Steen's Chronicle: The best of times, the worst of times

https://www.tradingfloor.com/posts/steens-chronicle-the-best-of-times-the-worst-of-times-4905342

 

Dear All,

 

Edited and improved version now "officially released" on www.tradingfloor.com

 

 

• Significant changes to our JABA model's long-term outlook
• Inopportune rise in gold and energy prices expected
• Commodities will outperform and yields will add another 100 bps
• Europe will suffer downturn and the US will flirt with recession in 2016

Gold is one of those items that should outperform over the longer term. Photo: iStock

 

By Steen Jakobsen

Saxo Bank's JABA model rarely makes significant changes to its long-term outlook, but this quarter is different. Not only do we expect a steep increase in yields but higher gold and energy prices too.

The dynamics at work are plenty: The model's predictions are always based on the lead-lag of different economic factors. Think of each economic data point, each market price as having its own Sinus curve. Once in a while this multitude of Sinus curves moves in the one direction and this time it's upwards in the second half of 2015.

The biggest "news" is that we are very close to the secular low in interest rates globally. This will have material impact on stocks, fixed income and asset allocation over the coming one to five years, and probably an "upside-down" return profile relative to performance since the financial crisis started. Commodities will outperform and yields will move up by another 100 bps before Europe once again slides to downturn and the US flirts with recession in early 2016.

 

The headlines for the next 6-7 months say:

 

• US, German and EU core government bonds will be 100 bps higher by and in Q4 before making its final new low in H1 2016. US 10-year yield will trade above 3.0% and Bunds above 1.25%
• Energy: WTI crude will hit US $70-80/barrel, setting up excellent energy returns.
• US dollar will weaken to EUR1.18/1.20 before retest of lows and then start multi-year weakness.
• Gold will be the best performer in commodity-led rally. We see 1425/35 by year-end.

 

US 10-year yield next cycle  >3.25% then <1.50% then normalisation

Source: Bloomberg 

Next cycle for the US dollar  – test of new lows until 2019

 Source: Bloomberg

 

US trade-weighted dollar index: gains first, then slides

 Source: Bloomberg

This, of course, is the same model that predicted Germany flirting with recession last year and the absence of lift-off growth in the US over the last few years. This very model has kept me 75% in fixed income since Q3-2013.

H1-2016 is now the cycle low for inflation, interest rates, the euro and employment. The year 2016 becomes the true zero against which we will compare all future data points.

The Saxo JABA model forces me to reverse engineer its predictions, and to be honest, it has taken me some time to adjust to this new reality – I like my 75% in bonds – but there is a logic to the model.

The changes in macro themes are:

 

1. China and the new Silk Road.
2. The zero bound interest rates and their unintended consequences. Expected return for all assets is zero.
3. The Federal Reserve's incoming margin call on the asset inflation and the Chinese impact on US rates.
4. Time.

China and the new Silk Road

I have often argued that what happens in Beijing is more important than what goes on in Washington. During the peak of the 2008/09 stock market selloff, 

 

China initiated the single biggest fiscal expansion in history (4 trillion yuan = USD 570bn). Almost singlehandedly the Chinese managed to keep world growth afloat at a time where everything was coming off the tracks.

Now China has initiated the Silk Road land route and a maritime equivalent. It's estimated to be the biggest economic experiment since the Marshall plan after World War II. China is going to use its excess savings to offer credit and infrastructure investment across Eurasia – from China's east coast to Venice and all the way down to Cape Hope in Africa.

With USD4 trillion of foreign exchange reserves, which by the way earns them zero interest, they have decided to expand their customer base by offering supply – credit and investment. This is a modern day version of Say's Law (supply offers its own demand), which by the way remains pretty much the only law I remember from economics and the only one of practical use.

When China comes online with the Silk Road it will be a significant boost to commodities as much of the work and investment needed across Eurasia is in infrastructure, buildings and railroads. 

 

China estimates the yearly value of the Silk Road and the supporting Asian Infrastructure Investment Bank in commerical terms alone will double to $1.25 trillion worth of business by 2020. 

 

This does not account for seed investment, lending and non-Chinese business among the counterparties in the Eurasia region. In other words it's enormous both in terms of scale and ambition.

 

China is renowned for its large-scale projects such as the Qinghai-Tibet railway above. 

But the new Silk Road project will dwarf even that. Photo: iStock

The zero bound interest rate and its unintended consequences: Expected return is zero

 

Keeping interest rates too low for too long entails plenty of risks. Chief among them, of course, are bubbles in the housing and the stock markets. The conclusion no one wants to accept, however, is that zero interest rates, zero inflation, zero reform and zero hope really must mean that the expected return in the near future (less than ten years) is zero.

I was happy to see GMO's recent predictions for asset classes over the next seven years in its Q1 2015 report called Breaking out of Bondage.

 

This has several implications but the one which I think will play a major role in H2 2015 is that commodities will experience a renaissance. They are deeply discounted and actually their return and Z-score almost scream for being bought:

Thomson Reuters /Core Commodity CRB Commodity Index – Price and Z-score on 52 weeks

 Source: Bloomberg

 

The chart above clearly shows that when CRY is 2 Z-score cheap it offers extreme valuations. For context the recent Bund move was an outsized move which should only happen once every 60 years – it's Z- score? Barely 2 Z!

The return profile YoY is even more interesting – it shows how big money can be made and lost in commodities:

Thomson Reuters /Core Commodity CRB Commodity Index – CRY index ROC 12-month

 

 Source: Bloomberg

 

Early 2015 saw commodities return reach minus 30% YoY. The only worse period was 2008/09 during the peak of the financial crisis. 

Add to commodities cheap energy prices. Energy is roughly 40-50% cheaper than a year ago. US studies shows energy costs are estimated to represent more than 15% of the total cost of production in the mining industry in the US. 

 

South Africa's mines uses more than 6% of all energy in the country, and in Brazil the Vale mining corporation accounts for more than 4% of all energy used. This of course makes the mining sector more attractive and mining futures less so.

The commodity outperformance is driven by multiple simultaneous factors:

Under-owned, comparative advantages in zero-bound interest rates (tangible over intangible), inflation hedge into rising inflation expectations, tail-wind from mining costs, the Silk Road and finally, an expected return which beats any other asset based on its recent history.

Interest rates: Secular change? Fed's incoming margin call on the asset inflation & the China impact on US rates

When Stanley Fischer was appointed vice-chairman of the Federal Reserve the dynamics of that institution's focus also changed. Fed chair Janet Yellen was already focused on inequality and job market prospects, but Fischer quickly established himself as pro "macro prudential frameworks". 

He quickly started to talk about "asset inflation" and the need for normalisation of interest rates. (Note, it was not a call for higher rates, but for "normalisation".)

I did extensive analysis of this in my "Is the Fed to do a paradigm shift":

Fischer: "Well, the — I started learning about the Fed when I was an undergraduate. And in those days, we spent a lot of time on the Fed's annual report of 1923, which set out how it thought monetary policy worked. I was amazed to discover in the NBR's most — one of the NBR's recent lists of papers, a paper saying, « When did the Fed give up on its 1923 principles?« , which included preventing banks' lending for speculative purposes. That was one of the things that they were supposed to stop."

..and later:

"The other fact which has come up is, should the Fed be involved in regulation in stabilizing the financial system? And that was something that was believed in 1923, was regarded as not very important in the early 2000s, and is now very important. And I think we're learning that. I don't think we've learned how to deploy it, but we've learned that we have to figure out how to undertake financial sector stabilization, and that's something which we'll develop in the next few years, and I think we're beginning to get a hold of that — that material now"

In other words Fischer believes in macro prudential frameworks and that it needs to be tied to misallocation of capital.

There is, however, one important caveat: If or when the Fed does hike it will be the first time in newer monetary history where it hikes despite not having financial support for it. I have created an extremely simple Fed Prediction Model which has been able roughly to call next direction and timing of change in Fed rates. Presently we are nowhere near a need for higher rates, the "magic" number being >1.0% against the present 1.6%. Clearly, this is not about the economy but entirely to deflate the "asset inflation" , which I guess is new central speak for "bubble like"….

Hike probabilities – inflation, growth and unemployment

Source: Bloomberg

 

The consensus expects the Fed to delay hiking rates in a classic move of "rather wait than act". This is interesting as the consensus as recently as early January saw 2015 as the lift-off point for growth in the US – expecting 3.2% as of end of January (Bloomberg Survey) – unlike the JABA model which early in Q1 called for "2015 to be another lost year for growth".

We have had the worst start to data since 2009 and it looks like that Q2 GDP is heading to another disappointment. Atlanta Fed's GDPnow model is indicating a Q2 growth of 0.7% vs a consensus of 1.7%

 

However, it should be noted that these data tend to mean-revert. I expect US data to pick up and by enough to create a real risk of the Fed raising rates in June or September.

Fed balance sheet and intervention is turning negative – few people realise this:

 

 

 

 Source: Federal Reserve

 

The final piece to this secular change to interest rates comes from China. The recent "dramatic" cut of RRR by a full percentage point adds $260bn worth of stimulus to the Chinese economy – the reversal of the last two decades' policy of sterlising the massive current and capital account surplus. Now China runs a capital deficit and needs to divest its holding – meaning foreign bonds. These are mainly in US Treasuries, but also in EUR government bonds. China will no longer be a net buyer but a net seller of bonds – the speed of which is dictated by how much China needs to cut rates further.

I did a back of the envelope calculation of this recently in a piece called: Why China is more important than the Fed:

RRR is now 18.50% – the 20-yr average is 12.00%. However, assuming significantly more stimulus is needed to reignite China growth into Silk Road projections, we can conservatively estimate that RRR needs to go down. The BIS capital requirement is set at 4.5% and the US has operated with 6-8% since July 2013. In other words, the banking sector is allowed to leverage 22x outside the US and 12.5% in the US. Let's assume China goes to the 12.00% 20-yr average:

The calculation then becomes:

($61 bn * ((20-12))*4 = $1.952 bn. ($61 bn per 25 bps, times 8% net change)) China FX reserves including "loss of RRR cuts"

Chinese FX reserves and the need for RRR to be cut to 12%:

 

Source: Bloomberg

This change of dynamics in China's foreign exchange accumulation comes simultaneously with the country's clear definition of the next political cycle based on the Silk Road initiative. China is slowly, gradually, becoming not only the biggest economy in the world, but also punching its weight in the financial markets. We remain US-centric and Europe-centric is our world view but remaining so in the next ten years can have huge negative implications on investments.

Time – the unknown dimension

The crisis started in 2008 – the low in S&P-500 was in March 2009 at 666.00 (the devil's number!) since then we have had an unpredecented party of easy money, buying time and ignoring facts.

The financial world today is now an island on its own – separated from the real economy, as can be seen by the paradox of record high valuation in the stock market coinciding with record low inflation, employment , productivity and no hope. There is asset inflation, but deflation in the real economy. 

My old theory of the Bermuda Triangle of economics is about to collapse – when the world has been long enough time at zero-bound the misallocation, the inability to reform, and a toolbox without new tools creates a mandate for change.

We are nearing the seventh year of the low, which means we are at the seventh year of the high in the stock market.  All measures of valuation are above neutral. Maybe not expensive, maybe not in bubbles, but a bottom analysis recently by a client I produced just thirteen cheap stocks in a universe of 10,766 stocks.

You will note I haven't "called" on the market in this report, merely because I think the rotation into commodities and the secular change higher in interest needs to have the main focus. 

 

I expect stocks to trade sideways for the balance of 2015 as I always following my "nine-month" rule which dictates that changes in the cost of capital will impact the market will a lag of nine month. I don't see stellar stock performance as the margin call would be an unpleasant surprise. The bigger risk probably is that for once I don't have a strong equity view.

I have now sold all my fixed income, increased my gold exposure, and I'm looking to buy mining companies and overall to increase my exposure to commodities beyond the normal allocation.
Remaining at "zero" is not an option for the real economy over the next 18 months. I expect the business cycle to come back with all the bells and whistles that entails after having spent seven years in hibernation. 

 

 Sometimes it's good to keep digging. Photo: iStock

 

– Edited by Clare MacCarthy

Steen Jakobsen is chief economist and CIO at Saxo Bank

 

Med venlig hilsen  |  Best regards
Steen Jakobsen  |  Chief Investment Officer

 

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