Marcuard's Market update by GaveKal Dragonomics
The commodity boom of the past decade had all the hallmarks of a typical bubble: massive retail participation (through ETFs, mutual funds etc…), large pension fund involvement, a widespread belief that ‘this time, things were different’ and that a ‘commodity super-cycle’ was unfolding.
But like all bubbles, this one too has come to an end. There were plenty of potential triggers in the shape of (i) the Federal Reserve’s decision to stop printing money; (ii) China’s slowdown and associated anti-corruption drive which means that managers at state firms have no incentive to bid up commodity-producing assets; (iii) China capitalising on Russia’s isolated geopolitical situation to turn itself from a ‘price-taker’ in energy markets to a ‘price-setter’ or (iv) the Saudis realising that the only way to keep Iran and Russia in their respective boxes was to squeeze both nations financially… Whatever the catalyst for the bubble’s implosion, it was undeniably the key financial event of 2014. An event which will likely cast a long shadow over 2015.
The first point is that lower commodity prices, especially for energy, keeps money in consumers’ pockets instead of directing it towards state coffers in the likes of Russia, Venezuela, Saudi Arabia and Nigeria. In this respect, the implosion of the commodity bubble should be welcomed. That said, for most investors, the coming quarters will mostly be about dealing with the fall-out of the commodity bubble implosion. Specifically:
– Wider spreads: After touching a low of 5.2% in the summer, yields on US junk-bonds started to creep up in the face of collapsing oil prices. As oil went into free fall in late November, yields jumped to 7%, only to pull back to 6.2% in the (thinly traded) closing sessions of the year (window dressing anyone?). The greater volatility in the high-yield corporate bond market will probably mean that in 2015 most companies will face a significantly higher cost of funding than in 2013 and 2014. All else being equal, this should logically equate to less share-buybacks, reduced mergers and acquisition activity, and lower capital spending by companies.
– Buybacks, M&A or capex: Which is most at risk? All else is hardly ever equal. And so while wider spreads may negatively impact corporate behaviour, the improvement in consumers’ disposable income, resulting from lower commodity prices, could provide an offsetting boost to corporate animal spirits, at least in Asia and the OECD. Hence, capital spending could still put in a decent performance in 2015.
– Impact on margins: Lower commodity prices should be good news for corporate margins, at least across Asia and the OECD. However, margins in a number of countries (especially the US) are already close to record highs, begging the question of how much further they can expand—especially if companies start to face higher interest bills, combined with a pick-up in capital spending.
– Impact on bank lending: the implosion of bubbles tends to be fundamentally deflationary since capital gets written off and assets must move from ‘weak/levered hands’ towards ‘strong/cash-flow positive hands’ (and such moves only occur at much lower prices). In turn, this begs the question of how much of the bubble was financed by banks? It would seem that the answer is ‘directly, not so much’. The bigger question is how much was financed ‘indirectly’, i.e., how exposed are banks to Russia, Brazil, Nigeria, Kazakhstan and other economies where activity is sinking fast in the wake of weaker commodity prices? The relative performance of bank shares over the last six months indicates that eurozone lenders are especially exposed.
– How will central banks react to the latest deflationary wave? Central banks could easily brush off the deflationary impact of the commodity bubble’s implosion as ‘good deflation’. To some extent, this is the path that the Fed seems to be taking, leading to an increased likelihood of rate hikes by June (if only to get rates ‘off the floor’). By contrast, investors expect the European Central Bank to embrace quantitative easing at its January meeting—an injection of liquidity which makes sense if European banks really are the most exposed to the indirect effects of the imploding commodity bubble.
In any event, reviewing the above, it seems obvious that the investment environment today is markedly different from six months ago. Back then, ever-tighter spreads, a very loose Fed, and record high profit margins meant that investors were happy to pay expanding multiples for US equities. Today, wider spreads, the possibility of a slowdown in bank loans, a Fed that is no longer pressing on the gas, and the uncertainty surrounding margins should curtail the willingness of investors to pay-up for growth. Instead, investors will likely look for the cushioning that comes from investing in more undervalued assets. Perhaps this explains why China is the one major market which, against most predictions of a serious economic cataclysm, has managed to outperform all other markets in the past six months.