Andy Pfaff - MitonOptimal South AfricaIt is trite to note that humans consistently display a magnificent capacity to mentally project any current trend infinitely into the future in a linear fashion – particularly bull markets in equities – and to demonstrate amazement & horror when these fail to materialise. It is equally trite to state that financial asset valuations have become extended in the afterglow of 10 years of QE post the 2008 GFC.

However recent interruptions to this pleasant reverie have included President Trump’s tweets, the nascent USA/China trade war, the USA’s one-step forward & two steps back approach to Russia, the reinstatement of sanctions on Iran and the markets current response to Turkish unconventional economic policies, where a textbook currency crisis is looks likely to morph into a debt and liquidity crisis due to policy mistakes. The Turkish economy therefore needs to be prepared for a hard landing, including corporate defaults on foreign currency debt and possible bank failures. As do other economies with “unconventional economic policies” dictated by political leaders out of step with international best-monetary-policy practice.

Will these elevated stress levels spread further through the market as per the Asian financial crisis in 1997, or will they be contained geographically as per the Latin American debt crisis of the 1980s and the Mexican crisis of 1994-95?

Like predators preying on the weakest in the wild, financial contagion typically affects the most vulnerable (“risky” or “volatile” assets) first, and then works its way up the quality gradient towards the core i.e. from commodities and EM equities to DM equities and, eventually, to US government bonds. This continues until the selling is exhausted and buying emerges, triggered either by investor perceptions of ‘value’ (assets become regarded as “cheap” or “oversold”) or policy measures taken by the monetary authorities as per QE in 2008.

Can commodity price behaviour perhaps provide any early indications of either contagion or containment of the Turkish Tantrum, of either crisis-type melt-down or simple economic slowdown?

Gold, the market’s age-old fear barometer, appears uninterested in anything except maintaining its usual inverse relationship with the US dollar and, more importantly, the current rate of normalisation of US monetary policy. Its reluctance to respond meaningfully to any geopolitical event in the last 5 years signals that the investment community has become blasé’ about headline news items. Like a horse observing human behaviour, the gold market ignores what people say, and focuses only on what the Fed & the US $ do. (chart Gold 1999-2018)

The industrial-type metals (base metals & PGMs) are also weak. But copper has been weak for the whole of 2018, reflecting the well-telegraphed economic slowdown in its main consumer, China. The PGMs have similarly been weak in 2018. But Platinum has been weak since mid-2014. It has had to contend with both VW’s ‘DieselGate’ and the ensuing fall in demand for diesel engine auto catalysts, and also South Africa’s persistent reluctance to ration supply in response to falling prices. In contrast, palladium has benefited from the increased sales of petrol (“gasoline”) vehicles in the USA in 2016/7, rising 150% in two years. So, while palladium’s 21% fall in 2018 technically qualifies as a bear market, in the light of its recent performance and the near-10% rise in the US $ in 2018, it is hardly to be categorised as a crisis. (chart Copper 1999-2018)

Energy demand, as evidenced by demand for oil, has continued to be robust. The only interruption to global oil demand in the last 20 years has been the 2006-9 stagnation, and it is currently a record high of just over 100 million barrels per day (refer chart 3). This is hardly what one would expect in a significant economic slow-down. (Chart Global oil demand (million barrels per day))

None of the major commodities therefore appear to indicate that the recent Turkish-style meltdown is likely to spread. Also, in spite of their recent sell-offs, individual commodity volatilities have not risen, indicating that commodity price behaviour is still ‘business as usual’ and not in crisis/contagion mode.

Vulnerabilities in global growth are now about 6 months old, coinciding with the downturn in industrial metals. Anecdotally, the recent sell-offs in base metals correlate highly with the timing of the US/China tariff announcements. Industrial metal prices specifically now strongly indicate that the market has recalibrated its collective opinion on global growth and the positioning of the economic cycle. Copper alone appears to be pricing in a greater reduction in growth. However, at current spot prices the industrial metal complex appears to be pricing in global GDP of ≈ 2.5%, down by ≈ 0.75% from its 1H 2018 average.

It is therefore this human’s considered opinion, taking into account all his frailites & magnificent intellectual biases into account, that the global economy is not on the edge of the precipice. Like gold, the pricing of many other financial assets will be determined by the behaviour of that cornerstone of the global financial markets, the US Fed. But like horses, we should be guided what the Fed does, not by what ‘the market’ says that the Fed will do.

As per John Maynard Keynes, change your mind (and portfolio positioning) when the facts change. But not before.

Download: Weekly Comment – August 24 2018 – AP


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