2016 Preview Part II: $US, China and Oil
From the January 31, 2016 HRA Journal: Issue 245-246
This is the second of three parts of the 2016 preview that appeared in HRA Journal Issue 245-246. This part deals with the outlook for the US Dollar, China and oil. The final section, dealing with several metals, will be issued shortly.
The $US: Still Tilting at the Windmill
Yes folks, it’s lonely in dollar bear land. I know there are others talking about “dollar collapse” but I’m not part of the perma-bear crowd that expects the global fiat currency regime to collapse. My views are more mundane and (I like to think) fact based.
I don’t expect the greenback to fall apart but I do think it’s topping. I don’t view this as something apocalyptic. On the contrary, reversing the upward trajectory of the USD will be good for everyone, including (perhaps especially) the US itself. The fact it would take a lot of pressure off commodities in general is a nice bonus.
The main reason the USD is expected to continue strengthening is widening interest rate differentials between the US and everyone else. If we accept the Fed’s comments and dot plots at face value we could expect four to six rate increases by the middle of next year.
The chart above shows the recent history of rate increases (colored lines) since the great recession. The grey lines trace later rate cuts as central bank after central bank backed off and lowered rates back towards, and in some cases below, zero.
I think the Fed is the least likely to reverse course but it’s equally unlikely it will raise rates more than a couple of times this year. We just had the first FOMC meeting since the rate increase and there was plenty of discussion about offshore risks and little wording that indicates its full steam ahead for rate increases.
Traders were disappointed with the meeting statement but it was about what I expected. There was never a chance of the Fed cutting rates this soon. What little credibility it has would be destroyed by that move. It does make the weak set of rate increases - one or perhaps two this year as implied by Fed funds futures—look much more likely.
If that is the outcome it won’t shock bond traders. The chart of the 2 year Treasury yield on this page makes their opinion clear. After the Fed rate increase the yield rose briefly then fell by over 0.4% since the start of 2016. So much for the Fed guiding rates higher.
Some of this is driven by oil prices that factor into inflation expectations. Those continue to fall along with market indices and commodity prices. I found it mind boggling to hear a couple of Fed governors wonder out loud if they might have underestimated the length, depth and impact of lower oil prices before the Fed meeting. Seriously?!
As the introductory editorial makes clear my base case for this year is a mild recession for the US and it may in fact be a couple of individual quarters of sub-zero growth that never gets officially classified as one.
This scenario means the growth differential between the US and the EU and Japan would be smaller than most currently assume. Real—inflation adjusted- growth rates are trickier but here too the spread may be much narrower.
Ironically it would not be narrower for “good” reasons. It seems highly likely both Japan and the EU will be suffering under deflation through the rest of this year, especially if oil prices don’t recover. If you have deflation it’s added to the nominal growth rate (i.e.—a one percent nominal growth rate with one percent deflation yields a two percent real growth rate). The math is about to get funny.
Both the ECB and the BoJ are fighting deflation (they apparently noticed it before the Fed). As this piece was being edited the BoJ announced it was moving to negative interest rates, charging banks 10 basis points for excess reserves on deposit. It joins three Euro area countries and the ECB itself that already have negative rates. One third of the bonds in Europe carry negative rates now, mostly at the short end of the curve. Monetary purists are horrified by the concept.
The US Fed wants to “normalize” rates but it’s tougher to do with other central banks cutting theirs. Janet Yellen and Company are not fools. They are well aware of the impact of a surging USD as much as they try to underplay it in news conferences. If Yellen could think of a way to jawbone the Dollar lower she would be doing it.
Do moves by other central banks make it tougher for the USD to complete topping process? Obviously yes, though increasing deflation in those areas will mute the impact of their rate cuts.
The US governing class has always had a strange relationship with the US currency. If you’re a US politician or other public figure you have to take the position you’re for a strong dollar, even if that position is patently stupid from a trade point of view.
The days of the US being the price maker and only game in town for a raft of products and sectors is long over. It’s a price taker now and its currency is squeezing margins across the board.
The bottom line here is that there are many reasons to expect a lower USD by year end. The question is whether it happens the easy way through traders closing long positions or the hard way through a surge that pushes the US into recession, followed by weakness later. I’m hoping for the former for everyone’s sake but both paths lead to the same destination, a weaker USD.
China. Here’s the thing:
Comments about metals on the following pages share some common assumptions. The loosest assumptions when it comes to base metals and bulk materials center on China.
No doubt about it. China is the 800 pound gorilla in the room when it comes to commodity demand. Much of the recent drop commodities can be blamed on fears that China’s slowdown is accelerating. It may well be though hard evidence - bear or bull—is hard to come by.
Bearishness increased after the latest round of yuan devaluation started. I said months ago China had little choice but to let its currency weaken. By the standards of most currency moves the Yuan hasn’t moved much but it’s spooking traders used to thinking of Beijing as having iron control of its markets.
It seems to be spooking Chinese nationals more. There is growing capital flight, much of it from Chinese getting money out or buying other currencies. China has no shortage of currency controls but the Chinese have always been gifted when it comes to finding work arounds.
The Bank of China has been expending foreign reserves at a furious pace to defend the Yuan. China greatly desires the status of reserve currency provider. That requires some stability in its currency. China’s foreign reserves are huge but the rate of shrinkage is getting alarming. More importantly, the trades the BoC must maintain to prop up its currency are effectively draining liquidity from its financial system.
Shroders recently generated an interesting chart, shown above, that compares central bank assets to GDP for several major countries. Many would be surprised at the size of the decrease in BoC assets. The steepest most recent drop is largely due to Yuan defense. Its “quantitative tightening” that is working against other measures like interest rate and bank reserve ratio cuts.
The official Q4 growth number came in at 6.8% and the 2015 annual growth was reported at 6.9%. There is more than a bit of skepticism about this rate in the West and I find it suspiciously close to government promises myself.
The real number? Good question. My best guess is around 6%, maybe a little higher. A growth rate most countries can’t dream of but lower than China has seen in decades.
No one really trusts government stats but Beijing does seem to be having success rebalancing its economy in favor of services which made up 50% of Chinese GDP for the first time in 2015. That means many of the old metrics like port traffic and electricity consumption are less useful. Some of the most bearish forecasts I’ve seen depend too much on these outdated metrics.
What IS true is that the shift in industries will generate a lot of creative (and not so creative) destruction. China may be at least partially command economy but there is plenty of “wild east” to it. When an idea gets hot Chinese businesses jump in with both feet. That means plenty of mal-investment that will take time to clean up. Lots of mom and pop steel mills going under, shipyards designed to build bulk carriers we’re up to our eyeballs with. The list goes on.
The transition won’t be painless and—as China perma-bears love to point out—there is a lot of debt piled up in China. A. Lot. That’s true but its true most places these days. I don’t want to sound like I’m underplaying the risk. There may be, indeed should be, many bankruptcies in China before the next couple of years are up.
We can only hope many of them are state owned enterprises. They are the epicentre of most mal-investment. I’m not confident the mandarins in Beijing will accept the loss of face inherent in writing off state enterprises. That’s the trouble with one party states; it’s harder to blame on the last guy.
China has announced ambitious plans to deal with all these SOE zombies. It also announced almost all of the state owned enterprises turned a “profit” in 2015. Its headline combinations like that which make traders skeptics.
China has slowed and its working to shift to a more service centered economy that relies on domestic rather than import demand. That plan is a long way from fruition however and China IS still growing at a high nominal rate. Industry rotation means less demand for metals but I think—in the case of metals we care about at least—we’re looking at slower demand growth rather than actual shrinkage. That might feel like shrinkage, especially for commodities that had the highest recent demand growth and supply response.
China is trying to put out fires on two separate fronts and that may not be possible. It’s trying to reassure investors and loosen fiscal policy to keep markets lubricated but at the same time it’s undertaking open market transactions to defend the Yuan that act as quantitative tightening. Something will have to give. Ham fisted interference in the equity markets already has traders offshore only believing Shanghai is trading freely when it drops.
There are growing calls for Beijing to try for a “one and done” solution to its currency, ripping off the bandage and cutting the Yuan’s value by 10% or 20%. I doubt the powers that be have the stomach for that but it’s an intriguing idea. Getting most (hopefully all) of the depreciation out of the way in one go would leave China with mountains of FX reserves to make the new level stick—if they can convince the market it really is a one shot deal.
While it might work it could make for some catastrophic market moves in the short term. I don’t think markets are in a position to handle that.
I think the Chinese economy will continue to slow and, as it’s still an export economy, worldwide slowing will generate further headwinds. That said, I still don’t see compelling evidence of a crash. Hollowing out of overbuilt industrial sectors will lead to weaker demand for several metals, with the bulks (coal, iron ore and perhaps aluminium) seeing the brunt of the weakness.
Demand for most base metals should continue to grow though at much lower levels than we’d like. There are a couple of major variables that will determine the growth rates. One is stimulus/planned spending by the Chinese government. If Beijing continues pushing to increase urbanization and moves aggressively on the Silk Road initiative. I think they will and that both will help underpin metals demand. Another will be domestic supply. If China really depreciates the Yuan that will cut costs for local miners (assuming Chinese smelters offer something close to international prices for concentrate)
The charts on the next page show the price drops for a variety of commodities while the lower chart shows China’s demand for and production of various commodities as a percentage of the global market (note that the lists do not match). Together these present an interesting picture that helps explain the predicament of many commodities.
Commodities where the difference between demand and domestic supply was greatest would have shown the fastest external demand growth. Those were the ones western miners really ramped up production on and which will have the longest hangovers.
Other metals where domestic demand and supply are closer to balance may be impacted by the scale of the Yuan devaluation. Not because they make imports more expensive but because they make operating costs in Chinese mines –many quite inefficient—lower. This may stave off some production declines.
The other change Chinese leadership is making that seems real is a newfound concern for the environment. They aren’t “greenies” by any means but I think the days of leaders turning a blind eye to pollution are over. This will have an opposing impact. Expect more consolidation and shutdown of the worst offenders which may keep production growth in check domestically. There are still a large number of “informal” mining operations in China that are environmental and safety disasters. Increasing crackdowns on this sector may put a brake on domestic supply growth which will cushion the blow (a bit) for Western miners.
Oil: One Thing to Rule Them All
This isn’t an oil and gas letter (my buddy Keith Schaefer handles that) but there is no avoiding the topic this year. Oil prices have impacted everything in the past year from general equity indices to bonds to sovereign finances and funds, not to mention currencies and, directly and indirectly, the cost structure of mining operations everywhere.
No other commodity is a better example of the decimation the whole sector has gone through. Oil is the big dog, with wealth flows and daily trading volumes nothing else can match. Oil and gas companies loom large in the SPX (and even larger in the TSX) and the destruction of the sector has been a key factor in the decline of US equity indices.
A big factor but by no means the only factor. When oil began falling the bullish argument was that savings at the gas pump would more than offset losses in the “unimportant” oil and gas producing sector. I stated last year that this view was oversimplified and understated the importance of the oil sector to US employment.
It’s estimated that job losses due to the weak oil market may be approaching 100,000. I think they are higher than that when secondary and tertiary effects are included. Jobs in the oil and gas sector pay much higher wages than average. When petroleum workers lose their jobs a lot of discretionary spending per worker goes with them. The impact of those job losses, plus weak wage gains elsewhere, may help explain why falling oil prices have not goosed the US economy. The other, simpler reason is the US isn’t the energy importer it used to be. The fracking revolution changed the equation.
OPECs resolve continued to harden as prices fell, at least the parts of OPEC that actually call the shots. Production has been surprisingly resilient. The bottom chart on the previous page tracks weekly US production for the past two years. The great fall off in shale and oil sands production hasn’t happened yet and above ground inventories continue to build.
Shale wells have steep production curves and drilling of new wells is grinding to a halt. Oil production in North America will fall but now we have up to a million bopd of new sales from Iran coming over the next 12 months. Unless the production decline really steepens we could still be facing oversupply through 2016.
While oil bulls point out that the market is “only” oversupplied by 1–2% that still represents 1-2 million barrels of excess supply and it’s a situation that has been going on for some time now. The chart on this page from the International Energy Agency shows data and 2016 estimates for overall supply and demand (the line graphs) and quarterly over or under supply (the bars) since 2009. The chart assumes Iran gets its production rate to 600k bopd and that other OPEC production is stable this year.
As you can see from the chart, inventories have been building since the start of 2014. The IEA estimates the build will fall sharply—though not disappear– later this year. This is largely due to drops in non-OPEC production. By late this year onshore storage worldwide will be bursting at the seams.
The IEA assumes demand increases by 1.2 MMbopd. That’s a fairly modest growth rate but still assumes generally favorable economic conditions. Demand jumped in the middle of 2015 as prices dropped but then levelled off late in the year.
Oil is the ultimate pro-cyclical commodity. The supply estimates for this year look reasonable, and might even be a bit high. The key determinant will be world growth. Estimates for 2016 global growth have been getting slashed for months. Should my assumptions of near recessionary conditions in the US and a downtick in China growth prove correct even modest demand growth may not occur until later in the year. I think odds are we see one more down leg in oil before things start to stabilize.
Speeches by Elon Musk notwithstanding we’re not at the end of the “Age of Oil” just yet. Prices will start to recover, probably later this year, but it could be quite a while before we see prices even approach the levels of 2-3 years ago. As the chart of the high yield bond index on the previous page shows trader think OPEC will get its wish. Lots more damage to energy companies before the price rout ends. That will be another drag on US markets. Lack of debt financing will hold back US production growth. That will help the oil price, just not right away.
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