Posted on 14 September 2011 | 2 responses
The OECD’s latest leading indicators present a sombre image of world growth – perhaps the best that can be said of them is that China looks to be shaking off the malaise that accompanied its recent attempts to rein in credit growth.
Looking first to the broadest of measures, the OECD plus six, while it remains above 100 and therefore signalling global expansion, the wind has clearly come out of the world’s economic sails. Turning to the rate of change in the leading indicator to get a sense of the momentum in growth, we see that it too is signalling that things are likely to get worse before they get better. There are no signs of finding a floor as yet, rather if anything it the pace of the decline is accelerating.
A quick survey of the CLI’s for the US and the Eurozone shows that it is these regions that are leading the slowdown – with at least the Eurozone likely to tip into contraction before the end of 2011.
Perhaps more encouraging for commodity exporters, the composite leading indicator for China looks like it may be making small steps towards pushing higher with the rate of change in the indicator starting to claw its way back up. If 2010 is any guide, then perhaps the Chinese construction machine has returned to the building site once more.
Posted on 13 September 2011 | 6 responses
Since the new world order was heralded in by the market naves in March 2009, the commodities complex has been broadly trumpeting the same tune. Whether it’s been due to the destruction of fiat money or the creation of lots of real demand, the trend across most commodity classes has been firmly up.
But the recent ructions in global markets are threatening to derail these broadly held beliefs. Following is a chart of daily copper price with the gold price mapped against it. Note that while copper peaked in early 2011, the gold price has kept pushing to new highs. This perhaps reflects the disconnect between the primal movers for these assets. While copper is expected to preserve it’s value in real terms (the destruction of money meme) – there’s no getting away from the fact that it is an industrial commodity. Gold on the other hand is almost purely a speculative asset – meaning that it is only worth what the marginal buyer is convinced its worth – it has little utility value.
So with the tailwinds from global stimulus nothing but a sweet memory, and the threat to the world order alternating between debt concerns in Europe and the US, and with China pursuing its very own debt funded growth model, maybe it’s not so surprising that copper has been weak. The question is really whether this weakness is a precursor to a deeper correction.
Notably this weakness is broadly matched by declines in the oil price and industrial commodities more generally.
Turning back to gold, it makes you wonder as to whether it can sustain its price strength if the rest of the market is crumpling around it. Certainly, should copper track lower the copper to gold ratio would be plumbing new depths in the absence of a similar move by gold.
Posted on 13 September 2011 | 2 responses
The European crisis of confidence continues to undermine world markets. Looking at breadth measures in the US equity markets, there is still no signs that selling has reached its climax. If anything, the weakness remains very widely spread.
From a valuation perspective, it is likely that this widespread weakness is throwing up opportunities to accumulate specific stocks. But until we start to see market breadth strengthen into weakness, the odds remain with the bears for the broader indices. Watch for government intervention in some form or another as the most likely catalyst for a rebound when the time comes.
Posted on 8 September 2011 | No responses
It may be premature to be talking inflation – as the odds of the sovereign credit bust taking us through another deflationary downdraft are pretty good. Still it is sensible to keep a weather eye on the inflationary indicators that may matter. If you believe in the theory that says inflation is likely to arrive in the developed world on a fast boat from Asia, then one obvious indicator to watch is the price of goods from China. In this context, this research by the New York Fed (click here) is well worth a read.
The logic goes that while China accounts for just over 20% of non-oil imports into the US, it is the marginal price setter in key sectors that determine prices for commodities as well as consumer goods. The import prices of goods from China since 1997 is illustrated in the following chart:
It’s notable that import prices trended down across the period – until the RMB was allowed to start appreciating against the USD (that’s the light blue line in the chart). From 2005, the prices of industrial supplies have taken off as these are more sensitive to movements in underlying commodity prices. Note too, that while the RMB has been permitted to appreciate by 20% from 2005 to 2009, consumer prices were only up 7%.
But from mid-2009 onwards, consumer prices have kept pace with the exchange rate:
And perhaps the most obvious catalyst are the rising labor costs in China:
This of course must happen if the root cause of the trade imbalance between China and the US is to be addressed – that is Chinese living standards have to rise relative to the West. Rising wages are also necessary if Chinese consumption is going to rise as a percentage of GDP.
It’s just that the risk is that with all this loose money floating around, the compounding effects of rapidly rising Chinese unit labor costs could get out of hand pretty quickly. It mightn’t be a problem for today, be it is a reasonably likely scenario for tomorrow.
Posted on 5 September 2011 | 2 responses
Spent too much of my weekend scraping and reshaping data – all in the cause of stepping aboard the Val Harian holodeck. One (relatively) interesting by-product is the following chart – that attempts to get a sense of the valuation of Australian equities as adjudged by consensus earnings estimates. A green colour has the respective company trading at a higher PE than the market average – vice versa for the red.
A couple of observations from this:
1) The weighted average PE at 10.4x is materially lower than trailing~11.5x that the market is currently trading around (very rubbery figures – but it’s order of magnitude we are looking at). Taken at face value, the difference implies around 10% EPS growth for the 2012 financial year.
2) It’s notable that the materials sector is generally trading under the average while the energy sector sits on the other side. What is this saying about demand for iron ore and coal?
3) Traditionally, Australian banks have traded at a premium to their global peers and have compared favourably to other defensively oriented stocks in the local market. So while we might reasonably expect consumer staples to attract a higher multiple, the fact that utilities are being favoured to banks (relative to earnings estimates at least) is an interesting outcome in this low interest rate environment.
Back to the data grindstone…
Posted on 1 September 2011 | 1 response
The following chart throws up some interesting questions about the Chinese growth engine. In this we are looking at the relative performance of the Shanghai Composite as against commodities prices (as broadly mapped by the CRB index):
So Chinese equities were first to accelerate out of the GFC lows fired up as they were by the sizeable fiscal stimulus that was directed particularly at infrastructure expenditure. Equities ran hard and fast peaking in early August 2009.
Meanwhile commodity prices themselves didn’t bottom until March 2009. And while they responded to the Chinese stockpiling that was conspicuous through to late 2009, prices themselves were relatively restrained in their appreciation. Until expectations of QE2 began to surface that is. From the correction lows in mid-2010, commodities prices have been on a tear.
For mine, this latter leg in commodity prices has been a investor driven phenomenon – whether it’s a response to the supercycle story or the fear of the failure of paper money. I’ve slotted the Baltic Dry Index into the background – as an admittedly flawed indicator of Chinese demand for bulk commodities – as it seems to make the same point.
Putting aside the issue of what factors have driven commodity prices higher, the fact remains that Chinese equities have been in a relative downtrend ever since the middle of 2009. The obvious conclusion is that higher commodity prices are bad for a infrastructure-build driven GDP. Is this exposing a key flaw in the Chinese growth model – that the more (debt-funded) investment is plowed into infrastructure, the higher commodities prices are driven and the larger the problem when this model is brought to its inevitable end?
It’s a valid question – as when we look inside the relative sector performance of Chinese equities since the beginning of 2009 we see that it is the energy and materials sectors that have been ‘holding up’ the composite index – or put another way, it is the financials in particular that have been hanging heavy around the neck of the Chinese equities markets. Are the financials hinting at what is to come?
Posted on 30 August 2011 | 1 response
In this 5 minute TED talk, psychologist Dan Ariely ruminates on the way that conflicts of interest encroach on even the best of intentions. It’s an issue that is endemic to the world of finance - and an area where communication technologies can assist. Let me explain by first referencing a simplistic model of how the investment world works.
In this model there are three moving parts, going through these we can start to see how the conflicts emerge and where the opportunity to create an alternative point of view may reside.
So we have Earnings – the elemental building blocks of any investment. Into this balloon is grouped everything that drives the fundamental earnings of individual companies – it’s a rich interplay between interest rates, inflation, demographics, innovation, legal process, tax treatments etc. The net result is a single number that defines the return on any investment. Needless to say, when we extrapolate this number into the future, the resulting ‘forecast’ earnings can be plagued with uncertainty – this is a big part of the risk bit of any investment.
Flows determine arguably the cleanest dataset in the capitalist world – price. Through the process of buying and selling an asset, good or service, a clearing price is set. And while prices can be distorted by fair means or foul, they can also be directly measured, compared and analysed. Price is the clearest expression of the herd as regards expectations for Earnings – so while interpretation of movements in flows and prices may be subjective, the underlying data is not.
The net outcome of flows is Valuation. It is the amount that the market is prepared to pay for the expected earnings on an investment – and is a result of the demand and supply of that investment on the market. Note that unlike earnings or flows, valuation is a derived, it is not directly observable as a distinct element in its own right. The implied valuation of an investment may change according to movements in its price but it is uncertain as to whether this is a result of changes in investor’s risk preferences, earnings expectations or some completely unrelated factor.
Circling back, how does this help addressing conflicts of interest in finance? Taking a leaf out of Dan’s book, we can use the model to take the first step and recognise what the conflict looks like. Then once we understand where the conflict emanates from we can look at alternatives that do not suffer from the essential conflicts or may help to address them.
So what does the conflict look like? There are a essentially two issues here:
1) Access to information – As we have seen, in order for investors to be derive informed views about earnings expectations and how the market is pricing these, they must have easy access to the information. The accessibility to information varies by country and market – for example in the US, information is relatively more mobile than in the UK or Australia. In these latter jurisdictions, some market platforms are conflicted by a profit motive which leads to asymmetric distribution of information.
2) Alignment of interests - The majority of people do not have the time nor expertise to directly manage their on-market investments – they require assistance. The conflict arises from within that the industry structure that has grown to provide this expertise. The issue is one of alignment with the end investor.
Typically, an analysis of the investment industry conflict will look to the remuneration structure of financial planners – but the issue is much broader than that. A quick example from my own experience might illustrate (ie. if I’m pointing a finger at anyone, it is at myself).
Let’s take a look at valuation. An investment banker when structuring a new investment offering looks to relative prices to determine valuations. The thing that really matters is whether this investment compares favourably to the rest of the market. Any such valuation is based on my expectations for earnings and how the market will price those earnings into the future. Remember I get paid to sell you this investment, not to make sure it performs according to my forecasts.
Now we could similarly look at how funds management is a relative business, or how independent research companies are compromised by their remuneration structures, the point is that there are few mechanisms that promote the alignment of participants with the interests of investors.
So how can information technologies assist? In short, through promoting accountability and by enabling the establishment of a truly aligned research and analysis model.
Make information more freely available
In an age where data is mobile at negligible cost, there should be no material impediment to allowing market data to move freely. We should be able to analyse flows as well as price and integrate analysis of economic data and other variables with relative ease.
In short, there is a public good to ensuring information is made widely available to all. It is one way that artificial distortions in price can be addressed. The extraction of monopoly profits for ‘ownership’ of such market information is clear evidence of undue influence by established interests. This is the simplest conflict of interest that can be addressed.
Encourage people to become more independent
Communication technologies are leading to a rapid evolution in the approach to education through online resources. The increasing sophistication of video tutorials and interactive real-world examples opens the way for real alternatives to be developed that will enable those that have the desire to increase their expertise when it comes to the finance sector. This is another way of promoting greater accountability.
Encourage truly independent analysis
Cheaper and more efficient communication can also assist by establishing alternatives for accessing research and analysis from within the current investment industry structure. Social media technologies offer the scale for more ‘aligned’ solutions to become viable. For example, there is the opportunity to establish an alternative research and analysis model that is not subject to conflicts because it is not reliant on income from those that sell goods and services for its survival. For those investors that require assistance, there is at least one truly independent source of research and analysis.
The emergence of product-comparison and swarm-purchasing-power sites is but the start of a move towards shifting more power to the consumer. As the technological blow torch gets applied to more information based industries, the likelihood is that those that rely on the current industry structure to protect their franchises will be challenged. I’m hoping the initiative we are working on will be part of the new landscape…
Posted on 15 August 2011 | 1 response
Perhaps it’s a function of being a resident of the deep south (hat-tip to all Tasmanians), but the view from the world’s shoelaces is currently dominated by China and it’s demand for commodities. As we noted in last week’s post, it looks suspiciously like China has loosened its monetary stance in response to the softening economic conditions. Add to that we have passed through the seasonally low PMI months, and perhaps it’d be reasonable to suggest that ‘China’ is a buy around these levels.
It’s just that the charts don’t support this view. In fact looking through the commodity complex and those stocks that are most exposed to its demeanour, there is a real sense that further weakness is on the horizon. A simple indicator to gauge this view is the Chinese equity market.
The point that is being highlighted is that if equities are to make a bottom around here, history would suggest that the recent low would at least be retested over the coming months. This makes some intuitive sense given the level of uncertainty that has arisen. Without direct government action, we can expect this uncertainty to translate into weaker longs selling into spikes in nervousness. At least this type of scenario might give the RSI a chance to recover even as the price goes lower…
Posted on 12 August 2011 | 2 responses
Watching the panic pervade our market this week I was sorely tempted to pick up a few large cap stocks that were pushing pre-tax dividend yields of ~15%. In hindsight it might have been opportune to do so. Yet, I’m of the view that we haven’t seen the full extent of this unwind.
Exhibit 1 – The downdraft has been accompanied by high volumes. It could be argued that this is capitulation by the weaker hands, but for mine we haven’t traded low enough to attract ‘value investors’ (witness Jeremy Grantham’s latest tome – S&P 950). Rather the volume selling suggests that this selloff is different relative to last year’s correction.
Note too, that momentum is still reeling from the severity of the fall. Given the damage done to confidence and level of uncertainty in the market, it is likely that we will at least revisit the recent lows. Watch to see how the MACD responds should this eventuate.
Exhibit 2 – An old favourite, the McClellan Oscillator that measures market breadth has completely broken down. Again, we’d expect to see a divergence in this indicator when investors are starting to accumulate on market weakness:
At the risk of repeating myself, the playbook we’re following is one where we take our lead from government stimulus. Negative real interest rates are not sufficient in a deleveraging market. That is why QE3 in whatever disguise is more likely than not and also why Japan, the UK and any other sovereign state with their hand still on the monetary tiller will follow suit. In the absence of fresh stimulus we’ll wait for signs that the market has exhausted it’s selling impetus before leaping into the void.
Posted on 11 August 2011 | 2 responses
The Chinese economy will not experience a “double-dip” nor big fluctuations, and the government is capable and confident of keeping steady and relatively fast growth in the long-run, an official said Tuesday.
Or so said Xinhua, the government run media organisation last week (here). This view has been supported by recent data released by the National Bureau of Statistics showing that industrial activity had cooled to a still strong 14.0% annualised rate in July and that fixed asset investment was still climbing, with residential construction investment up 36.4% compared to the same period last year.
Perhaps it is for this reason that the headlines remain focussed on inflation (here – CPI was up again to 6.5% in July with PPI even higher at 7.5%). The rise in consumer prices was driven by a 14.8% increase in food costs – though officials believe inflation has peaked:
Zhou Wangjun, vice director of the National Development and Reform Commission’s pricing department, reiterated that the current round of inflation is approaching a turning point after rising 25 months, and price rises will likely ease for the rest of the year.
Taken at face value this would suggest that there aren’t further interest rate hikes on the agenda – though it’s notable that Zhou Wangjun warned of a “big possibility that the United State will introduce a third round of quantitative easing policy to repay debt and boost economic growth, which may push up prices of international commodities and increase pressure of imported inflation.”
Manufacturing data suggests economy is slowing
In contrast, the latest manufacturing survey compiled by Markit (here) is suggesting that this sector of the economy is now contracting:
They note that these results are consistent with recent electricity consumption trends:
Looking to the OECD’s Composite Leading Indicator, that lags Markit’s PMI data by a month, it seems to confirm that China’s industrial production has been slowing.
A reading below 100.0 in June is indicative of a mild contraction. Note too that the current reading in the CLI is lower than that recorded in mid-2010. This would all seem to confirm that the manufacturing sector in China has indeed been struggling under the tighter money policy of China’s central bank.
Monetary constraints have been eased
China’s economic cycle has tended to be a little ahead of the developed world over recent years, perhaps this pattern is about to be repeated? Notably, it appears that money conditions have eased over recent weeks as evidenced by falling short term interest rates in China (following is a chart of the overnight Shibor rate):
It is perhaps for this reason that the authorities are more hopeful that economic activity is set to stabilise. Looking to the rate of change in the OECD’s leading indicator, there is the suggestion that the pace of the contraction had been easing going into July.
Infrastructure investment has been critical to maintaining China’s growth since the global debt deleveraging collapse began in 2007. For good or ill, it looks like China remains bound to this model for the forseeable future. With money conditions easing and the rapid growth of yuan denominated debt issuance out of Hong Kong, it may be that China has set the stage for another round of construction driven spending to stimulate economic growth. In any event, we will continue to watch the evolution of liquidity in China for clues as to the direction of its economy.