December saw equities markets rally into the year end but in most cases it wasn’t quite enough to drag them into positive territory for the whole year. Early in the new year we’ll post an article looking in more detail at the results across different markets, but the ASX200 finished the year at -2.1%, or +2.25% if you include dividends. Interestingly, whereas in 2013 and 2014 the top 20 stocks were the strongest performers, this year the ASX20 fell 6.4% – three times more than the market overall. Within the leaders there were some pretty awful results: the commodities collapse hit BHP -33% and RIO -23%, falling oil hit Woodside -24% and Origin Energy -54%, years of underinvesting in the business hit Woolworths -20%, and even the banks copped it as they were forced to raise capital with Nab -9% and ANZ -13% (though note CBA 0% and WBC +2%). It was a memorable lesson in the consequences of the top 20 stocks accounting for about 60% of the overall market.
The US market, which was +1.2% including dividends, was the opposite story: to the end of November the top 10 stocks of the S&P500 has risen an average of 14%, whereas the bottom 490 had fallen an average of 6%!
At long last…
Undoubtedly the biggest financial news of the month was the Fed, the US central bank, finally pulling the trigger on raising interest rates. Having been on hold for almost 10 years and threatening for the last 11 months to increase the cash rate, it was finally moved by 0.25% so that it can trade in a range of 0.25-0.5% – still incredibly low. And the response to possibly the biggest financial event of the year: a bit of a yawn, and so it should have been.
Why did the Fed raise? The chart below gives as good a reason as you’ll get for why the Fed decided it was time to raise interest rates. Unemployment at 5% is very low, so the theory is that wage pressures should start to rise, which in turn means inflation starts to go up. But economic growth in the US is still running at only 2%.
US employment well up, jobless well down
Source: Bloomberg, AMP Capital
What impact will it have? Probably not much. Importantly the Fed is not trying to slow the US economy down, rather it wants to give itself some more flexibility in case it needs to respond to any kind of economic troubles in the future. Moreover, interest rates around the rest of the world are still very low (see the chart below) and are likely to stay low for the foreseeable future in an effort to support anaemic economic growth. Most importantly, our own Reserve Bank still seems to have an easing bias.
Global Interest rates are still low
Source: Bloomberg, AMP Capital
Probably the biggest impact will be in the currency markets. The US$ has risen strongly against other currencies ever since the Fed started rattling the cage about higher interest rates. In fact, it’s estimated the rising US$ had the equivalent effect on the economy as the Fed raising rates by 1.5%! And here in Australia our own Reserve Bank has been trying to talk the A$ down for the past couple of years, so the higher US$ makes them happy too.
The biggest risk for the Fed in raising interest rates is that it will put downward pressure on inflation. With headline inflation in the US and elsewhere around the G20 nations remaining very low, it’s something the central banks will be vigilant about. The only niggly thing to bear in mind is that services account for 75% of the US’s core inflation number and they’ve been rising in price by 2.7% p.a., which is substantially more than the -0.6% for goods (see the chart below), so the Fed will need to be careful inflation doesn’t take them by surprise because they’ve been focusing on the wrong thing.
US core goods and services inflation
Source: BLS, CBO, Census Bureau, Haver and Deutsche Bank
The European Central Bank had got the markets all excited by promising further easing measures, but left everyone feeling like they’d put the party hats on and the guest of honour failed to show up. Benchmark interest rates were left unchanged at an unbelievable 0.05%, but they did cut the deposit rates banks receive for leaving money sitting with the ECB from minus 0.2% to -0.3%. In other words, they’re pressuring the banks to lend the money out, while the banks are saying they’re finding it tough to find people to lend it to and companies are saying we can get better deals by just issuing bonds.
We’ve always argued the most important thing is not when the Fed moves but the trajectory rates take once they start to go up. The Fed said any moves will be “gradual” and “driven by the data”, which of course sent commentators into a frenzy trying to analyse exactly what that means. I think we can take it as it’s stated: the Fed is in no hurry, and low interest rates will continue to be part of the economic landscape for some time yet.
Commodities and capitulation
There’s nothing like a bit of long-term perspective to put things into context. The chart below is the IMF’s Commodities Index going back 23 years.
IMF Commodities Index
The first thing we would point out is that we are not commodities experts, so these comments are from the standpoint of an interested observer. Mind you, the track record of experts’ forecasts in the commodities space beggars belief that they can still be called experts. A first observation is that before China began to seriously ramp up its industrialization program (China boom Mk I), commodities prices traded in a fairly restricted range. The effects of China’s urbanization program on commodities demand were obviously profound: that’s going to happen when more than 20 million people move from the countryside into cities every year for more than 10 years and they have to be housed, have work places and be able to get to and from them. Just think about that: it’s the equivalent of having to build five Melbournes every year from scratch. One mind blowing estimate is that in the three years to 2013 China used 40% more cement than the US did in the entire 20th century, so you can presume the amount of steel and what have you wouldn’t be too different. In fact steel production in China this year was estimated at 823 million tonnes; between them, the US, Japan and Russia never got close to 200 million tonnes.
The second observation is that the period of growth after the GFC (marked above as China boom Mk II) was after the government launched an economic package equivalent to about 6% of GDP aimed almost entirely at investment. That would be the equivalent of Australia launching well over $100 billion worth of construction programs today. That boom in Chinese demand saw a huge increase in commodities production capacity across the world. For example, iron ore supply more than doubled between 2000-2014, an annualised growth rate of more than 6%. The problem is, that rate of increase in demand was never going to last for ever, despite all that talk of the commodities ‘super cycle’, and now overall global economic growth is about half of what that growth is supply has been. In other words, there was a massive structural shift in demand for commodities, supply responded thinking it was a permanent change, but it wasn’t and now we have an oversupply.
And as we’ve written many times before, the composition of China’s economic growth is changing: the government is engineering a deliberate shift toward consumer spending to drive growth rather than fixed asset investment. Moreover, this year marked the first time the number of people moving to the city from the country didn’t grow. All of that means a slowdown in the rate of growth of China’s commodities demand, just at a time when growth in the rest of the world is also very low.
Reversion to mean is one of the immutable laws of financial markets. It is possible that’s what we’re seeing in the commodities space: reversion to a time when commodities prices traded in a fairly restricted range.
Got a spare oil tanker?
Oil is still the most influential commodity of all on global growth, and what an amazing ride it’s been over the last 18 months with prices collapsing by 65% – see the chart below.
West Texas Intermediate oil price
And since natural gas is a substitute for oil in many industries, its price is now at its lowest since 1999! – see the chart below.
US Natural Gas price
Prices fell after OPEC decided to put the squeeze on US shale oil producers by maintaining production at high levels: the higher the supply, the lower the price. In fact OPEC crude oil production hit a three year high in November. The US shale industry responded by slashing the amount of drilling it’s doing, but production hasn’t followed it down – yet. See the chart below.
US oil rig count and oil production
Source: Datastream, Bloomberg, Deutsche
And in the way that pictures speak a thousand words, the photo below of oil tankers parked off the coast of New Mexico is a stark illustration of what’s going on. The FT estimated last month there was an unprecedented 100 million barrels of oil sitting around on boats.
Fully laden oil tankers berthed off the US Gulf Coast
As a result, the level of short positions, that is traders betting the oil price has further to fall, is the highest since 1998 – see the chart below.
WTI: Long vs Short F&O positions % of OI
Source: Deutsche Bank
The bottom line is enjoy these low oil prices while you can. Global demand is 100 million barrels per day and the current excess production is only a few million barrels a day. The pressure on the marginal producers is enormous so that buffer could disappear quickly.
Watch the credit cycle
Merrill Lynch reported last week that there have been record outflows over the past six months from high yield and credit funds, especially those holding emerging market debt. What does that mean?
Investors are worried the credit cycle is turning, that is, how easy it is for companies (and people) at the riskier end of the spectrum to borrow money and repay the loans. If a company is considered to be a riskier lending proposition, then it will be forced to pay a higher interest rate on its debt: so higher yield equals higher risk. The underlying concern is that we are at risk of seeing a rise in defaults, which would dramatically reduce the value of all outstanding loans, so they’re taking their money out of funds that invest in that risker, higher yielding debt. Once again, the collapsing commodities prices could well be behind some of the turn in the credit cycle.
Earlier this year McKinsey estimated there was a total of US$50tn of new debt created between 2007 and 2015, and about half of that total came from the emerging markets. That’s a really big number and unprecedentedly low interest rates combined with a commodities boom accounted for a sizeable chunk of it. Likewise, the FT reported that to the end of November companies had defaulted on $78bn worth of debt this year, which puts us on target for the highest amount of defaults since 2009.
With the fall in commodities prices, particularly the oil price, credit markets have seen an increase in what’s called distressed debt, which is debt that looks at increased risk of not being paid back. That makes sense: if an oil company borrowed money when oil was trading at $100 per barrel to drill a bunch of holes it’s going to be a lot tougher to pay that money back when oil is below $40.
‘Deeply distressed debt’ can trade at interest rates as much as 20% above what’s considered to be a low risk loan, like bank bills. The chart below shows there has been a spike in the amount of debt trading at these distressed prices, especially in the US and the emerging markets.
% of debt trading as ‘deeply distressed’
Source: Deutsche, Reuters
Deutsche has calculated that as much as 40% of the high yield debt issued by emerging market companies was related to commodities, so with commodities prices falling across the board, those loans are going to be harder to service. If defaults ramp up and we see lots of write offs, that would usually see credit dry up pretty quickly, which in turn slows the general level of economic activity.
A turn in the credit cycle has historically put a lot of pressure on companies, so this is something the markets will be watching very, very carefully.