Markets and Cycles

Cyclical trends tend to reverse direction more frequently, with the peak-to-peak wavelength normally lasting several years, and are much harder to predict. Interest rates, commodity prices, gold and exchange rates are typical examples.

The Interest Rate Cycle

Interest rates and inflation are closely linked and probably most predictable of the short- to medium-term market cycles. Interest rates are normally raised by central banks (such as the Fed) in order to curb a build-up of inflationary pressure in the economy.

The consumer price index (CPI) is quite volatile, affected by fluctuating crude oil and agricultural output, while core CPI (excluding Energy and Food) offers a more stable measure of prices.

Growth in hourly wage rates, however, offers greater insight into underlying inflationary pressures that are likely to affect future price rises.

Currently annual wage rate growth is subdued but a rise above 3.0% would be likely to elicit monetary tightening from the Fed.

Monetary tightening from the Fed in turn affects the yield curve, credit growth and the money supply, slowing economic growth and often leading to a recession (depicted by gray bars on the chart above).

Lower interest rates and monetary easing are normally a response to the sharp fall in aggregate demand which accompanies a recession.

Interest rates in one economy may also have an impact on other economies through the exchange rate mechanism.

Exchange Rates

Floating exchange rates are meant to balance trade flows (imports and exports) between an economy and its major trading partners but seldom do.

The US has run almost continuous current account deficits since the 1980s.

Japan and China have run corresponding surpluses.

Capital Flows

Exchange rates are affected by capital flows as well as trade flows between countries.

Currency Manipulation

Both Japan and China accumulated massive foreign reserves in the last two decades. These surpluses were largely invested back in the US to slow appreciation of the Yen and Yuan against the Dollar, giving the two a significant trade advantage.

Pegging Against the Dollar

Pegging against the Dollar is a two-edged sword, however, as Japan and emerging Asian economies discovered in the 1990s. If confidence is disrupted, investors withdraw capital while domestic borrowers repay dollar-denominated loans (a cheap source of money while the currency is pegged). The country starts to hemorrhage foreign reserves in order to maintain the peg. Collapse of the peg can be devastating to the local economy, as demonstrated by the Asian Tigers in 1997. Indonesia was the worst hit, losing 58% of GDP between 1996 and 1998.

Interest Rate Differences

A source of shorter-term capital flows is the carry trade, where hedge funds borrow large sums at low interest rates and invest in another country which offers higher interest rates. This can be highly profitable when there is a decent interest rate spread, with relatively low risk if the central bank in the receiving country is doing its best to prevent appreciation against the Dollar.

Dutch Disease

Then there is the dreaded “Dutch Disease” which blighted the Netherlands and much later, Australia. Discovery of extensive gas reserves in the early 1960s caused an influx of investment to the Netherlands. Large capital inflows drove up the exchange rate, damaging the local manufacturing sector.

Australia experienced a similar influx of investment in response to the commodities boom of the early 2000s. The Australian Dollar more than doubled in value against the greenback, while manufacturing employment in Australia headed in the opposite direction.

The Influence of Commodity Prices

Commodity prices also affect exchange rates of resource-rich economies such as Australia and Canada. A chart of the DJ-UBS Commodity Index against the Australian Dollar shows how commodity prices affect the currency.

Commodity Prices

China’s investment-led growth of the last two decades is unprecedented, with its share of global industrial production rising from 5% in the 1990s to one-third by 2015. Rapid growth of steel and cement production during the infrastructure boom is unsustainable in the long-term.

Declining investment in real estate and infrastructure is expected to slow demand for bulk commodities like iron ore and coal. Prices have been falling since 2012, a combination of falling demand and rising production from investments initiated in the pre-2008 boom.

Crude Oil

Crude oil is the largest global commodity. Jeremy Grantham reminds us that crude represents not only half of the value of all commodities traded but also roughly half of the cost of other major commodities.

Extraction and shipping for mining, and cultivation, harvesting and shipping for agricultural commodities, are all substantial costs.

Crude prices are dominated in the short- to medium-term by anticipated changes in global production.

The rise of shale production in North America, and output from Libya and Nigeria has largely negated OPEC efforts to support prices by limiting production.

Fluctuations in demand caused by the global economic cycle and the steady rise of renewable energy are also expected to have greater impact in the long-term.

Gold

Gold exists somewhere between a commodity and a currency. A store of value during times of political uncertainty and times of high inflation, the precious metal is also subject to speculative demand, impacted by interest rates. Rising interest rates are bearish for gold, increasing the opportunity cost of holding gold and discouraging inflation.

Gold & Crude Oil

There is also a strong correlation between gold and crude oil prices. Whenever there is a strong surge in crude prices, gold tends to follow. The long-term chart below shows gold and crude oil prices adjusted for inflation (CPI).

Rising crude prices and higher consequent inflation reduce confidence in the Dollar, leading major oil producers to buy more gold with their newfound surplus as a store of value. The opposite occurs if oil prices fall. Oil producers are forced to sell gold reserves in order to fund the unexpected deficit.

External Shocks

We monitor macroeconomic and volatility filters to alert us to elevated market risk.

Apart from regular cycles or long-term trends, stock markets also suffer from external shocks such as wars and natural disasters.

Some shocks have an immediate impact as in a “flash crash” caused by faulty (“fat finger”) order entry or defective (or fraudulent) algorithms which may trigger a rash of automated stop-loss selling.

Most external shocks, however — whether a country default, collapse of a major bank (Lehman Brothers) or hedge fund (LTCM) — take time to be absorbed by the market. A chart of the S&P 500 shows how volatility spiked on September 15, 2008 when Lehman Brothers filed for Chapter 11 bankruptcy but the market took several weeks to react.

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