Most market participants have seen the markets shoot up in a straight line and suggest it is overdone, failing to recognize that other than the S&P 500, most indices are still recovering from their 2018 losses. The Emerging Market index $ (EEM) is still down 12% from its highs and the Eurostoxx 50 $SX5E is just breaking higher by 5% only this December. One cannot focus solely on the S&P 500, which is up 25% this year but up about 12% from its 2018 highs, mostly because of technology stocks -- it is not a fair comparison as that sector has been the single most powerful growth engine in the market the past few years.
But what the sceptics do not appreciate is that the technology sector is no longer leading the rally today. It may be up in absolute terms, but the momentum and surge higher is coming from cyclicals and value-oriented sectors like Energy, Mining, and Banks; sectors that have been perennial underperformers for years. So, what has changed?
I would be remiss if I didn't start this exercise by giving due credit to the U.S. Fed and to Fed chair Jerome Powell, who did two drastic U-turns this year, one in January and then again in September. The Fed's balance sheet touched a low of $3.76 trillion in September and is currently at $4.137 trillion -- up around $377 billion in 3.5 months. That changed the course of the markets and asset prices altogether.
Whatever the reason, whether they were running scared or unable to explain how asset prices collapsed in December 2018 -- due to rising dollar rates and quantitative tightening, or the repo crisis that unfolded in September that saw overnight rates surge to 10%. What the Fed has started to understand is that they are not just conducting monetary policy for the United States, but for the rest of the world as well.
With its global reserve status and with most countries' debt priced in dollars, the dollar's path affects the fate of most developing countries, especially China. Since the Global Financial Crisis, we have reached a state where risk assets and economies around the world cannot risk higher dollar interest rates or a higher dollar for too long, and the Fed now knows it. It is slightly cornered.
It is a mystery how this all ends, as we can't keep inflating out of a problem forever, but one needs to focus on the liquidity momentum for now. To put it plainly, after four rate hikes in 2018, the S&P 500 returned -6.3% -- the worst result since 2009, even though it had the best earnings per share in eight years at around 20%. In 2019, after three rate cuts, the S&P 500 returned 28.5% -- the best results since 2013 -- while its earnings per share produced the worst return since 2015-2016. Case rested.
But we cannot brush off fundamentals entirely, there is still some logic left to the market. The liquidity argument just exacerbates a trend that is already in place, but the trend needs to be there. Take commodities for example. Oil, Copper and most Base Metals have been underperforming for the last year and a half, since Trump decided to go on his Trade War rampage against China and the rest of the world. This had a direct impact in slowing growth and halting supply chains, which was evident in the demand/supply balances, hence lower prices. Commodities are driven by global growth and demand prospects. If that slows and supply is flat or growing, prices will continue falling.
The Fed and various central banks are now pumping liquidity to avoid a deflation or recession, they are bent upon getting inflation higher. That is their "whatever it takes" policy. Their solution to a crisis is to stimulate their way out of it and that will get growth to pick up. That is where we are now. Asset prices first rise then ask questions later. Analysts look at present data to pinpoint a slowdown, but that present data is based on "past" trends. It does not tell you what is about to happen, only what has happened. Low and behold, the data in November has started showing signs of stabilization and even a modest improvement.
Friday morning, China's Industrial profit increased 5.4% year over year (y-o-y) in November, vs. a 9.9% fall in October, the steepest drop in eight months. Over the last few weeks, they have announced a few measures missed by the market, suggesting a pick-up in spending and infrastructure as that is the best way to get better growth in a short time.
They announced plans to invest 800 billion yuan in railway, 1.8 trillion yuan in highway and waterway and 90 billion yuan in civil aviation in 2020, according to the country's Minister of Transport. This is in addition to the 1 trillion yuan that Beijing brought forward of the 2020 special purpose bond quota to this year, giving local governments more leeway to borrow money to fund local infrastructure growth this year. The one commodity that will benefit the most from this is and will continue to be copper.
Copper's supply side has always been stressed, but lower demand has kept prices in check. About 18% of global supply of around 3.7 million tonnes of Copper are at risk of supply disruption due to labour contract rollover next year and potential unrest in Chile. If demand were to pick up, Copper could be set up for a big squeeze. After all, it was only trading $7200/tonne back in June 2018, not that far off, and we all know Copper supply is limited as there are not that many big supply projects coming on as such in the near term. Outright short positions have fallen to 73,000 contracts from an August peak of 118,000 while long positioning have moved up to 60,000 contracts from 41,000 at the start of December. The shorts have started closing as they fear a change, but we are far away from longs stepping in.
Assuming Trump does nothing to escalate Trade War tensions into this re-election campaign year, Copper equities like Freeport $ (FCX) , Southern Copper $ (SCCO) , Kaz Minerals $ (KZMYY) , Antofagasta $ (ANFGF) are all set to rise even further as Copper grinds higher. They are pure value names that can now see the benefit of a rising Copper price, not to mention a world of investors still short and underweight this sector as they are still in the recession camp. The music will only stop once the Fed and central banks stop their liquidity injection. Until then, enjoy the ride.