Commentary

Historically when the US Dollar (USD) has been high there are knock on effects with commodities and emerging markets. This update will take a look at those in detail, as a similar situation is the case today.

There are 5 times in history when the US Dollar was strong and a major market event followed:

1. 1987 USD Index bottomed out. Stock market crash of 1987.
2. 1995 Extension of a 7 year rally. Asian Financial Crisis of 1997.
3. 2000 Last push by the USD. Dot-Com Bubble burst.
4. 2005 Dollar rebounds. The following year the US housing market triggers the financial crisis.
5. 2014 FED stopped QE. Dollar resumes its rally. Oil prices slashed. Commodities head toward their Emerging market currencies plunge.

Commodities & Precious Metals in a Bear Market

Previously the atmosphere was good for this sector as the USD weakened and China was a major consumer. Presently both these factors have reversed. The Bloomberg Commodity Spot Index (Fig. 1) is at the 2008-2009 levels and it is forecasted to go sideways for a while awaiting the next stimulus. Copper (Fig. 2) has retraced 50% from its high in 2011 with previous retracements from the highs are in the order of 70%. Oil (Fig. 3) is also nearing the 2009 levels currently at $41 and a potential 70% retracement from the highs of $115 equates to $35. For Gold (Fig. 4) a 50% retracement from the highs of 1900 equates to 960 with current prices at 1069. We’ve made earlier comments on gold to continue its down trend and go sideways unless there are any fiscal policy changes to favour gold.

Commodities Cutting Production

The slump in commodity prices has forced mining companies to begin to cut production.

2015

• September: Commodities giant GLENCORE announced its two flagship COPPER mines in Africa will be discontinued in 18 months cutting is copper production by about 20%.
• October: GLENCORE announced it would cut annual production of ZINC by 500,000 tons, which is a third of its output.
• November: ALCOA, the largest ALUMINMUM manufacturer in the US, plans to cut its smelting capacity by 503,000 metric tons and its refining capacity by 1.2 million metric tons by the end of Q1 2016.

 

Emerging Markets

Goldman Sachs closes its BRIC Fund

We’ve not recommended precious metals, commodities or the emerging markets sector the last few years. Goldman Sachs closed its BRIC fund as from 2010 it has dropped a staggering 88% from its highs (Fig. 5). Performance was lacking and they closed it then merged it with a broader emerging-market fund. Bloomberg also reports that Goldman pulled the plug because it doesn’t expect “significant asset growth in the foreseeable future.” To our strategy, this was sector was in play the last cycle we traded between Oct 2008 – Sep 2011 and not now. Brazil (Fig. 6) is at the 5 year low & Russia (Fig. 7) near the lows of 2009.

 

Downgrades

OECD, Organization for Economic Co-operation and Development, fear a drag on the global economy by emerging markets. OECD have thus revised their global economic growth forecast to 2.9% for developed countries.

According to the Institute of International Finance (IIF), since 2009 the cumulative growth of national debt in emerging markets has been rapidly rising. Emerging market non-financial corporate debt reached a record high of 83% GDP in 2014, up from 67% in 2009 (Source: IIF.com).

Moody’s also reports that the slowdown in China and other emerging markets continue to affect the economic growth in the global economy. Furthermore the commodity prices are unlikely to rise sharply in the next 2 years and the global economic growth is still weak.

Standard Chartered could potentially default on their borrowed money, as mentioned in a previous update having 90% of their businesses in this sector. These factors, along with once you start to see related companies go bankrupt, will see new lows perhaps next year.

 

All eyes on the Fed for Possible Rate Hike

To summarize why there is justification to raise interest rates, here are our notes:

• High government debt, too much speculative money.
• Rising inflation and economic data.
• QE is a temporary measure and no help on the real economy.
• Strong dollar, a hike will help the US find buyers of its goods reducing inflationary pressures.
• Delaying the normalization of the dollar will undermine the status as the world reserve currency.
• Delaying normalization will lead to a potential credit rating downgrade. Stock and bond markets have greater adjustment pressures similar to 2011.

Ratings are also important and move markets. Below are the current ratings of each country and region (Fig. 8).

 

Conclusion

In summary the effects of different factors are summarized in Fig. 9 & Fig. 10 for the US and emerging markets. These are historical factors we’ve personally seen that affect the model portfolio over the last 10 years. Like before we are on the sidelines awaiting a clearer direction. It would be very difficult to make back a 20-30% loss as a manager of this portfolio if we took risk at the moment. The next FOMC meeting is scheduled for Dec 15-16, 2015.

Best,
Michael