Gold
Highlights The resilience of EM industrial commodity demand, which is helping to lift inflation and inflation expectations in the U.S., will be tested over the next few months, as markets gear up for a possible oil-production deal between OPEC and Russia, and the first of perhaps three Fed rate hikes in December and next year. Any indication Janet Yellen has persuaded her colleagues to run a "high-pressure economy" will provoke us to get long gold, given its sensitivity to the Fed's preferred inflation gauge. We remain wary, however, given the higher-rates stance favored by some Fed officials, which, our modeling suggests, would reverse the pick-up in inflation and inflation expectations in the U.S. by depressing EM growth. Energy: Overweight. We continue to favor U.S. shale-oil producers at this stage in the cycle, and continue to look for opportunities to take commodity price exposure. Base Metals: Neutral. We downgraded copper to neutral from bullish last week, expecting prices to trade sideways over the next three months. Precious Metals: Neutral. We continue to be buyers of gold at $1,210/oz. If we continue to see the Fed's preferred inflation gauge increase, we will raise that target. Ags/Softs: Underweight. We are recommending a tactical long position in Mar/17 wheat versus a short in Mar/17 soybeans. Feature In her Boston Fed speech last week, Fed Chair Janet Yellen dangled catnip in front of commodity markets by discussing the possibility of "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market" as a means of countering the prolonged hysteresis in the U.S. economy.1 Any indication Dr. Yellen has succeed in convincing her colleagues to pursue such a strategy would compel us to get long gold, given the sensitivity of the yellow metal to core PCE, the Fed's preferred inflation gauge (Chart of the Week).2 Indeed, we find there is a long-term equilibrium between spot gold prices and the core PCEPIand U.S. financial variables, which is extremely robust over time.3 Core PCEPI has been ticking up this year, most recently in March and appears to be leading 5-year/5-year inflation expectations tracked by the St. Louis Fed, which bottomed in June and have been trending higher since (Chart 2).4 In our modeling, we find a 1% increase in core PCE translates into a 4% increase in gold prices, suggesting gold would provide an excellent hedge against rising inflation. Chart of the WeekGet Long Gold If Pressure ##br##Builds in U.S. Economy Chart 2Core PCE ##br##Ticking Up Core PCE And EM Commodity Demand There is an enduring long-term relationship between inflation generally and EM commodity demand, which we have highlighted in previous research.5 This week we are exploring long-term equilibrium relationships between EM industrial commodity demand and core PCE, given the obvious interest among commodity investors. The big driver of core PCE is EM industrial commodity demand, as can be seen in Chart 3, which shows the output of two regressions we ran using non-OECD oil demand - our proxy for EM oil demand - and world base metals demand, which is dominated by China's roughly 50% share of global base metals demand. Core PCE is cointegrated with these measures of industrial-commodity demand, which makes perfect sense considering most - sometimes, all - of the demand growth for industrial commodities (oil and base metals, in this instance) is coming from EM economies.6 For example, of the total growth in oil demand since 2013, non-OECD demand accounted for 1.1mm b/d of an average 1.2mm b/d global demand growth. Within other markets, China accounts for more than 50% of global iron ore, copper ore, metallurgical and thermal coal demand.7 At the margin, prices in the real economy are being set by EM demand, not by DM demand. This, in turn, feeds into core and headline PCE and other inflation gauges. Feedback Between Fed Policy And EM Commodity Demand Leading economic indicators for EM growth are turning up, which is supportive for commodity demand near term (Chart 4). This has been aided by accommodative monetary policy in the U.S., which has kept the USD relatively tame after peaking in January 2016.8 Chart 3EM Industrial Commodity Demand,##br## Core PCE Share Common Trend Chart 4EM Leading Indicators ##br##Point to Growth Upturn The single biggest risk to commodity demand and commodity prices remains U.S. monetary policy. The longer-term cointegrating relationships highlighted in this week's research are consistent with earlier results we reported on the impact of U.S. financial variables on commodity demand.9 When we model EM oil demand as a function of U.S. financial variables, we find a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 22bp decrease (increase) in consumption using these longer-dated models. For global base metals, a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. As a general rule, each 1% increase (decrease) in the USD TWI is accompanied by a 25bp drop (increase) in EM demand for oil and global base metals (Charts 5 and 6). Chart 5EM Oil Demand Will Fall If ##br##The Fed Gets Too Aggressive... Chart 6...As Will##br## Base Metals Demand As mentioned above, we continue to expect a 25bp hike by the Fed at its December meeting, followed by two additional hikes next year. Our House view continues to maintain this round of rate hikes will cause the USD to appreciate by 10% over the next 12 months. If this is fully passed through, we expect this gauge to register a ~ 2.5% decline in EM demand for industrial commodities. This would reduce the core PCE's yoy rate of change to ~ 1%, vs. the current level of 1.7% yoy growth. Walking A Tightrope Chair Yellen's speech makes it clear the Fed is well aware of how its monetary policy affects the global economy and the feedback loop this creates. This is of particular moment right now, given the Fed is the only systemically important central bank even considering tightening its monetary policy. As she notes, "Broadly speaking, monetary policy actions in one country spill over to other economies through three main channels: changes in exchange rates; changes in domestic demand, which alter the economy's imports; and changes in domestic financial conditions - such as interest rates and asset prices - that, through portfolio balance and other channels, affect financial conditions abroad." The other major threat to EM commodity demand is the oil-production deal being negotiated by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia. Should these negotiations result in an actual cut in oil production, it would accelerate the tightening of global oil markets - likely increasing the rate at which global inventories of crude oil and refined products are drained - and put upward pressure on prices. While we do not expect a material agreement to emerge from these negotiations - KSA and Russia already are producing at or close to maximum capacity at present. A freeze in production by these states would result in no change in production globally. The risk here is KSA actually cuts production beyond its seasonal decline by adding, say, a 500k b/d cut to the expected 500k b/d seasonal decline, and Russia agrees to something similar. This would be offset by continued production increases in Iran, and possibly in Libya and Nigeria, but would, nonetheless, surprise the market and rally prices. All else equal, higher prices would weaken EM demand growth at the margin, and feed back into lower inflation expectations. We do not believe it is in KSA's or non-OPEC producers' interest to try to tighten markets sharply, since a price spike would re-energize conservation efforts by consumers, particularly in DM economies, and incentivize alternative transportation technologies like electric cars, as happened when oil prices were above $100/bbl from 2010 to mid-2014. Nonetheless, KSA, Russia, and other parties to any production-management agreement will have to balance this risk against the likelihood U.S. shale producers step in to fill the production cutbacks before any meaningful increase in revenues accrues to these states. Bottom Line: It still is too early to discuss the implications of a production cut, given negotiations between the KSA and Russia camps ahead of OPEC's November meeting continue. However, this could become a material issue next year, just as the Fed is considering whether to hike rates two more times, as we expect. A combined oil-production cut emerging from the KSA - Russia negotiations, which is a non-trivial risk, coupled with two Fed rate hikes could set off a new round of disinflation or even deflation, just as EM commodity demand was starting to enliven inflation and inflations expectations in the U.S.10 This could force the Fed to back off further rate hikes, or even walk back previous rate hikes. If on, the other hand, Chair Yellen is successful in persuading her colleagues to run a "high-pressure economy" we would look to get long commodities generally, gold in particular, given our expectation core PCE inflation and inflation expectations will move higher. As our research has shown, the yellow metal is particularly sensitive to the Fed's preferred inflation gauge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS China Commodity Focus: Softs Grains: Focus On Relative-Value Trade We remain strategically bearish grains, but we are upgrading our tactical view for wheat from bearish to neutral. We believe most of the negative news already is reflected in wheat prices. Over next three to six months, we expect wheat to outperform soybeans. Wheat prices could move up on reduced U.S. acreage, rising Chinese imports, or any unfavorable winter weather in major producing countries while expanding area-sown in Brazil, Argentina, China and the U.S. will likely pressure down soybean prices. We recommend a tactical long position in March/17 wheat versus March/17 soybeans. We suggest a 5% stop-loss to limit the downside risk. Grain prices have already rebounded 10.3% since August 30, when prices collapsed to a 10-year low (Chart 7, panel 1). There were three main reasons behind the precipitous price drop from early June to late August. 1.The 25% rally grain prices in 2016H1 encouraged global planting of spring wheat, soybeans, corn and rice. 2.Favorable weather lifted yields of all grains to record highs. 3.Extremely cheap Russian, Ukraine, Argentine and Brazilian currencies boosted exports from these major grain producing countries. In addition, grain-related policy changes in Argentine and Russia also have stimulated their grain exports (wheat benefited most and corn next). Given a 10% rebound recently, as the USDA expects global grain stocks to rise 3% to a new high next year, we remain a strategical bearish view on grain. Looking forward, we will continue to focus on relative-value trades in grain markets. Tactically, we are interested in long wheat versus soybeans. Wheat: Tactically Neutral Wheat has underperformed other grains so far in 2016 (Chart 7, panel 2). Prices fell to 361 cents per bushel on August 31, which was the lowest level since June 2006 (Chart 7, panel 3). Wheat prices have already recovered 16.7% from their August bottom. We believe, over the next three to six months, wheat prices may have limited downside due to one or a combination of the following factors. U.S. farmers are currently in the process of planting winter wheat. According to the USDA, as of October 9, 59% of winter wheat acreage has been planted. As U.S. wheat production costs are well above current market prices, U.S. farmers likely will further cut their wheat acreage over the next several weeks. This year, U.S. wheat-planted acreage has already dropped to the lowest since 1971 (Chart 8, panel 1). Global wheat yields improved 2.8% this year, with 13.4% and 20.8% increases in Russian and U.S. yields, respectively. Even though Russia will raise its wheat-sown area for next season, the country's wheat crop still faces plenty of risks during its development period. Too cold a winter or too hot a summer, which may not even result in a considerable drop in yields, still could spur a temporary rally in wheat prices. Similarly, U.S. wheat yields are also likely to retreat from the record high in 2017H1. In addition, extremely low wheat prices will encourage global farmers to plant other more profitable crops instead. As a result, both global wheat acreage and yields will likely go down next year (Chart 8, panel 2). Speculators are currently holding sizable net short positions. Market sentiment is also extremely bearish. Given this backdrop, any short-covering also would drive prices up (Chart 8, panels 3 and 4). Chart 7Wheat: Cautiously Bullish Chart 8Wheat: Upgrade To Tactically Neutral ##br##On Supportive Factors Soybeans: Tactically Bearish Soybeans have outperformed other grains significantly this year (Chart 7, panel 2). As planting soybeans general is more profitable than planting corn, wheat and rice, global farmers are likely to expand their soybean acreage for the next harvest season. According Conab, Brazil's national crop agency, Brazil's soybean production next spring will increase 6.7% to 9%. Record high U.S. soybean production is likely to weigh down the market as well. According to the USDA, 7.1% jump in the yields will bring U.S. soybean crop to a record high, an 8.7% increase from last year. As of October 9, 2016, only 44% U.S. soybean has been harvested, 12 percentage points behind last year. Chart 9China Grain Imports Will Continue Rising How does China contribute to our grain view? As the world's largest grain producer and also the largest consumer, China is an important player in global grain market. Last year the country accounted for 20.7% of global aggregate grain production and 23% of global consumption. In terms of grain imports, as we predicted in our January 2011 Special Report "China-related Ag Winners For The Long Term," China's grain imports have been on the uptrend, despite the depreciating RMB in the most recent two years (Chart 9). In terms of individual grain markets, China has been the most significant player in the global soybean market, accounting for 62.7% of global imports last year. China is also the world's largest rice importer, accounting for 12.5% of global rice trade. However, for corn and wheat markets, China only accounted for about 2% of global trade. In late March, the Chinese government announced an end to its price-support program for corn, but the government maintained price-support policies for wheat and rice. The government also announced its temporary reserve policy will be replaced by a new market-oriented purchase mechanism for the domestic corn market. In addition, the policy of giving direct subsidies to soybean farmers will continue in the 2016-17 market year. What Are The Implications Of China's Grain-Related Policy? Domestic corn prices fell sharply with global prices, while the gap between domestic soybean prices and the international ones remains large (Chart 10, panels 1 and 2). This will discourage domestic corn sowing and encourage soybean production, which is positive to global corn markets, but negative for global soybean markets. China's imports of wheat and rice are set to rise, given a widening price gap (Chart 10, panels 3 and 4). The country's demand for high-quality wheat and rice are rising as household incomes have greatly improved. China will likely liquidate its elevated grain inventories, which account for about 45% of global stocks. This will be bearish for all grains. However, as most of the domestic grain stocks are low-quality grains, inventory liquidation may affect animal feed market rather than the good-quality grain market. Overall, China's grain policy is positive for international corn, wheat and rice prices, but negative for global soybean prices. Investment strategy As we expect wheat to outperform soybeans over the next three to six months, we recommend a tactical long position in March/17 wheat versus short March/17 soybeans with a 5% stop-loss (Chart 11). Chart 10Implications Of China Grain Related Policy Chart 11Go Long Wheat Versus Soybeans With Stops Downside risks To Our Relative-Value Trade Position Currently, global wheat inventories still are at a record highs, and almost all the major wheat exporting countries continue to hold considerable inventory for sale. If farmers in Russia, Ukraine and Argentina rush to sell to take advantage of recent price rally, wheat prices will fall. Also, a strengthening USD will put a downward pressure on grain (including wheat and soybeans) prices. For this reason, it will be important to monitor U.S. dollar strength against the currencies of these countries - too-strong a USD will keep grains from being exported, which will keep domestic U.S. prices under pressure. However, our relative-value trade may weather this risk well as a strengthening dollar affects both wheat and soybeans. Moreover, if weather continues to be favorable during the winter, wheat prices may drop below the August lows. On the other side, if unfavorable weather reappears in South America next spring like this year, soybean prices may quickly go up. To limit our downside risk, we suggest putting a 5% stop-loss to our long wheat/short soybeans trade. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see "Macroeconomic Research After the Crisis," Dr. Yellen's speech delivered at the October 14, 2016, Boston Fed 60th annual economic conference in Boston. She highlighted hysteresis - "the idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy" - in her discussion on how demand affects aggregate supply. She noted, "interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand." 2 Core PCE is the Personal Consumption Expenditures (PCE) price index, which excludes food and energy prices 3 The relationship shown in the Chart Of The Week covers the period March 2000 to present. The adjusted R2 of the cointegrating regression we estimated is 0.97; the price elasticity of gold with respect to a 1% change in the core PCE is close to 4%. The model is dominated by real rates, however: a 1% increase in real rates translates to a 15% decrease in gold prices, while a 1% increase in the broad trade-weighted USD implies a decrease in gold prices of just under 2.5%. Data and modeling constraints took the last observation to August 2016, when the model suggested the "fair value" of gold was close to $1,200/oz. At the time, gold was trading at just below $1,310/oz. Prices subsequently fell into the low to mid $1,200s, and were trading at ~ $1,270/oz as we went to press). 4 For this chart, we use the St. Louis Fed's 5y5y U.S. TIPS inflation index. Please see Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR , October 19, 2016. 5 Please see "Memo To Fed: EM Oil, Metals Demand Key To U.S. Inflation" and "Commodities Could Be Hit Hard By Fed Rate Hikes," in the August 4, 2016, and September 1, 2016, issues of BCA Research's Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. See also "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 6 The adjusted-R2 statistics for cointegrating regressions we ran for core PCE as a function of non-OECD oil demand and world base metals demand were 0.99 and 0.98 from 2000 to present. 7 Please see discussion beginning on p. 4 of "China's Evolving Demand for Commodities," by Ivan Roberts, Trent Saunders, Gareth Spence and Natasha Cassidy," presented at the Reserve Bank of Australia's Conference focused on "Structural Change in China: Implications for Australia and the World," 17 - 18 March 2016. 8 The Fed's broad trade-weighted USD index post-Global Financial Crisis peaked in January at just under 125 and currently stands at 122.6. Please see Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. Dollar Index: Broad [TWEXBMTH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TWEXBMTH, October 18, 2016. 9 Please see p. 3 of "Commodities Could Be Hit Hard By Fed Rate Hikes," in the September 1, 2016, issue of BCA Research's Commodity & Energy Strategy, available at ces.bcaresearch.com. 10 We define a non-trivial risk as a 1-in-6 chance of occurrence - i.e., the same odds as Russian roulette. Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades
Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions Chart 2Earnings Set To Disappoint? Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) Chart 8Small Business Concerns (Part 2) Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls
The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.
Gold prices and gold-related equities have been caught in a sharp selloff. The motivation behind our early-August profit-taking stemmed from extremely overheated sentiment at a time when the yellow metal was vulnerable to an increasingly more hawkish Fed. Despite rumblings about asset purchase tapering at the ECB and Bank of Japan, we continue to see gold as an excellent long-term play given the likelihood of a prolonged period of depressed real interest rates. We are looking for an opportunity to return to an overweight position, but are reluctant to add just yet given that the Fed still seems intent on tightening policy, which could support U.S. dollar strength. In addition, neither technically overbought conditions nor extreme bullishness have been fully unwound. The bottom line is that near-term policy threats may keep gold and gold shares in consolidation mode for a while longer. Stay neutral, but be prepared to lift positions in the coming months.
We put the odds of an oil-production freeze agreement between OPEC and Russian officials next week in Algiers at slightly better than a coin toss.
Fed policy - and, importantly, policy expectations' effect on the broad trade-weighted USD (TWI) - will dominate price evolution over the short term, as markets puzzle out if and when a rate hike is coming this year.
Gold stocks have been pummeled since we recommended booking profits on our overweight position on August 1. While the cyclical backdrop of policy and political uncertainty, rampant debt growth and negative interest rates are bullish for the yellow metal, tactical froth remains to be wrung out. The chart shows that flows into gold ETFs have been very aggressive this year, and speculative positions are running hot. Meanwhile, the relative gold share price ratio had reached extraordinarily overbought levels, and overheated conditions have barely been dented by the recent pullback. With the Fed talking tougher, the risk is that any premature tightening in financial conditions through a stronger U.S. dollar will continue to weigh on gold shares. We recommend staying on the sidelines for a while longer and will look to reestablish overweight positions once tactical downside risk has been expunged.
A Fed rate hike by December could erode the slowly evolving fundamentals favoring base metals.
Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.
Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.