Lucy: It's enough to destroy one's faith, isn't it?
Jerry: Oh, I haven't any faith left in anyone.
The Awful Truth (1937)
For us the 5 most dangerous words have always been:
"It is different this time"
Evolution of rubber in the largest exchanges in China and Japan since March 2010 - source Bloomberg:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis
In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?
Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically. As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.
We believe that the current disconnect between oil prices, the Standard and Poor's index and the US 10 year Treasury yield warrants caution, as it seems to us that the divergence is very significant as displayed in this graph from Bloomberg from the 12th of April:
In a recent note entitled "The asymmetric beta of credit spreads" , Bank of America Merrill Lynch points as well to a weakness of oil prices which might be indicative of weaker growth expectations:
"Is oil re-pricing growth expectations?
A slowing economy could push Brent down below $95/bbl Brent prices have declined by almost $20/bbl on a combination of seasonal and cyclical headwinds. Some of these cyclical pressures are too large to ignore, such as China’s drop in energy demand growth or Europe’s sharp contraction in credit supply. In addition, emerging and developed markets face mounting structural challenges. To name a few, energy importing countries like China, Japan or India are seeing $15/MMBtu nat gas prices at the margin, while others like Brazil are struggling with high labor costs and rising inflation. In Italy or Spain, a high cost of capital poses a major challenge to a recovery. Should the global economic recovery stall further, Brent oil prices could fall below $95/bbl in the near-term.
Our economists see few downside risks to EM growth…
At any rate, our economists still expect China to post GDP growth of 8.0% in 2013 and 7.7% in 2014. These numbers are consistent with our expectations of 360 and 485 thousand b/d in oil demand growth, respectively. A robust China outlook should translate into strong EM growth and hence oil demand. Having said that, Chinese oil demand in March grew by just 255 thousand b/d, consistent with average GDP growth of around 5 to 6%. Surely, solid EM demand has been a constant in the oil market for decades, so a structural slowdown in economic activity would not bode well for global crude oil prices."
…so we keep our $112/bbl Brent forecast in 2014 for now
Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch - 17th of April 2013.
The issue of course is that we believe that "Abenomics" is a game changer from a pareto efficient allocation approach and that Emerging Markets in the vicinity of Japan which are already suffering, will be facing even more suffering in the second quarter hence our negative stance on emerging market equities, and on commodities as well.
On a final note, the latest hedge fund monitor from Bank of America Merrill Lynch from the 19th of April shows that they are positioning for a market correction:
"Based on our exposure analysis, macro hedge funds sold the S&P 500, NASDAQ 100, and commodities to a net short while increasing long exposure to the US Dollar Index. This suggests that macro funds are positioning for a market correction. Macros also sold 10-year T-notes to a net short. Within equities they switched to favor small caps from size neutral but are not at an extreme reading." - source Bank of America Merrill Lynch.
Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...