that any rate rises will be very slow. The Fed and financial markets alike are adjusting to what appears to be the new paradigm: low inflation and low rates for some to time to come – as the charts below indicate. The first chart shows what the Fed thought would happen to interest rates over the past few years – as you can see the coloured lines have gradually become less steep, meaning a slower rate of increase in interest rates. The second chart shows how the market sees it: it too is factoring in a far less aggressive rate tightening cycle.
Where the US Fed thought interest rates were going
Where the markets thought interest rates were going
As for Australia, inflationary pressures here are still hard to find – as the charts below indicate. Once again, it’s the trend that matters most.
Australian Consumer Price Inflation (CPI)
Source: Deutsche Bank
Australian Producer Price Inflation (PPI)
Source: Deutsche Bank
Australian wage inflation
Source: Deutsche Bank
So does that mean we should be expecting more rate cuts here in Australia? Not necessarily. The Reserve Bank of Australia has arguably done a great job of navigating the exceptional economic circumstances we’ve encountered over the past five years, and both the past Governor and the present one have been urging the federal government to step up and do more rather than relying on monetary policy to do all the heavy lifting.
Also, when was the last time you heard a Federal Treasurer argue there shouldn’t be any more rate cuts?! That’s exactly what Scott Morrison said earlier in the month, arguing that monetary policy (that is, changing interest rates) has “exhausted its effectiveness”. So while Australian inflation may be showing few signs of life, queries over how helpful it would be to keep cutting interest rates are growing louder and louder – the old ‘pushing against a string argument – just as they have all over the world.
