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?

In any event, the strength in markets gives us reason to test our assumptions – cause based on these, our expectation is that we will experience a reasonable correction as we head into the end of QE2.  Last weeks selloff did not tick this box.

So how to characterise the information flow over recent weeks:

1) The economic growth cycle looks to be peaking – per OECD leading indicators (here) – this is consistent with a tightening of money in China and the final wave of stimulatory action in the US.

2) But, more importantly, monetary stimulus stepped up a notch with the response of the Japanese authorities. Perhaps there is a growing consensus that more monetary stimulus is inevitable – whether as part of the refinancing of the European periphery or by the US itself.

If it is expectations about more monetary stimulus driving the recent price action, then this should be reflected in a relative outperformance of real assets – think precious metals, energy and commodities in general – versus financial assets – bonds of all ilks and defensive equities. As a quick proxy consider the outperformance of the CRB against LQD since the Jackson Hole speech:

The CRB has certainly bounced hard over the last week and may yet retest its highs. And while we are here, we can push a little further down the risk curve via the relative performance of JNK as against LQD:

On the face of it, JNK does seem to do pretty well for itself when the Fed is actively buying securities. It too has enjoyed a steepling bounce recently though is short of its highs.

Also, those currencies that are home to the QE stimulus efforts should underperform.

It’s clear that Gold, as measured against US dollars, has barely stopped for breath as it has ridden the easy money train. The ‘hard asset’ Australian dollar may not have kept pace, but has certainly benefited from trade. While the carry trade pair of choice, borrowing in Japanese Yen to buy the AUD has been flatlining since the risk selloff last April.

Zooming in to the period since Bernanke visited Jackson hole the same trends prevail – XAUUSD beats AUDUSD that beats AUDJPY. And on even closer inspection, the same trends are replicated over the recent bounce. These charts seem to indicate that it is the US in particular that is driving the appreciation of real assets.

Conclusion

Recent price action suggests that capital flows have taken on some of the character of a flight from easy money – and particularly the US variety. Whether this is the moment when the ‘governments are debasing our currencies’ meme goes mainstream is beyond my reckoning.  If it is, then we can expect gold to lead real assets in a substantial spike higher.

Probably more likely though is that this thesis needs further testing – for example, as the expiry date for QE2 draws closer and the debate about further QE rises to the fore, then uncertainty should creep into the equation. It is for this reason that we remain under our target weighting in gold and energy in particular. We continue to expect volatility across risk markets as the first half of 2011 draws to a close.  Hang tight.

Postscript – Bruce Krasting at Zero Hedge succinctly looks at the question of ‘measuring the success of QE2′ (here)

Market indicators

1) The USD is rallying – and the CRB has rolled over

With at least the juiciest dishes on the commodities smorgasbord priced in USD, the recent strength in the greenback will hurt commodities. Demand may have become more price inelastic than in earlier years, but with the CRB breaking its recent support expect further weakness to come.

2) China stockmarkets and the Baltic Dry Index are also soft

If the BDI is a reasonable indicator of bulk commodity demand, then it’s hinting at weakness.  Similarly, if China has lead the global recovery, the relative underperformance of its stock markets suggest that something is amiss.

Put these together and you get a near term picture suggesting lower commodity prices are on the way.

Economic indicators

1) Leading indicators – as we noted here, it looks suspiciously like the OECD CLI is marking out a turn.  This indicator has a reasonable track record in forecasting industrial production.

As Albert Edwards pointed out (analysed in “Leading indicators as buy/sell indicators for equities markets” here) – the lesson from the Japanese experience of the 90′s was to sell the rally when the stimulus was removed.  With the US and China both applying their own versions of the withdrawal method (though we note that Japan is still pumping away as furiously as ever) now is that time .

2) Purchasing Manager Surveys – Quite apart from the decline in China’s PMI (discussed here) – consider what these charts are saying:

As with many market signals in recent times, the bounce back in the steel price has been unusual as it has not yet been accompanied by supply constraints. In the context of a slowing in new orders growth (as might be expected if the OECD CLI were reading the pulse correctly) this inconsistently looks even weirder.   (See here for Markit’s steel report.)

The disconnect between price and supply is even stronger in the copper market.  You could reasonably argue that the market is anticipating shortages to come as the new orders are stronger in this metal with only the US looking like turning weaker.  Note however the new order to inventory ratio (not shown – go to Markit’s report here for further charts) is falling, suggesting speculative balances are on the rise.

Finally, aluminium too has seen its price run ahead of supply.  Same picture as copper for the new orders too and (would you believe it?) the new orders to inventory has also turned down suggesting at the very least a cap on prices to come. (Full Markit report here.)

Conclusion:

Short term – the odds are for a pullback in prices.  Whether this develops into something deeper depends to a large degree on how China’s demand is impacted by tightening in liquidity and more generally, how the US-China trade tensions are resolved. Even given a negative shock to China’s demand, the longer term picture remains favourable. This is not only because industrialisation will inevitably continue in China and India but the ultimate effect of money printing by the developed world will be debasement of paper relative to hard assets.

Buy the dip – and load up if there’s a deeper correction.

While the CRB did so early last week.

It is notable that the CRB made a low at the same time as the S&P500, while the BDI did so a week later. Not sure what that means. Could be the BDI is losing it’s touch. Or that the transportation sector is not as confident about the state of things.

Also, looking to the performance of the Shanghai Index:

If not as energetic a bounce, at least the Chinese market has found some legs in the face of the seemingly tighter credit conditions.

So what does it all mean?

Blogs like The Smart Money Tracker have been arguing that we are due for stage three of this cyclical rally. While White Magic & its Exposure makes a good case that whatever logic would suggest, the technicals are supportive of a strong push higher .

With prices rebounding strongly off their recent lows have to consider the alternative that equities can go on to make new highs. So while the fundamentals, don’t support it – if anything liquidity has peaked, broad money is still contracting, and the industrial production based leading indicators suggest that the global recovery may be topping – these may be yet to exert their pull.

Technically, we are about to enter the real resistance zone where any nervous longs may be anxious to sell.  The manner in which the S&P500 pushes through this resistance will say a lot about the market’s ability to go on an make new highs.

For the moment then it’s a market neutral position – though still with underweights in materials and financials while overweight in health care and staples.  Got a watching brief on the property and utilities sectors – think there may be opportunities amongst some of the recapitalised stocks but that is for another day.  It may hurt over the near term as risk appetite could go on a tear – but don’t like the risk/return of moving up the risk curve from here.

And if you really want to get inside the third leg – here is Rolf Harris and his timeless contribution to Elliot Wave Theory – Jake the Peg:

Leadership in the Australian market’s rally since March 2009 has come from financials and the materials sectors.  It was notable then that the recent high in the All Ordinaries was not matched by the financials.

XXJ was rejected off the longer term downtrend from the September 2007 peak while it has definitively broken the Mar-09 uptrend.  With the weekly MACD crossing over, expect further weakness in the sector.

Turning to the materials sector.  While that line from March remains unbroken, the trend is up. Yet there are signs of weakness that will be a worry to those with their Tonka trunks full of dirt.

Is that weekly MACD turning over?  Considering the weakness in the AUD and CAD – seems like something is afoot.  Both have broken their uptrends and have formed double tops…

And then there is the Baltic Dry Index – that peaked in November and has been dithering through January looking for direction – while the CRB has similarly pulled back from its January highs.

On balance, the current selloff has more legs.  Having pulled back in a hurry, we may pause for a smoko, but for mine the risks are to the downside with a test of the 200 day MA (XJO ~4350) the most likely scenario.