Stocks battered by headwinds from Asia
Falling demand from China and rising inflation in Japan are both having an impact on stocks and Treasury markets. Precious metals have also suffered from the sell-off, while crude and industrial metals warn of a global contraction.
Stocks
The top 7 technology stocks all fell, led by a steep plunge in Tesla (TSLA) and Nvidia (NVDA), two stocks with considerable exposure to China.
The Nasdaq plunged 3.7%, its second 3.0% draw-down in July confirms selling pressure signaled by declining Trend Index peaks. Lawrence MacDonald:
The NDX went 17 months without a 3.0% drawdown. To us this means a lot. Looking back 20 years, these events come in patterns and clusters, NOT isolated events. This speaks to high volatility ahead.
The S&P 500 recorded its first 2.0% draw-down in 357 trading days. Declining Trend Index peaks reflect selling pressure. Breach of support at 5400 is likely and would offer a target of 5200.
The S&P 500 Equal-Weighted Index ($IQX) broke support at 6800, offering a target of 6600.
Declines were across the board, with both the Russell 1000 Large Cap ETF [blue] and Russell 2000 Small Cap ETF [pink] falling sharply.
Treasury Market
Two-year Treasury yields are falling in anticipation of an early rate cut by the Fed.
But 10-Year yields respected support at 4.20%, signaling a test of 4.5%.
Liquidity in financial markets is strong but rising long-term yields could come from Japanese selling in support of the Yen.
Jim Grant on the prospects for US and Japanese interest rates:
How the turntables have turned: as the Federal Reserve and Bank of Japan each prepare to render their respective rate decisions next week, recent events suggest a shift in the zeitgeist. Thus, former New York Fed president William Dudley took to the Bloomberg Opinion page Wednesday to lobby his former colleagues for a July cut, citing a weakening labor market along with ebbing inflationary pressures and moderating wage growth.
“I’ve long been in the ‘higher for longer’ camp. . . [but] the facts have changed, so I’ve changed my mind,” Dudley writes…..
Monetary crosswinds are swirling in the Far East. Futures assess the likelihood of a July BoJ hike from the current 0% to 0.1% range at 72%, up from 51% three weeks ago. Similarly, more than 90% of economists surveyed by Bloomberg “see the risk” that the BoJ will opt to pull the trigger, turning the page on its longstanding negative, now, zero-rates policy in the face of mounting price pressures.
To that end, core CPI grew a 2.6% annual clip in June, remaining north of the bank’s self-assigned 2% goal for the 27th consecutive month. On Friday, Tokyo’s Cabinet Office bumped its forecasted inflation rate over the fiscal year ending March 2025 to 2.8% from 2.5%.
“We expect underlying inflation to remain around 2% until early 2025, which we think will prompt the BoJ to hike rates both this month and in October,” writes Marcel Thielant, head of Asia-Pacific at Capital Economics, adding that pronounced currency weakness is placing upward pressure on the price level, as evidenced by a recent pickup in the “other industrial products” CPI component.
The prospect of simultaneous Fed and BoJ policy pivots duly resonates in the currency market, as the yen has snapped higher by 5% over the past three weeks to 154 per dollar after marking a near 40-year low against the buck. Hefty outlays from the Ministry of Finance in service of propping up the yen – estimated by Reuters at $38 billion in July alone – have added oomph to the present course correction.
“This week has seen more pronounced unwinding of carry trades, underscoring the concentration of short JPY positioning that is now facing intense pressure from Ministry of Finance intervention to support the [yen],” Richard Franulovich, head of FX strategy at Westpac Banking Corp, commented to Bloomberg this morning. “Local politicians have become more vocal about the economic dangers from unfettered JPY weakness,” he added.
Financial Markets
Monetary easing continues, with the Chicago Fed Financial Conditions Index declining to -0.58% on July 19, signaling rising liquidity in financial markets.
Dollar & Gold
The Dollar Index continues to test support at 104, despite strengthening long-term Treasury yields.
Gold fell to $2,375 per ounce, signaling a test of long-term support at $2,300. Respect of $2,300 remains likely and would be a long-term bull signal for gold.
Silver fell to $28 per ounce, signaling a bear market driven by falling industrial demand. Expect a test of support at $26.
Industrial demand for silver is falling as Chinese solar manufacturers face severe overcapacity:
China should push struggling solar manufacturers to exit the market as soon as possible to reduce severe overcapacity in a sector that’s vital to the energy transition, according to a major industry group. Central and local government, financial institutions, and companies should coordinate to speed up industry consolidation, Wang Bohua, head of the China Photovoltaic Industry Association, said at a solar conference in Zhejiang province on Thursday. ~ Bloomberg
Crude Oil
Nymex WTI crude ticked up slightly but is unlikely to reverse its steep down-trend, headed for a test of support between $72 and $73 per barrel.
Low crude prices are likely to lead to falling inflation, increasing pressure on the Fed to cut interest rates.
Industrial Metals
Copper and aluminum continue in a strong down-trend as Chinese demand falls.
Iron ore has so far respected support at $106 per tonne. The steel industry faces similar overcapacity to other industrial metals and has only survived so far by exporting steel, driving down prices in international markets.
But resistance is growing. Iron ore is likely to plunge if international markets, like India below, erect barriers to Chinese dumping.
Conclusion
Financial market liquidity is strengthening but stocks and Treasury markets are being battered by headwinds from Asia.
The Bank of Japan is expected to hike interest rates at its next meeting in response to rising inflation caused by the weakening Japanese Yen. The result is likely to be bearish for US Treasuries, driving up long-term yields.
Falling demand from China is likely to impact on revenues from Western multinationals with large exposure, leading to a correction in stocks as growth prospects fade.
The probability of a rate cut at the next Fed meeting grows increasingly likely. Inflationary pressures are declining — as crude oil plunges in response to weak global demand — and economic headwinds are rising.
Gold and silver are likely to diverge. Silver is likely to enter a bear market as industrial demand from China fades, while gold is likely to benefit from safe-haven demand as the global economy contracts.
Industrial metals are already in a bear market which is likely to worsen as international resistance to China exporting its overcapacity grows.
Acknowledgements
- Jim Grant: Yen Diagram
- Lawrence MacDonald: Nasdaq Volatility
- Michael Pettis: Chinese solar manufacturers warns about “severe overcapacity”
- Bloomberg: Chinese Solar Group Urges Faster Consolidation as Glut Deepens
- CNBC: 2-Year Treasury Yields
- Macrobusiness: Iron ore trapdoor opens
Australian Outlook | Chris Joye
Central banks are too much under the sway of government and not doing enough to contain inflation. None worse than the RBA which is holding rates lower than they should be. The last time that we had inflation at 4.0% in 2008, the cash rate was 7.25%. Now the cash rate is only 4.35%.
RBNZ is far more independent and hiked their official cash rate to 5.5%. The NZ economy is in recession but they still face the threat of stagflation, with low growth and high inflation.
In Australia we have a negative output gap, where demand exceeds production capacity, far worse than in most other major economies. The only solution is to raise unemployment to lower demand. But RBA governor Michelle Bullock has publicly stated that the RBA is not looking to reduce employment.
The latest Australian government budget is highly stimulatory and likely to fuel further inflation.
The outcome is likely to be long-term inflation and higher long-term interest rates.
Conclusion
We expect strong inflationary pressures in the next decade as governments run large fiscal deficits. Additional government spending is needed to:
- Address the energy transition from fossil fuels to renewables and nuclear;
- On-shore critical supply chains; and
- Increase defense spending in response to geopolitical tensions.
Long-term interest rates are expected to rise over the next decade, fueled by higher inflation.
Central banks may attempt to suppress interest rates by further expanding their balance sheets to buy long-term fiscal debt but that is short-sighted. Inflation would accelerate even higher.
Apart from the hardship to wage-earners, and the subsequent political chaos, high inflation would threaten bond market stability. Bond market investors would be reluctant to fund deficits when interest earned is below the inflation rate. Unless there are no alternatives.
That is why the long-term outlook for gold and silver is so bullish.
What really drives inflation?
Every month, after the FOMC meeting, Fed Chairman Jay Powell fronts the media and tells everyone how the Fed is determined to maintain the fed funds rate in the same 5.25% – 5.50% range in order to contain inflation. But he is well aware that the Fed funds rate has had close to zero impact on inflation.
CPI peaked in June 2022 when the fed funds rate was an eye-watering (sic) 1.25%. CPI then plunged sharply when the Fed was still in the early stages of hiking rates. The lag between rate hikes and the resultant decline in inflation is normally 12 to 18 months. Now the Fed would have us believe that CPI declined in anticipation of rate cuts.
Financial conditions did tighten when the Fed introduced QT, with the Chicago Fed Financial Conditions Index (FCI) rising to -0.1%. But then FCI started a sharp decline in June 2023, when the Fed was still hiking rates, indicating monetary easing.
Rising interest rates and tighter financial conditions had even less than usual impact on consumer spending because of a strong upsurge in personal savings during the pandemic. A large percentage of government transfers were not spent but went to increase bank deposits.
Energy is driving inflation
The primary cause of the strong upsurge in CPI in ’21/22 was energy prices. The chart below shows how energy CPI (orange) led CPI (red) higher, reaching a peak of 41.5% in June 2022 — the same month that CPI peaked at 9.0%. Energy prices then plunged to a low of -16.7% in June 2023. CPI followed, reaching a low of 3.1% in the same month. Since then, CPI energy has recovered to close to zero, producing a floor in the annual CPI rate.
Energy CPI is a relatively small component of CPI — 6.6% of total CPI — but it is a major cost component of most other variables. Food, for example, requires energy for planting, irrigation, harvesting, processing, refrigeration and transport. Cement requires energy for heating limestone in kilns, crushing and transportation. Steel needs energy for extraction and transport of iron ore, smelting and transportation. Even online services. The latest AI data centers require up to 1 GW of electricity capacity — enough to power 300,000 homes.
The most important determinant of energy prices is crude oil. Nymex light crude peaked between March and June 2022 at prices of $100 to $120 per barrel before commencing a prolonged decline to between $70 and $80 by December of the same year.
Conclusion
Raising the fed funds rate has had little impact on actual inflation. Rate hikes are more about restoring the Fed’s credibility as an inflation hawk after a disastrous performance in 2021. High energy prices and easy monetary policy and were a recipe for inflation.
The sharp decline in CPI in the 12 months to June ’23 was caused by falling energy prices. Energy CPI fell from an annual increase of 41.5% in June 2022 to a low of -16.7% a year later.
Nymex light crude has now broken resistance at $80 per barrel. Expect retracement to test the new support level but respect is likely and would confirm another advance, with a target of $90 per barrel.
A sharp rise in crude prices would be likely to cause a significant upsurge in CPI — and long-term interest rates. With bearish consequences for stocks and long-duration bonds.
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Eleven reasons for optimism in the next decade
This might seem more like a wish list than a forecast — there are always risks that can derail predictions — but we believe these are high probability events over the long-term.
Our timeline is flexible, some events may take longer than a decade while others could occur a lot sooner.
Also, some of the reasons for optimism present both a problem and an opportunity. It depends on which side of the trade you are on.
#1 US Politics
The political divide in the United States is expected to heal after neither President Biden nor his predecessor, and current GOP front-runner Donald Trump, make the ballot in 2024. The first due to concerns over his age and the latter due to legal woes and inability to garner support from the center. A younger, more moderate candidate from the right (Nikki Haley) or left (Gavin Newsom?) is likely to be elected in 2024 and lead the reconciliation process, allowing Congress to focus on long-term challenges rather than political grandstanding.
Nikki Haley & Gavin Newsom – Wikipedia
#2 The Rise of Europe
Prime Minister of Estonia, Kaja Kallas – Wikipedia
Europe is expected to rediscover its backbone, led by the example of Eastern European leaders who have long understood the existential threat posed by Russian encroachment. Increased funding and supply of arms to Ukraine will sustain their beleaguered ally. NATO will re-arm, securing its Eastern border but is unlikely to be drawn into a war with Russia.
#3 Decline of the Autocrats
We are past peak-autocrat — when Vladimir Putin announced Russia’s full-scale invasion of Ukraine on February 23, 2022.
Vladimir Putin announces invasion of Ukraine – CNN
Russia
The Russian economy is likely to be drained by the on-going war in Ukraine, with drone attacks on energy infrastructure bleeding Russia’s economy. Demands on the civilian population are expected to rise as oil and gas revenues dwindle.
Fire at an oil storage depot in Klintsy, southern Russia after it was hit by a Ukrainian drone – BBC
China
The CCP’s tenuous hold on power faces three critical challenges. First, an ageing population fueled by the CPP’s disastrous one-child policy (1979-2015) and declining birth rates after the 2020 COVID pandemic — a reaction to totalitarian shutdowns for political ends.
Second, is the middle-income trap. Failure to overcome the political challenges of redistributing income away from local governments, state-owned enterprises and existing elites will prevent the rise of a consumer economy driven by strong levels of consumption and lower savings by the broad population.
Third, the inevitable demise of autocratic regimes because of their rigidity and inability to adapt to a changing world. Autocratic leaders grow increasingly isolated in an information silo, where subordinates are afraid to convey bad news and instead tell leaders what they want to hear. Poor feedback and doubling down on past failures destroy morale and trust in leadership, leading to a dysfunctional economy.
Iran
Iranian Ayatollah Ali Khamenei – Wikipedia
Demographics are likely to triumph in Iran, with the ageing religious conservatives losing power as their numbers dwindle. The rise of a more moderate, Westernized younger generation is expected to lead to the decline of Iranian-backed extremism and greater stability in the Middle East.
#4 High Inflation
The US federal government is likely to avoid default on its $34 trillion debt, using high inflation to shrink the debt in real terms and boost GDP at the same time.
#5 Negative real interest rates
High inflation and rising nominal Treasury yields would threaten the ability of Treasury to service interest costs on outstanding debt without deficits spiraling out of control. The Fed will be forced to suppress interest rates to save the Treasury market, further fueling high inflation. Negative real interest rates will drive up prices of real assets.
#6 US Dollar
The US Dollar will decline as the US on-shores critical industries and the current account deficit shrinks. Manufacturing jobs are expected to rise as a result — through import substitution and increased exports.
#7 US Treasury Market
USTs are expected to decline as the global reserve asset, motivated by long-term negative real interest rates and shrinking current account deficits.
Central bank holdings of Gold and commodities are likely to increase as distrust of fiat currencies grows, with no obvious successor to US hegemony.
#7 Nuclear Power
Investment in nuclear power is expected to skyrocket as it is recognized as the only viable long-term alternative to base-load power generated by fossil fuels. Reactors will be primarily fueled by coated uranium fuels (TRISO) that remove the risk of a critical meltdown.
TRISO particles consist of a uranium, carbon and oxygen fuel kernel encapsulated by three layers of carbon- and ceramic-based materials that prevent the release of radioactive fission products – Energy.gov
Thorium salts are an alternative but the technology lags a long way behind uranium reactors. Nuclear fusion is a wild card, with accelerated development likely as AI is used to solve some of the remaining technological challenges.
#8 Artificial Intelligence (AI)
Scientific advances achieved with the use of AI are expected to be at the forefront in engineering and medicine, while broad productivity gains are likely as implementation of AI applications grows.
#9 Semiconductors
Demand for semiconductors and micro-processor is likely to grow as intelligent devices become the norm across everything from electric vehicles to houses, appliances and devices.
#10 Industrial Commodities
Demand for industrial commodities — lithium, copper, cobalt, graphite, battery-grade nickel, and rare earth elements like neodymium (used in high-power magnets) — are expected to skyrocket as the critical materials content of EVs and other sophisticated devices grows.
Expected supply shortfall by 2030:
Prices will boom as demand grows, increases in supply necessitate higher marginal costs, and inflation soars.
#11 Stock Market Boom
Stocks are expected to boom, fueled by negative real interest rates, high inflation and productivity gains from AI and nuclear.
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Conclusion
There is no cause for complacency — many challenges and pitfalls face developed economies. But we so often focus on the threats that it is easy to lose sight of the fact that the glass is more than half full.
Our long-term strategy is overweight on real assets — stocks, Gold, commodities and industrial real estate — and underweight long duration financial assets like USTs.
Acknowledgements
- World Politics Review, Alexander Clarkson: In Russia and Iran, External Aggression Masks Internal Vulnerabilities
- McKinsey: The semiconductor decade, A trillion-dollar industry
- ZeroHedge: Skyrocketing Battery Mineral Demand Set to Outpace Supply By 2023, February 14, 2024
- Wikipedia: China’s One-Child Policy
Australian CPI falls but no rate cuts in sight
Quarterly CPI fell to 4.1% for the 12 months to December, while the trimmed mean is not far behind at 4.2%.
Household rent increases remain strong, however, boosted by a surge in immigration.
Conclusion
Inflation, apart from rents is generally falling as the economy slows. But the RBA is unlikely to cut rates soon unless we see a sharp contraction in household consumption.
ASX 200 tests support
The ASX 200 retreated from resistance at the high of 7600 and is now testing support at 7400. Breach would warn of a correction to test primary support at 6750.
The Financials Index has similarly retreated from resistance at 6800. Reversal below 6650 would warn of a correction.
The A-REIT Index would likewise warn of a correction to test 1200 if support at 1440 is breached. The recent rally was in response to falling long-term bond yields.
The correction in yields is secondary in nature and is unlikely to reverse the long-term up-trend. Further increases in long-term yields are expected to weaken A-REITs.
Healthcare also rallied strongly in the past two months but could reverse if long-term bond yields strengthen.
Consumer Staples are in a strong down-trend. Breach of support at 11500 would warn of another decline.
Discretionary has surprised to the upside, breaking resistance at 3200. A Trend Index trough at zero indicates buying pressure. Retracement that respects the new support level would signal a further advance.
Energy rallied to test resistance at 11000 but a Trend Index peak below zero warns of selling pressure. Another test of primary support at 10000 is likely.
The All Ordinaries Gold Index fell sharply as the US Dollar strengthened. Follow-through below 6500 would warn of another test of support at 6000.
The ASX 300 Metals & Mining Index is falling sharply as China’s recovery falters. Another test of primary support at 5600 is likely.
China
Rate cuts and measures to stimulate the Chinese economy have been modest as the PBOC is trying to protect the Yuan from further depreciation against the US Dollar.
The result is slowing growth and deflation as weak demand persists.
Conclusion
Falling long-term bond yields have boosted Financials, REITs, Health Care and Consumer Discretionary sectors but the correction in yields is secondary and we expect this to reverse in 2024.
The Metals & Mining sector is falling sharply as China struggles to overcome weak demand while at the same time protecting the Yuan from further depreciation against the Dollar.
Our overall outlook for the ASX 200 remains bearish. Breach of support at 7400 would warn of a correction to test primary support from the October 2022 low at 6750.
Dr Lacy Hunt: The impending recession
Not the best interviewer but you always get your money’s worth from Dr Lacy Hunt, former chief economist at the Dallas Fed.
The highlights:
- Dr Hunt warns of a hard landing.
- Recent GDP gains are led by consumer spending (+4%) but real disposable income declined (-1%). Personal saving depressed at 3.4%, compared to the GFC low of 2.4%.
- UOM consumer sentiment is below level of previous recessions.
- A sharp surge in the economy often occurs just before recession.
- Dollar is too strong for global stability. It will fall as US goes into recession but then stabilize as the impact flows through to rest of the world.
- Three signs of weakness:
- Negative net national saving has never occurred before in a period where GDP is rising (economy is weaker than we think).
- Bank credit is already contracting. This normally only occurs when the economy is already in recession.
- Inflation is likewise falling before the recession.
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Investing in Real Estate
In Monday’s update, we compared investing in stocks to investing in financial securities and concluded that stocks offer better long-term performance. Today, we use long-term data series for US and Australian real estate to evaluate their comparative performance.
US real estate data was sourced from Prof Robert Shiller, who created the Case-Shiller Index series. The chart below shows that US home prices from 1933 to 2023, a period of ninety years, appreciated to 69.5 times their original value.
Adjusting for inflation, we get real appreciation of 2.9 times.
Again, CPI seems to understate inflation. Comparing the home price index to Gold, rather than CPI, provides a more accurate measure of appreciation in real terms. Gold appreciated 94.5 times over the same period, so the home price index actually lost value.
Calculation: 69.5/94.5 = 0.735 (i.e. a 26.5% loss of value)
Comparing data sources
A second source of home price data compares median prices, based on sales of existing homes, from 1953 to 2023. That shows growth of 22 times over the past seventy years, which is close to the Home Price Index appreciation of 21.25 over the same period.
Australia
Australian housing data is harder to come by but we found an excellent source of long-term median house price data in the 2007 UNSW thesis of Dr Nigel David Stapledon. Using data from within the thesis, we were able to adjust nominal house prices to reflect constant quality (house values with no improvements) below.
Australian house prices appreciated 191.4 times between 1933 and 2006.
Unfortunately the data ends there, so we had to calculate a weighted average of median houses for 2007 to the present.
CoreLogic kindly provided us with values for their hedonic Home Value Index (for 5 Capital Cities) which also adjusts for quality:
Property Type 31/01/2007 31/07/2023 Houses $399,182 $891,747
The gain of 2.23 is slightly higher than the 2.14 calculated from weighted average data for the 8 capital cities provided by the ABS.
We opted for the higher figure from CoreLogic as likely to be more in line with the earlier Stapledon data. That gives a total nominal gain, adjusted for quality, of 426.8 for the ninety years from 1933 to 2023.
The price of Gold fines was fixed at £6-3/9 per troy ounce fine according to the Sydney Morning Herald on 2 January 1933, that converts to 12.375 Australian Dollars. Total gain for Gold in Australian Dollars over the past ninety years is therefore 232.9 times (A$2881.90/12.375).
We calculate the real gain for Australian house prices as 1.83 times over the past ninety years (426.8/232.9).
Conclusion
The US Home Price Index lost 26.5% in real terms, over the past ninety years (1933 – 2023), when compared to Gold.
The S&P 500 appreciated 6.8 times over the past ninety years when measured against Gold, and 9.7 times compared to US real estate (Home Price Index).
Using Gold as the benchmark, we conclude that Australian real estate prices appreciated faster than US real estate over the past ninety years, growing 1.83 times in real terms, whereas the US depreciated to 0.735 of its original real value.
We suspect the difference is largely due to the substantial fall in US real estate values after the 2008 sub-prime crisis, whereas Australian home prices continued to grow. We expect that performance of the two will converge in the long-term.
Lastly, when measured against Gold, US stocks outperformed Australian real estate. The S&P 500 grew 3.7 times against Australian home prices, in real terms, over the past ninety years.
This does not mean that we should ignore real estate as an investment medium. But a portfolio concentrated in real estate, without diversification into stocks and precious metals, could underperform in the long-term.
Acknowledgements
- Robert Shiller at Yale for Home Price Index data.
- DQYDJ for median home prices.
- Nigel David Stapledon, UNSW: Long term housing prices in Australia and some economic perspectives.
- CoreLogic Home Value Index 2007 – 2023.
- ABS Capital Cities House Price Data (Excel Spreadsheet)
Warren Buffet: Fiscal Deficits and Runaway Inflation
“During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion. Though economists, politicians and many of the public have opinions about the consequences of that huge imbalance, Charlie and I plead ignorance and firmly believe that near-term economic and market forecasts are worse than useless…..Berkshire offers some modest protection from runaway inflation, but this attribute is far from perfect. Huge and entrenched fiscal deficits have consequences.”
~ Berkshire Hathaway Newsletter to Shareholders, 2022
Comments
There are three potential sources of funding for fiscal deficits of which two are inflationary:
- The private sector. Deficits funded by the private sector have no impact on inflation. The rise in public spending is offset by a decline in private spending/increase in savings.
- Commercial banks. Inflationary. The bank simply swaps one asset on their balance sheet for another: bank reserves at the Fed are exchanged for Treasury securities. Public spending rises but is not offset elsewhere.
- Foreign investors (including banks). Inflationary. Public spending rises but there is no offset. The inflow on capital account is matched by an outflow on current account.