Please note the views expressed in this bulletin are those of the author and do not necessarily reflect AMP Capital’s house view.
Theme 1: Emerging market consumer dragging the chain
Emerging market economies are weakening which is bad news for global growth.
The rise of the emerging market consumer is a popular, well understood, and valid longer-term theme. But on a cyclical basis the emerging market consumer has seen a significant slump recently (partly due to the commodity collapse, partly due to soft demand from developed economies, partly due to China slowing, and partly due to structural weaknesses). Retail sales have slumped and with the downturn in economic growth, real income growth has also plunged. As emerging markets are an increasingly important part of the global economy (emerging and developing economies account for about 55% of global GDP) it’s also notable that emerging market import growth has fallen to recessionary levels (contracting on an annual basis). This is a risk worth monitoring as emerging market economies command a greater share of the global economy - so any upward or downward movement will be felt more acutely by the global economy. Stronger US and European growth should provide some offset and help support external demand for emerging economies.
Theme in pictures
Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream, CPB
Oil prices have fallen again. This has put US high yield credit under pressure, and could spill over to other risk assets if it goes further.
Theme 2: What about the fall in oil?
An interesting way to think about global markets and economies is like a big 3D puzzle where if you move one piece you immediately set off movements in other pieces. Oil is a great example of this. The crash in the oil price last year set off a number of ripple effects. It triggered a collapse in inflation expectations which saw bonds rally, while at the same time, bond spreads from emerging market economies that produce oil and US high yield credit spreads sold-off. This ended up spilling over to other risk assets e.g. a 10% correction in the S&P500 index. Now that oil has fallen again, will we see the same spill-overs? The first port of call will be to review US high yield credit spreads which have reacted in a similar fashion, with limited spill-over to broader credit spreads so far. The reason it reacts this way is that US high yield credit has a relatively high concentration of energy companies (around 15%). As you can see on the high yield ETF (HYG), it recently suffered from the general rise in bond yields, and is once again suffering from the fall in the price of oil. At some point this might cause investors to think twice about chasing for yield in risky spaces. In any case, keep an eye on the trends in oil and US high yield credit as they could be warning signs of a sell-off in the S&P 500.
Theme in pictures
Source: AMP Capital. Bloomberg, Barclays
Gold faces headwinds. It could see a rebound at some point – but the prevailing currents suggest more downside.
Theme 3: The trouble with gold
Gold is a difficult commodity to analyse. Firstly, there is a set of logical, sensible, fundamental drivers such as real interest rates – secondly, there is a set of mythical faith-based drivers such as the belief that gold has intrinsic value or various conspiracy theories such as the Chinese planning to link the RMB to gold. Not my place to debate that here, but in terms of the traditional drivers of: real yields, US dollar, and positioning we can try and make some judgements about the outlook.
The US dollar is strengthening and this is usually bearish for gold. Similarly, real yields have begun to rise again, and could go higher if monetary policy and economic conditions begin to normalise. Speculative futures positioning is still net long, but has come down to the bottom end of the range. This could mean the current wave of selling is near exhaustion, but in the context of a down-trending market, with the headwinds of a rising US dollar and rising real yields, there would need to be some other driver to turn it around.
Theme in pictures
Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream.
Gold mining stocks have been hit hard – but be very careful about catching this falling knife!
Theme 4: But what about gold miners?
Before you go out buying gold mining stocks because they’re now ‘cheap’ or because they’re so low they can’t get any lower, it might pay to check a couple of interesting charts. It’s worth noting that there has been an ongoing trend for gold miners to underperform versus just holding gold itself. How could this be? A couple of factors are at play.
Firstly, there is the profit aspect - any given change in the gold price will have a potentially disproportionate impact on profit margins of gold miners. For example, if a company has a cost of production of $1200 it means two things if gold fell from $1,300 to $1,250 (i.e. made less profit) versus falling from $1,300 to $1,150 (i.e. lost money).
The second aspect is that commodity prices generally reflect present supply and demand conditions, whereas equities are anticipatory assets in that they try to predict what future value or future cash flows will be. So, if the price of gold was expected to decline in the future, then gold miners would get hit now.
Finally, when we think about commodities we often look at price versus cost of production as it tends to force adjustment over time on the supply side… it’s the producers who do the hard work to balance out supply and demand. This is hard work in terms of expanding and investing when prices are high, and scaling back or going bankrupt when prices are low. So, as the price of gold goes down towards or below the cost of production, it may be supportive for gold prices further out in that it will force adjustment to supply – but it is the miners who will be doing the hard work on the adjustment!
Theme in pictures
Source: AMP Capital, Bloomberg, Thomson/Reuters Datastream
China is undergoing a gradual but important transition. The next five-year plan to be announced in October will be worth paying close attention to.
Theme 5: China rebalancing
China’s economy has been slowing but it’s worth noting that some parts have been slowing faster than others. As a result, there is a sort of rebalancing underway which moves away from the old model of high exports and industry towards the consumer. However, the key transition from investment to consumption is not quite in full swing. Thinking about China’s economy over the next 10 years there are three key things to be mindful of (or maybe even be positive about!). Firstly, One Belt One Road; secondly, Made in China 2025; and thirdly, Reform and Rebalancing. The first two aspects are quite interesting, particularly the One Belt One Road program, but it’s the reform and rebalancing that is the core part that will shape China over the next decade and beyond.
It’s worth highlighting that in October this year the Chinese Communist Party will hold its fifth Plenum where it will work on its next 5 year guideline for the years 2016-2020 (it used to be called 5 year “plan”, but changed to “guideline” in 2006 to reflect the transition from a planned economy to a market economy). Note, typically these are announced at that time and then approved in March in the following year. As China is still partly free-market and partly command and control, these things are highly important. Reform is likely to remain a key theme. Notably, also on the calendar in October is the IMF SDR review. So, if you thought the year so far has been interesting for China, it will only get more interesting as we approach the announcement of the 13th five-year guideline.
Theme in pictures
Source: AMP Capital, Bloomberg, National Bureau of Statistics.
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