What a difference a few months makes to asset allocation and sector preferences. We started the year chasing the reflation trade and all the cyclical stocks and sectors like energy, mining, industrials and financials, all because of bond yields rising, indicating an economic recovery.
It got to the point where certain commodities like oil and copper went over and above their own market fundamentals as the generalist traders chased them blindfolded trading it tick for tick with the U.S. bond market. Oil was a clear example of this during Q1 when generalists kept quoting the reflation trade and took oil all the way to $77/bbl. Brent. Of course, OPEC+ played an important role in keeping the market tighter for a lot longer as they have the advantage to control the prices for now.
Three months later, cyclicals have given away and now Hedge Funds are positioned defensively, covering their shorts and now long the same "growth" proxies like technology, ones that they shunned just a few months ago.
Commodities are driven not only according to their micro bottoms up demand vs. supply inventory dynamics but also by the macro economic drivers at play. This is especially important for commodities like copper known endearingly as Dr. Copper for a reason. It is the best temperature gauge of the economic cycle. Copper peaked in May at close to $11000/tonne and has since been stuck in a downward range, today testing its 100-day moving average. This is happening at a time when if one reads most sell side reports, they all call for a super "tight" market and how copper should move upwards of $11000/tonne to $15000/tonne even. We have the sustainability movement, climate change, cleaner energy, electric batteries -- all factors that help keep the demand for copper up. But then why is it falling despite these bullish calls? In a nutshell, Chinese growth dynamics!
Post the pandemic, we know China, along with most other developed countries, stimulated their way out of the economic slump induced by COVID. They all printed their way out of the mess. Today we are at a level where global debt is absolutely unsustainable, and U.S. debt to GDP is higher than even post WW era! After getting the "bounce" China needed, they put their foot on the brake some time in November 2020. Since then we have seen their credit impulse go into negative mode. They started reigning in the excess growth of the past year and started deleveraging as they got their desired GDP growth. From the lows of 3% GDP growth in Q2, Q4 moved back in excess of 6%. The best way to jumpstart the economy is to boost infrastructure projects which is what they did.
That is one of the reasons why we saw such a surge in demand of copper, iron ore, steel, cement and all commodities related to construction and spending. Today, China's industrial output grew 6.4% y/y in July vs. the expected 7.9%. Retail sales grew by 8.5% vs. 10.9% expected and fixed asset investment was lower too. It is not the absolute level but the rate of change that has moved down. It was only a matter of time when the Chinese slowdown would affect developed markets, as they too are now showing signs of plateauing after the excess stimulus growth of last year.
Today Q3'21 global GDP growth expectations have moved down towards 6% from highs of 8% just a few months ago. Growth is slowing down across the board and that is one of the main reasons why base metals like copper are falling, as China is one of the key demand drivers and they have hit the brakes months ago. It is astonishing to think that central banks printed in excess of $20 trillion in just a few months to help the global economic recovery and the growth phase could not last for more than a year! Today we are faced with higher input prices and sticky inflation at a time growth is slowing. This is not the best mix for cyclical assets or equities in general as it indicates stagflation.
All hands-on deck into Jackson Hole as Fed Powell presides. The market will look for any clues as to what the Fed is thinking with regards to their asset purchases. I would be remiss if I did not mention that a year after all financial assets have recovered back to the highs and economies opened and people vaccinated, the Fed still needs to buy $120 billion/month of asset purchases. One can only wonder what will happen when the market goes through the next speed bump! Will Powel do a Volcker and pre-empt the higher inflationary pressures or follow the Greenspan put model and just keep on printing. That remains to be seen.
