37903088 the World Explained

8/8/2019 37903088 the World Explained

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The World Explained

UBS Macro SalesFriday September 17 2010John Clemmow +1 212 713 3090Please note that these ideas may differ from theUBS house viewThis is somewhat abridged version of a presentation that I roadshowed around Europerecently. It summarises a number of themes I've been discussing through the NorthernHemisphere summer.

Hi

Once again I want to return to the vexed question of asset correlations and what they mean. Thechart shown below is my old favourite, the S&P versus the 3 month copper price. It shows that atleast since the beginning of 2008, the price of copper and the value of the S&P have moved inthe same direction. The only sizable deviation from the lock-step performance of the two hasoccurred quite recently when the S&P has failed to match the magnitude of the rally in copper buteven in this case, the direction of the daily performance has remarkably similar. Copper and theS&P are just the most visible examples of the Risk On - Risk Off phenomenon which hasdominated investment strategy for the past few years. Essentially Risk On is when expectationsfor the global economy are positive and equities, emerging markets (currencies, debt andequities) and commodities all move higher whilst the USD falls. Risk Off is the inverse, the USDrises, whilst equities, emerging markets and commodities fall. There is very little need forsophisticated investment strategies in such an environment. All large, liquid, risk assets move inthe same direction the only difference is their beta to the risk trend. As one large macro fund said

to be earlier this year, give me the copper price and I can guarantee returns.


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The reason this chart engages me so much is that theoretically it just should not be correlatedwith the S&P. Even as I write there are unfortunate students being taught that commodities andequities have a negative correlation - that equities are leading and commodities a laggingeconomic indicator. Indeed part of the justification for investors pouring money into commoditiesas an alternative asset class is that doing so reduced overall portfolio risk. Well it may have doneso in the past, but it certainly doesn't now. To me the puzzle is why has there been this change inthe market because it does not make obvious investment sense. Consider the market ten yearsago - I have a generally positive view about the US economy and hence the S&P, why would Ichoose to express this view by selling the USD? Surely if the US is expanding that should begood for investment flows and positive for interest rates, all of which should be supportive for thedollar. Why should I buy copper? The US has a low marginal consumption of copper per unit ofGDP growth. High beta plays on US economic growth would be something like technology spend.Without understanding why the illogical and theoretically wrong correlation of the S&P and copperhas occurred it is impossible to justify arguments about when and if it will break down allowing themarkets to return to "normal".

Looking back into the mists of time we can see the correlations started to move towards one asfar back as 2005 with the degree of alignment increasing over the proceeding period. Hence weare looking for a market factor or factors that first became apparent during this period and whichhas subsequently become more and more important. One of the explanations put forward is thesuperficially attractive thesis of increasing risk. The argument holds that as perceptions of marketrisk have increased, investors willingness to place value on future events diminishes. Futureearnings become less and less important leaving market performance driven my current resultswhich are themselves a reflection of past performance. So the fact that copper and the S&P havebecome coincident is not because copper has become a lagging indicator but rather is due to theS&P rating moving back in time. It's a wonderful argument but unfortunately its completely wrong.If we use the VIX as a measure of market risk then we can see that apparent market risk declinedin 2005/06 and early 07 and most dramatically during 2009 whilst correlations increased. Risk isnot the cause of copper and the S&P becoming as one.

The second answer is money flow. The argument points to the increased influence of fast moneyaccounts on market direction and the lack of conviction that is apparently ubiquitous amongstinvestors. Without long-only funds drawing a line in the sand, the market is whipped up and downby fast money accounts that are desperately trying to catch the next trend. Now I would acceptthat there is some justification to this view but it does not explain why money flows into copperand the S&P at the same time when prior to 2005 it really didn't. It is obvious that money doesflow into Risk On and Risk Off assets en masse but just pointing to an event and observing itsoutcome does not explain why it is happening. The money flow justification for correlations is justsophistry.

My suggestion is that the rise in correlation is linked to the rise of the economic importance ofChina. Prior to 2005, the US was the proxy for the health of the global economy post 2005 itsplace has been taken by China. Consider your own morning meetings and compare the time youspend discussing the US and Chinese economies and recall how the relative importance of thetwo has changed over the years. If global growth is now driven by China then it makes greatsense that equity markets and commodities are linked as a booming China means a hugeincrease in raw material demand as China is the most commodity intensive user of raw materialsper unit of GDP growth. A booming China was also bad news for the USD as it meant a rise inthe US trade deficit. So now it makes huge sense to equate positive global economic conditionswith a weak USD and strong commodity prices. It is my belief that China establishes the causal


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link behind correlation one. But what it singularly fails to do is explain why Risk On and Risk Offruns for what appears to be a six to nine month period before reversing. After all China apparentlymanaged to grow vigorously for over a decade with exhibiting the abrupt changes characteristicof current asset class cycles. What is different about now?

Again I think that we have to turn back a few years. (Please note that I have discussed thisrepeatedly in previous notes so forgive me for rapidly sketching out what is a rather complicatedstory very quickly.) Any superficial glance at the Chinese economy shows that it is a very curiousbeast. China does things that don not appear to make economic sense. Particularly when itcomes to heavy industry - a sector that has generated most of the country's recent growth - itseems that China can ignore the economic realities that affect most of the rest of the world. Thehuge Chinese, steel, aluminium, fertiliser (and other chemical industries), smelting and cementindustries for example use such low grade raw materials, or consume so much energy or usesuch inefficient technology (in some cases all three) that would not operate in a real world pricingenvironment. They have prospered and flourished inside China because it is at heart acommunist country which has not priced inputs according to the market but rather via diktat.Communist countries can defy the market - as in the case of Russia - by pricing by decree ratherthan the market, but in the end, when they lose self-sufficiency at have to start pricing - albeit atmargin to start with - using real costs; they break down. As the charts shown below make clear,

China has now lost self sufficiency in basic raw materials. The first chart shows the monthlyimports of coal and iron ore in volume terms. The second shows imports of soybeans and copper.


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How is the cycle going to be broken? I would suggest that there are three ways. The first is thatwe ban investments in commodities. Now I rather like this solution as I am increasingly of theview that commodities are too important, they have too many real world consequences, to allowtheir price to be set via investment flows. But such a ban would require leadership from the USand an unprecedented level of global coordination, neither of which looks set to appear over thenext two years. The second break to the cycle would occur if China ceased to be the locomotivedriving global growth. If the US or India replaced China then the link between commodities, theUSD and equities would break, but once again this seems unlikely to occur within the next twoyears. And finally the current conditions could end if the shape of the Chinese economy changed- if China became a country driven by consumption rather than construction. Now clearly theChinese authorities would like this to occur - indeed the change in Chinese demographics fromhugely favourable to extremely poor dependency ratios almost ensures that such a move will takeplace, but as I stated earlier it is unlikely to happen over the short-term. So, I would argue, thatwe are stuck with the stop-start of Risk On - Risk Off for at least the two years.

This is all rather wonderful but it doesn't really help make investment decisions. The need is to tryand find a number of guides that can tell whether we are in a Risk On or Risk Off environment,even better that can predict when the market is about to change from one phase to the other.Through the summer I tried to come up with a number of such indicators and published mythoughts in a series of notes. I have narrowed the field down to five. (For a detailed explanation of

why I think these tools are useful see the attached individual notes).

1) The Shanghai Composite2) The Baltic Dry Goods Index3) The spot price if Chinese HRC4) The ratio of the BP closing price in New York to that in London5) The ratio of palladium to gold

Shanghai Composite and Baltic Dry Goods Index

S&P and Chinese HRC prices


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The smoothed ratio of BP US to BP UK

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

03/05/2010 21/05/2010 10/06/2010 30/06/2010 20/07/2010 09/08/2010 27/08/2010 16/09/2010

5 day MAVG BP

5 day MAVG S&P


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Palladium Gold and the S&P

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0.55

0.6

0.65

01/01/2008 09/09/2008 19/05/2009 26/01/2010

800

900

1000

1100

1200

1300

1400

1500

1600

Palladium,/Gold

S&P

The similarity in patterns is uncanny. There is a sharp reversal around the end of June, a majorrun-up in July followed by sideways to down during August and now signs of a revival inSeptember. I contend that the last Risk Off cycle ended at mid 2010 and that we are now in thenext up Risk On cycle. The Chinese authorities have moved from a contractual stage in theircycle to a more expansionary position. I don't listen to what the Chinese authorities are saying Ilook at what those players inside the economy are doing and they have built steel stock andinvested in the market. I don't listen to the siren call of gold rising because of an upcomingapocalypse - sure gold is up, but other risk assets including the uber-risk on palladium are up bya lot more. And look around you. There is almost universal gloom here in America but I can tellyou from personal experience that the feeling is not shared in Europe and Asia. And consider UScorporates. Most are bearish about the economy but are optimistic about their own prospects.Aggregating the individual optimism makes the consensual pessimism look odd. Finally look atthe wave of M&A and corporate action hitting the tape. We are back in Risk On mode and themarket will accelerate from here.

The first Risk On cycle lasted 9 months, Risk Off around 6 months and we are now 2 months intothe next Risk On. How far can we go before the commodity brakes crimp the Chinese and globaleconomy? The simple answer is that I don't know but what I have assumed is that at some stageduring the first half of 2008, when commodities shot to their collective apogee, demanddestruction occurred. So what I did was to take the average price of a basket of commoditiesduring H1 2008 and compare it to todays spot. When I first ran the data the general level ofpotential upside was 20% - 25%. After another month of Risk On in commodities, the margin isnow much tighter. Excepting natural gas which has been distorted by shale gas discoveries, thecommodity growth gap has closed to an average of 10% -15%. Given the correlation between


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commodities and the S&P, that implies maybe a further 150 points on the index before thecommodity brakes force China to shift into Risk Off mode.

H1 2008 Average Spot Spot as % of Max Price

Corn 574 507 88%Wheat 928 733 79%

Soybeans 1355 1052 78%

Cocoa 1369 1902 139%

Cattle 92 99 108%

Copper 8034 7700 96%

Nickel 27476 23250 85%

Lead 2612 2202 80%

Aluminium 2888 2165 84%

Oil 111 75 68%

Nat Gas 10.13 4.08 40%

So what could go wrong? I can see three potential upsets to my Risk On cycle. The first is thatthe US authorities, who are clearly concerned with supporting asset prices, will conclude thatasset prices have rebounded from their June lows and that there is therefore no need to considerany further market intervention. This is possible, but given that employment and housing remainsin the mire I would suggest that they will certainly want to maintain at least current policy levelsuntil these indicators (both lagging) turn positive. The second is that a republican landslide inNovember wrests control of the House and Senate from the Democrats ushering in a period ofdeficit activism. Again this is entirely possible, although after the primary votes a republicansenate is looking less likely than it was before. But remember that Republicans are alsopoliticians and politicians when it comes to an apparent choice of pain for the people who votedfor you or spending other people's money tends to opt for the latter. Its the final hurdle that

bothers me and this is the issue of food prices.

China faces two sources of cost push commodity inflation. The first is driven by its own actionsand this largely means its heavy industry policy settings. The second is not and that largelymeans food prices. Whether China is expanding or contracting does not really affect global foodprices but global food prices seriously impact China. I am - as most of you know - a long-term bullon agriculture but I have consistently warned that even if the trend of prices is up, the amplitudeof swings in basic food prices can wipe investors out. More than any other asset class, agricultureis a trading investment. Given that, I have been pointing out that there is the potential for a rathernasty spike in food prices during the course of the rest of this year (see my notes on corn andwheat). The only policy weapon in China's arsenal to combat the influence of rising food prices isto allow the Yuan to appreciate. Many would see this as positive for commodities and other risk

assets; I would not as an appreciating currency would act to even further suppress exportindustries. I am therefore concerned that China might be close to a currency realignment whichwould bring a premature end to Risk On. On balance I suspect that China will accept that thisyear's food spike is temporary and will resist the urge for a major revaluation but I would not besurprised if we see a combination of a mildly appreciating Yuan coupled with a moreaccommodating domestic lending policy.

To conclude - correlation 1 has been driven by the rise of China; it will be with us for at least thenext two years. Risk On - Risk Off is a function of China accelerating and then braking as


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commodity prices threaten to unleash cost push inflation. We are now two months into the nextRisk On cycle and have about 10%-15% further upside before policy reverses once again. Foodis a major risk and needs to be watched but at the moment is not sufficient to break the up-cycle.

John

Contacts for Investment in Commodity markets through ETFs, ETCs, structured fund, structuredproducts, other index linked structures;

- Asia: Katia Demekhina +852 2971 6627; [email protected]

-Europe:Zak Cherkaoui +44 20756 75317; [email protected]: Jon Fraade +1 203 719 3904; [email protected] for trading CommodityExchange Traded Derivatives;- Asia: Terence Noe +65 649 53637; [email protected]

-Europe:David Cunningham +44 20756 87067; [email protected]: Patricia Flakus +1 312 525 6604; [email protected]

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37903088 the World Explained

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