Jason Bordoff, Founding Director, The Center on Global Energy Policy, Columbia University:
“We are going to have a severe energy crisis in Europe this winter. That’s almost inevitable.”
Ed Morse | Oil will fall to $85 per barrel
Citi’s Ed Morse says that supply is growing faster than expected, while demand is contracting as recession fears grow. His base case is that crude will fall to $85 per barrel.
Global recession warning
Copper broke primary support at $9,000 per metric ton, signaling a bear market. Known as “Dr Copper” because of its prescient ability to predict the direction of the global economy, copper’s sharp fall warns of a global recession dead ahead.
The Dow Jones Industrial Metals Index broke support at 175, confirming the above bear signal. A Trend Index peak at zero warns of strong selling pressure across base metals.
Iron ore retreated below $125 per metric ton, warning of another test of $90. Further sign of a slowing global economy.
The Australian Dollar is another strong indicator of the commodity cycle. After breaking primary support at 70 US cents, follow-through below support at 68.5 confirms a bear market. A Trend Index peak at zero warns of selling pressure.
Brent crude remains high, however, propped up by shortages due to sanctions on Russian oil. Penetration of the secondary trendline (lime green) is likely, as signs of a slowing economy accumulate. Breach of support at $100 per barrel is less likely, but would confirm a global recession.
Long-term interest rates are falling, with the 10-year Treasury yield reversing below 3.0%, as signs of a US contraction accumulate.
ISM new orders fell to their lowest level since May 2020, in the midst of the pandemic.
The Atlanta Fed’s GDPNow forecast for Q2 dropped sharply, to an annualized real GDP growth rate of -2.08%.
Conclusion
We would assign probability of a global recession this year as high as 70%.
ASX confirms a bear market
The ASX 200 broke primary support level at 7000, confirming a bear market.
Long-term interest rates are rising, with bond ETFs falling.
A-REITs respected resistance at the former primary support level of 1500, confirming the primary down-trend. Trend Index peaks below zero warn of strong selling pressure.
Financials fell dramatically last week, testing primary support at 6000, as the prospect of falling residential property prices and rising defaults looms. Higher interest rates and wider net interest margins should offset this to some extent. Expect retracement to test resistance at 6000. Follow-through below this level would confirm a primary down-trend and strengthen the overall bear market (Financials have been one of the stronger sectors).
Consumer Discretionary respected resistance at 3000, signaling another decline with a target of 2600 [3000-400]. Trend Index peaks below zero warn of strong selling pressure.
Consumer Staples broke support at 13K, with respect of the new resistance level warning of another test of 12K.
Utilities continue their primary up-trend, rising Trend Index troughs indicating strong buying pressure.
Industrials are headed for another test of support at 6350. Breach would warn of another test of primary support at 6000.
Telecommunications broke support at 1400, signaling a primary down-trend. Trend Index peaks below zero warn of strong selling pressure. Breach of support offers a target of 1200 [1400-200].
Health Care is consolidating below 42.5K. Reversal below 40K would warn of another test of primary support at 37.5K. A Trend Index peak close to zero would warn of fading buyer interest.
Information Technology continues in a primary down-trend, with Trend Index peaks below zero warning of selling pressure. Follow-through below 1400 would offer a target of 1100 [1500-400].
The Energy sector is advancing strongly, while Trend Index troughs above zero signal buying pressure. The prospect of Chinese lockdowns easing is likely to boost demand for oil and gas, sending prices soaring.
Metals & Mining respected resistance at 6250, warning of another test of 5500. Declining Trend Index peaks suggest buyer interest is fading. Respect of support at 5500 would signal that the up-trend is intact but breach seems more likely and would offer a target of the November ’21 low at 4750.
The broad DJ Industrial Metals Index respected resistance at 200, while Trend Index peaks below zero warn of strong selling pressure. Easing of lockdowns in China may increase demand but a bear market remains likely.
Iron ore is also undergoing a correction. Breach of support at 125 would warn of another test of primary support at 90.
The All Ordinaries Gold Index is again testing support at 6000, while Trend Index below zero warns of selling pressure.
The price of Gold in Australian Dollars, however, is trending upwards, with rising Trend Index troughs indicating increased interest from buyers. Expect a test of A$2800 per ounce. Breakout would offer a target of A$3400 [2800 + 600].
Conclusion
ASX 200 broke support at 7200, confirming a bear market. Rising long-term interest rates and a poor global economic outlook are expected to weaken most sectors, while easing of China’s lockdown restrictions should provide some relief to energy and metals.
Our weighting for ASX sectors is:
- A-REITs: heavily underweight
- Financials: neutral
- Staples: neutral
- Discretionary: heavily underweight
- Utilities: overweight
- Industrials: neutral
- Telecommunications: underweight
- Health Care: neutral
- Information Technology: heavily underweight
- Energy: heavily overweight
- Iron ore & Base Metals: underweight
- Critical Materials (e.g. Lithium and Rare Earth Elements): heavily overweight
- Gold: overweight
Current turmoil and its impact on Gold
Michael Every from Rabobank is bearish on Gold in his recent video:
“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”
Several readers have written, asking if this changes our view on Gold.
The short answer is NO, for three reasons:
1. The Fed can only hike rates until something breaks
Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.
The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.
Bank credit still grows at a healthy rate.
The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.
Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.
Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).
Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.
A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.
2. A strong Dollar is destroying US industry
The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.
This has allowed the Financial sector to grow to a point where it dominates the US economy.
Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.
In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.
The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.
The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.
The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.
Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.
The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.
3. US debt above 120% of GDP would destroy the bond market
Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.
Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.
That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.
The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.
Current turmoil
The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.
China & the Dollar
After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.
China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.
The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.
In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.
The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.
The Belt-and-Road initiative
In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).
China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.
The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.
Funding the federal deficit
China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.
But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.
The US is faced with a difficult choice:
- Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
- Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.
It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.
China
Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.
Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.
Team USA
This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:
- Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
- The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.
Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.
There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.
Conclusion
Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.
It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.
The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.
The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.
Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.
Acknowledgements
- Tom Mclellan for the Unemployment/Consumer Sentiment comparison
- Frankoz for the BRI insight
Michael Every | Commodities and the US Dollar are key
This is a follow-on to — A New World Order — posted yesterday. The first 13 minutes are worth listening to.
Michael Every, Global Strategist at Rabobank, says commodities and the US Dollar are key investments in the coming decade.
No soft landing
10-Year Treasury yields have climbed in response to the December FOMC minutes which suggest a faster taper of QE purchases and faster rate hikes. Breakout above 1.75% would offer a medium-term target of 2.3% (projecting the trough of 1.2% above resistance at 1.75%).
The Dollar Index retreated below short-term support at 96, warning of a correction despite rising LT yields.
Do the latest FOMC minutes mean that the Fed is serious about fighting inflation? The short answer: NO. If they were serious, they would not taper but halt Treasury and MBS purchases. Instead of discussing rate hikes later in the year, they would hike rates now. The Fed are trying to slow the economy by talking rather than doing — and will be largely ignored until they slam on the brakes.
Average hourly earnings growth — 5.8% for the 2021 calendar year — is likely to remain high.
A widening labor shortage — with job openings exceeding total unemployment by more than 4 million — is likely to drive wages even higher, eating into profit margins.
The S&P 500 continues to climb without any significant corrections over the past 18 months.
Rising earnings have lowered the expected December 2020 PE ratio (of highest trailing earnings) for the S&P 500 to a still-high 24.56.
But wide profit margins from supply chain shortages are unsustainable in the long-term and are likely to reverse, creating a headwind for stocks.
Warren Buffett’s long-term indicator of market value avoids fluctuating profit margins by comparing market cap to GDP as a surrogate for LT earnings. The ratio is at an extreme 2.7 (Q3 2020), having doubled since the Fed stated to expand its balance sheet (QE) after the 2008 global financial crisis.
Stock prices only adjust to fundamental values in the long-term. In the short-term, prices are driven by ebbs and flows of liquidity.
We are still witnessing a spectacular rise in the M2 money stock in relation to GDP, caused by Fed QE. The rise is only likely to halt when the taper ends in March 2022 — but there is no date yet set for quantitative tightening (QT) which would reverse the flow.
Gold continues to range between $1725 and $1830 per ounce with no sign of a breakout.
Conclusion
Expect a turbulent year ahead, driven by the pandemic, geopolitics, and Fed monetary policy. Rising inflation continues to be a major threat and we maintain our overweight positions in Gold and defensive stocks. A soft landing is unlikely — the Fed could easily lose control — and we are underweight highly-priced growth stocks and cyclicals, while avoiding bonds completely.
Inflation is coming
Inflation tops investor concerns according to Fed report
Concerns over higher inflation and tighter monetary policy have become the top concern for market participants, pushing aside the COVID-19 pandemic, the Federal Reserve said on Monday in its latest report on financial stability. ….Roughly 70% of market participants surveyed by the Fed flagged inflation and tighter Fed policy as their top concern over the next 12 to 18 months, ahead of vaccine-resistant COVID-19 variants and a potential Chinese regulatory crackdown. (Investing.com)
The market is no longer buying the Fed’s talk of “transitory” inflation.
Fed’s Bullard expects two rate hikes in 2022
St. Louis Federal Reserve Bank President James Bullard on Monday said he expects the Fed to raise interest rates twice in 2022 after it wraps up its bond-buying taper mid-year, though he said if needed the Fed could speed up that timeline to end the taper in the first quarter. “If inflation is more persistent than we are saying right now, then I think we may have to take a little sooner action in order to keep inflation under control,” Bullard said in an interview on Fox Business Network……Bullard has been among the Fed’s biggest advocates for an earlier end to the Fed’s policy easing, given his worries that inflation may not moderate as quickly or as much as many of his colleagues think it will. (Reuters)
The Fed are reluctant to hike interest rates, to rein in inflationary pressures, as it would kill the recovery.
Producer Price Index
Producer prices (PPI) climbed more than 22% in the 12 months to October 2021, close to the high from 1974 (23.4%). Consumer prices have diverged from PPI in recent years but such a sharp rise in PPI still poses a threat to the economy.
Iron and steel prices, up more than 100% year-on-year (YoY), will inevitably lead to price increases for automobiles and consumer durables. Other notable YoY increases in key inputs are construction materials (+30.6%), industrial chemicals (+47.3%), aluminium (+40.7%), and copper (+34.5%).
Underlying many of the above price rises is a sharp increase in fuel, related products and power: up 55.7% over the past 12 months.
Conclusion
Inflation is coming, while the Fed are reluctant to hike interest rates. Buy Gold, precious metals, commodities, real estate, and stocks with pricing power — a strong competitive position which enables them to pass on price increases to their customers — if you can find them at reasonable prices. Avoid financial assets like bonds and bank term deposits.
Technology-critical elements
Technology-critical elements (TCEs) are elements for which a striking acceleration in usage has emerged, relative to past consumption, and which are critical to emerging technologies.
Wikipedia provides a useful list:
Rare-earth elements (REEs)
In atomic order:
Light (LREEs)
- scandium
- yttrium
- lanthanum
- cerium
- praseodymium
- neodymium
- promethium
Heavy (HREEs)
- samarium
- europium
- gadolinium
- terbium
- dysprosium
- holmium
- erbium
- thulium
- ytterbium
- lutetium
Platinum-group metals (PGMs)
- iridium
- osmium
- palladium
- platinum
- rhodium
- ruthenium
Other elements
- antimony
- beryllium
- caesium
- cobalt
- gallium
- germanium
- indium
- lithium
- niobium
- tantalum
- tellurium
- tungsten
Productivity not population key to Aussie living standards | Macrobusiness
From Leith van Onselen at Macrobusiness:
Former ALP minister Craig Emerson has penned an article in The AFR calling on the Morrison Government to tackle Australia’s declining productivity growth, which is central to boosting the nation’s living standards:
“Productivity growth has contributed 95 per cent of the improvement in Australians’ material living standards since 1901”.
“From the turn of the century, Australia’s productivity performance began to slide and the longer it has gone on the worse it has gotten”.
“Over the period from 2015 until the COVID-19 pandemic struck, actual productivity growth was worse than the low-productivity scenario included in the 2015 intergenerational report”.
“In the decade since 2010 – even excluding last year – Australia recorded its slowest growth in GDP per capita of any decade in at least 60 years”.
“Without a comprehensive economic reform program, Australia will inevitably have weak growth in living standards during the remainder of the 2020s and into the 2030s”.Craig Emerson’s assessment is broadly correct, as evidenced by the stagnant real per capita GDP, wage and income growth experienced over the past decade (even before the coronavirus pandemic).
Sadly, however, the Morrison Government with the help of the Australian Treasury seems hell bent on leveraging the other ‘P’ – population growth – to mask over Australia’s poor productivity performance and to keep headline GDP growing, even if it means per capita GDP, income growth and living standards deteriorate.
Rather than using the coronavirus pandemic as an opportunity to reset the Australian economy to focus on quality over quantity, the Morrison Government is intent on repeating the policy mistakes of the past by returning to the lazy dumb growth policy of hyper immigration.
Rebooting mass immigration will inevitably contribute to Australia’s poor productivity growth by:
- Crush-loading cities, increasing congestion costs and rising infrastructure costs;
- Encouraging growth in low productivity people-servicing industries and debt creation, rather than higher productivity tradables; and
- Discouraging companies from innovating and adopting labour saving technologies.
It’s time to put the Australian Treasury’s Three-Ps framework to rest once and for all, along with the snake oil solution of mass immigration.
Policy makers must instead focus first and foremost on boosting productivity, followed by lifting labour force participation. These are the two Ps that actually matter for living standards.
We agree with the concern over poor productivity growth, but focusing on labor force participation is putting the cart before the horse. The key cause of low productivity growth is declining business investment.
Without business investment, new job creation and wages growth will remain low. The way out of this trap is to prime the pump. Boost consumption through infrastructure programs — investment in productive infrastructure that will boost GDP growth (to repay the debt). Boost business investment through strong consumption, a lower Australian Dollar and tax incentives (like accelerated write-off) for new investment.
The lower exchange rate is important to rectify a serious case of Dutch disease1 from the resources industry. There are only three ways to achieve this:
- Increase imports, which would be self-defeating, destroying jobs;
- Reduce exports; or
- Export capital, of which Australia has little.
China is doing its best to help us with the second option, by restricting imports of a wide variety of Australian resources, but that has so far achieved little. David Llewellyn-Smith came up with an interesting alternative:
If we accept that the CCP is the latest manifestation of the historical tendency to give rise to political evils intent on dominating the lives of freedom-loving humanity, then why don’t we cut the flow of iron ore right now…….
The results would be instant. The Chinese economy would be structurally shocked to its knees. 30% of its GDP is real estate-related. 60% of the iron ore that drives it is sourced in Australia. Roughly speaking that is 18% of Chinese GDP that would virtually collapse overnight. Vast tracts of industry would fall silent. An instant debt crisis would sweep the Chinese financial system as its bizarre daisy chain of corruption froze. Local governments likewise. Unemployment would skyrocket.
…..What we can say with confidence is that it would pre-occupy the CCP for many years and hobble it permanently. Its plans for regional domination would be set back decades if not be entirely over.
The problem is how to convince the old boys around the boardroom table at BHP that this would be in their interest as well as in the country’s interest.
Notes
- Dutch disease is a term coined by The Economist to describe the impact on the Netherlands’ economy of a resources boom from discovery of large natural gas fields in 1959. The soaring exchange rate, from LNG exports, caused a sharp contraction in the manufacturing sector which struggled to compete, in export markets and against imports in the domestic market, at the higher exchange rate.