March 7, 2016

Green shoots are sprouting across asset classes, but prices may have risen too quickly

Commentary by Robert Balan, Chief Market Strategist

"The actual job gains are better than expected, which is good for those who are looking to the economy to continue to elicit positive activity. At the same time, the backup in wage gains suggests that while the labor market improved, it’s far from being tight as to warrant wage inflation, which would draw the Fed from the sidelines.” Mark Luschini, Chief Investment Strategist, Janney Montgomery Scott LLC

Four systemically inter-meshed financial trades dominated in the markets over the past five years: (1) long the U.S. Dollar, (2) short emerging market stocks and bonds, and (3) short commodities and commodity stocks, and the whale -- (4) long US and DM bonds. It is the EM equivalent of the “Big Short”. We have always said that when the time has come to unwind those trades (the "ultimate market squeeze" in our view), we will all know – the market itself will tell us. That is happening right now – green shoots are sprouting all over the assets classes, and the most impressive recoveries are being seen in the assets and currencies of emerging economies. We document this revival in the subsequent charts of the week below.

Resource equities and commodity indices

Those have been practically one-way trades – "winners" kept winning, and "losers" kept losing, with only insignificant counter-trend moves, which were not large enough to reset the trade modalities. The relentless, 25% appreciation of the US Dollar Trade Weighted Index since 2014 was devastating. The one-way decline decimated former resource stalwarts (e.g., Glencore, Freemont-McMoran, etc.) as their equity valuations fell to levels which were even lower than those seen during the Great Financial Crisis of 2008. It devastated the entire commodity space, and with it, the entire universe of commodity producing countries sank. But from January this year, following a sharp decline in USD valuation, resource equities and commodity indices are starting to recover (see the second chart of the week below).

EM USD debt funds and ETFs back in favour

By late February, oil futures rose sharply on reports of a possible production freeze, investors’ global economic fears declined slightly after China lowered its reserve requirement for that nation’s banks, and DM and EM equity markets continue to rally. And with this, investors began once again testing the waters of EM hard currency debt ETFs, injecting a net $162 million for the fund-flows week ended February 24 and a net $213 million for the week ended March 2 in a move back to riskier assets. While a two-week net-inflows period does not make a trend, it suggests that appetite for larger yields and capital gains potential, given widening spreads, is coming back.

Catalysts for the recovery

In January, stock market investors were cheered by the prospect of US interest rates rising at a slower pace and by the Japanese move, which followed the similarly aggressive precedent set by the European Central Bank in June 2014. The negative rate is designed to encourage commercial banks to use excess reserves – which they normally keep with the central bank – to lend to businesses instead. Then an unexpectedly high February CPI inflation data came in. It changed a lot of market assessment, forcing a rethink of market assumptions. That started a new slew of green shoots, presaging a new spring season for many risky assets. The February inflation data was a game-changer – it started the “short squeeze”.

Then a better than expected ISM print gave even more momentum to the rally. The ISM index came in way stronger than expected (49.5) and almost printed above 50. Risk assets (equities, commodities) have very high correlation with the ISM Index. Improvement in the ISM and base metals went together, and subsequently equities followed suit. These developments were encapsulated in the Citi Economic Surprise Index which had been rising sharply in the past 6 weeks. The US jobs report this week further confirmed the bullish case. U.S. stocks soared to a two-month high , following the US blowout jobs report, with the S&P 500 passing 2,000 again as it looks on track to end the week above this key support level. Emerging market equities are even more impressive, as China’s equity markets caught a bid on government intervention to support the domestic equity markets.

Will the recovery last?

The big question is this: will this last? The world’s markets are rallying nicely as the U.S. enjoys improving data and China looks set to implement stimulus to forestall further growth deterioration. But inflation remains the ultimate test and goal. The world’s central banks are trying everything, even negative interest rates, to battle disinflation (and promote a little bit of inflation), but while the investment markets don’t seem to think anything is working, economic data suggests that we’re on the cusp of inflation beginning, at least in the U.S. We believe that positive jobs and wages data are a sign that inflation — the current gold standard for economic recovery — may be right around the corner. The Fed’s latest Beige Book indicated that wage pressures are escalating, which of course a prerequisite for inflation to catch a foothold. The primary cause for disinflation – falling energy prices – might disappear soon. Oil prices might be on the path to recovery as investors have been rewarding major oil giants for cutting their capital expenditures plans for this year, which will help limit oil output, requisite to higher prices. With stable oil prices, rising cost of services will be instrumental in pushing CPI inflation in the US. This should go a long way in assuaging the deflationary impulse which has been the immediate cause of the bad market sentiment for risk assets in the past few months.

There is a broad confluence of fundamental factors which brought on this recovery, but like in any extreme short-squeeze, prices have gone up sharply in a short time. We believe that after this initial impulse, prices will rationalize so there should be opportunities to catch the next up-wave at lower levels, perhaps in a few weeks. In our view, that will be the optimal time to take action.

Commodities and Economic Highlights
Commentary by Robert Balan, Chief Market Strategist and Sammer Khatlan, Oil Analyst

OPEC Watch: Saudi Arabia ready and able to play the long game

The fall in Saudi’s total foreign assets has been well-documented. Since its peak in August 2014 of ~$746bn, reserves have dropped by an average of ~$8.5bn per month and a total of ~$144bn to January’s $602bn mark. Low oil prices do hurt; Saudi is dependent on the petrochemical industry for 90% of its budget revenue and the low crude price environment has seen Riyadh amass a budget deficit of nearly 20% of its GDP. However, despite the significant drop in income, Saudi’s spending did not slow last year. Lavish public sector-wages, large-scale infrastructure projects and significant subsidies on power, fuel and other consumer goods have been features of Riyadh’s increased spending. The new king, Salman, has also been pursuing a more active foreign policy, with the nation’s defence budget rising by 17% to $80.8bn, becoming the 4th biggest military spender in the world.

Last week, Saudi Arabia was reported to have asked banks to discuss providing it with a major international loan. This could total around $10 billion dollars and would represent the first significant foreign borrowing by the government in over a decade. This invitation combined with a rising deficit, falling foreign assets and increased spending has led commentators to make pessimistic predictions about the kingdom’s financial health. With US shale still persevering in the face of the Gulf-OPEC market share strategy, many analysts and agencies believe the writing is on the wall for Riyadh. However we feel this is too simplistic – the economic situation is far more complex and arguably far less ominous.

Saudi, unlike many of its OPEC peers, used the era of +$100/bbl oil to pay its own debts. As crude prices fell in 2014, Saudi had one of the lowest debt levels in the world, reaching 2% of GDP at the end of that year. Of course, it also garnered a huge stockpile of forex reserves. This allowed Saudi to embark on its market share strategy as it would have considerable room to navigate the adjustment of lower oil prices in a more temperate manner than its OPEC peers: in order to sustain domestic demand, Saudi could run down its sizeable reserves and like last year, issue debt on its national market.

Riyadh did not blindly spend its forex reserves. The Saudi Arabian Monetary Agency (SAMA) transferred $71bn of the $72.8bn of net assets into less volatile and lower risk products. This was overlooked by the IMF and many commentators as they continued to write predictions of Saudi’s bankruptcy. Moreover, the government began a wave of departmental and ministerial budget cuts in addition to tightening the management of its finances in 2015. Infrastructure spending has been reviewed, resulting in the prioritisation of key long term projects over those deemed unessential: for example, the metros of Riyadh and Jeddah have been extended whilst the construction of new sporting stadiums have been postponed.

Saudi’s long term strategy to diversify is also well underway: several key industries continue to be of focus for development such as mining, automobiles, plastic and pharmaceuticals. The kingdom’s financial sector is also in a stronger position than most would assume, with a consistently low rate of non-performing loans whilst bank reserves remain high. In the summer of 2015, Saudi also opened up its stock exchange, the Tadawul, to foreigners (and flows of foreign capital) for the first time in its history.

Saudi will seek to lower its budget deficit in spite of the collapse in oil prices – certainly, diversification is needed in the long term to maintain sufficient levels of available liquidity for private sector loans but the decision to issue domestic bonds helps in the immediate term. Tapping the international bond markets is another sensible move – this can help fund government spending without falling back on the absorption of bank liquidity.

It is worth noting that Saudi has weathered similar economic storms in the past, even more severe ones, and survived. The recession of the 1980s and 1990s, saw far greater fiscal challenges than today’s situation (for example cash reserves were only 25% of GDP versus 100% in 2014). Moreover, its budget deficit climbed to its highest level of 77% in 1991 but the economy prevailed. We feel that 2016 is make-or-break for the oil market; something will need to give. The market share strategy is producing results as key upstream non-OPEC operations are squeezed or written-off and as US shale approaches the spring redetermination period with falling production, significant capex cuts and severe corporate financial distress. A move into the international debt market does not indicate the raising of a white flag by Saudi: given the state of oil reserves accumulated during the oil boom and the financial steps taken in last 18 months, bankruptcy is not on the cards for Saudi Arabia. It is strapped in and ready for the last rounds of the bout.

How far will the zinc rally go?

Zinc prices rallied by roughly 25% in the weeks after reaching a low of $1,445 per ton on January 12, this year, which certifies that the zinc market has entered a bull market. There are reasons why zinc prices are rallying now – and primarily it has to do with the fact that global production growth is significantly slowing remarkably, driven by the combination of permanent mine closures last year such as Century, mines in Inner Mongolia, and production cuts announced by Glencore and Nystar. It is now apparent that supply and demand balance is tightening, reflecting those stronger supply fundamentals, which are now a source of support for prices. Proof of the tightening supply: zinc treatment charges (TCs - fees paid by miners to smelters to turn concentrate into finished metal) - have fallen sharply in recent months. In January TCs reached a one-year low of $135 per ton, down 36% from their peak of $210 per ton in June last year.

The other support comes from the demand side. The global automotive market, which is a large source of demand for zinc, remains robust, on net. China has been a strong source of demand, as Chinese car sales continue to boom. The market was up 9% year-on-year in January after rising 13.4% in the Q4 2015 from the corresponding period of last year. Car sales have taken off since the Chinese government implemented a tax cut last October which has boosted buying sentiment and should continue to do so for the rest of the year. European car sales also rose 6.3% in January from last year after increasing 9.3% in 2015, supported by strong demand from the southern peripheral countries. The US was also a source of demand – US car sales jumped 5.7% in 2015 to a record, but auto sales fell slightly 0.3% in January year-to-date, partly due to the snowstorm at that time.

The latest data from the International Lead and Zinc Study Group (ILZSG) captures the trend of tightening being seen in the supply and demand balance in the last quarter of 2015. The ILZSG estimates that the zinc market recorded a deficit of 25,400 tons in December, followed by a deficit of 20,000 tons in November and 38,100 tons in October, after having shown a surplus of 206,500 tons in the first nine months of 2015. Nonetheless, the zinc market posted a surplus of 123,000 tons in 2015. But after seeing concrete evidence of tightness in the physical market in the latest months of last year, zinc investors have turned more optimistic regarding the supply and demand balance of the zinc market.

This redounds to improved investor sentiment which is reflected by the recent increase in net long speculative positions on the LME. The latest LME statistics show that the net speculative length, which was 36,745 lots as of November 2015 rose to 39,287 lots on February 26. It is noteworthy remembering that money managers were net short of 2,542 lots by November 6 last year, suggesting an extremely bearish sentiment then. While investor sentiment has improved since then, it is also worthy to note that the current net speculative length remains well below its high of 99,251 lots seen in May last year. This tells us that there is still room for a further improvement in speculative positioning, which could remain the source of bullish impulse over the next few months at least.

There still are bearish factors in the zinc market, which could slow or even halt spot prices from rallying above $2,200 price levels. Global economic growth, notably in China which show continue to experience an ongoing slowdown in its economy this year, may fail to pick up speed in H2 2-16 as we expect. China is showing further signs of deterioration in its manufacturing sector. The official manufacturing PMI came in at 49 in February, down from 49.4 in January while the Caixin manufacturing PMI slipped to 48 from 48.4 from January. Those disappointing numbers could have been due to seasonal effects as consequence of the Chinese New year. However, the recent decision of the PBOC to cut the reserve requirement ratio for a fifth time by 50 basis points to 17% shows that the authorities are determined to check the deterioration of domestic economic conditions. The slowdown in China is a big concern because the country represents about 50% of global demand for zinc.

Therefore zinc prices could strengthen over the next few months, and will be principally driven by improving investor sentiment. And if it does come to pass that global economic conditions will improve by H2 2016 as we expect, the current still high level of apparent inventory, which could cap zinc prices below $2,200, will not matter much – we expect zinc, and the rest of the base metals to outperform in the commodity space during H2 2016.

Charts of the week: EM assets and commodities; resource companies and commodities devastated by USD rise since 2014

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Last update on January 12, 2015