Indexology^® Blog

The People’s Bank of China (PBoC) announced rate cuts on Nov 21; with 1-year deposit rate lowered by 25bps to 2.75% and the lending rate lowered by 40bps to 5.60%. The market is expecting the rate cut not only to revive the growth but also accelerate the interest rate liberalization.  The cash bonds responded favorably as the yield curves tightened.

The S&P China Composite Select Bond Index is an investible, liquid and transparent index that covers Chinese sovereigns, policy banks and Central State-Owned Enterprises (CSOEs).  According to the index, the yield-to-worst has tightened by 12bps in a week and 22bps in November.*

Comparing across the sectors, the Chinese government bonds outperformed the corporate bonds last month; the S&P China Government Bond Index advanced 1.56%.

Looking at the 2014 year-to-date performance, the S&P China Composite Select Bond Index has delivered a total return of 10.03%.* The index’s yield-to-worst has tightened by 170bps to 3.96%, while touching the YTD low at 3.85% on Nov 12. Nevertheless, Chinese bonds continue to gain traction among global investors as they offer higher yields than the bonds from other major markets.

Exhibit 1: The Total Return of the S&P China Composite Select Bond Index

*All data are as of Nov 28, 2014.

Please click here for more information on the S&P China Composite Select Bond Index.

Now that the shock of oil under $75 per barrel and gasoline under $3 per gallon has begun to wear off, the debate has shifted to when oil prices will rebound.  A look at the economics of supply and demand suggests that the rebound probably won’t take prices back over $100 that quickly.  Unlike earlier oil price collapses, this time both demand and supply moved and both pushed prices down.  The collapse of oil prices when the global financial crisis morphed into the Great Recession was driven by plunging economic activity and plummeting oil demand.  The oil price drops in the early 1980s were driven by increased supply from the North Sea; falling oil prices after the first oil crisis in 1973 reflected slower economic growth and weak demand.

This time around expanding oil production in the US, largely from shale in Texas and North Dakota, are expanding supply while slowing economies in Europe and Japan, and slower economic growth in China are shrinking demand for petroleum.  The result is a large drop in oil prices.  The diagram shows why getting back to the prices seen last summer would require reversing both these moves.   The initial picture in the summer was demand marked D1 and supply marked S1 intercepting at A.  Then the supply curve shifted outward to the right so that more oil would be supplied across the range of prices.  Now demand D1 and the new supply curve S2 meet at B, price is lower and quantity is larger.  This was followed by a fall in demand which shifted from D1 to D2. The new intersection is C and prices are further down.  Oil consumption is lower at C than B because demand is less.

Were supply to completely reverse, prices would move to E, but the price rebound would not be complete. Likewise, were demand to expand and return to D1, prices would not return to A.  Only the combination of reversing both these moves could put prices back to the levels seen in June and July 2014.  Since the new fields in Texas and North Dakota are online and producing, a complete reversal of the supply increase is unlikely.  There is some price which is low enough to make production uneconomic; but price needs to only cover operating expenses – the capital investment for exploration and development is a sunk cost.  Speculation in the media about what price would force a production shutdown varies from $70 down to $40 or maybe less.

The price gyrations over Thanksgiving weekend are largely a response to OPEC’s decision not to cut production back.  Just as prices settled into a range between $85 and $110 in 2013 and the first half of 2014, it is possible that a new range centered near $75 will develop going forward.  However, neither that $75 range, or any other price point, will last forever.

Theories that aim to predict stock market performance range from the complicated and impenetrable to the arcane and simply ridiculous.  But some are wonderfully clear: for example, December is usually a good month.  In the festive spirit, and not to be taken too seriously,  we’ve duly found that the evidence supports the existence of a “Santa Claus Rally”.

Our test of choice, which we may as well call a “Santa Score”, is the result of dividing the average performance each December by the annualized total return over the period.  Since there are 12 months in the year, a Santa Score of around one twelfth (about 0.08) would be expected; a Santa Score above 0.08 indicates that December is a better month for stocks, on average.

With an average Santa Score of 0.36, not a single market fails our test.  December has been, on average, around four times more profitable than the average month.  A Santa Score above 1.00 implies that investing only in December (and doing nothing for rest of the year) is a market-beating strategy; Japan clocked in a remarkable Santa Score of 1.13.

Have you been good?  

At least in the past few years, December has borne gifts for equity investors.  But does the market’s good or bad behavior earlier in year have any influence? Exhibit 2 shows the average performance during December for each of these markets, split into those times when the previous 11 months had generated positive (“nice”) or negative (“naughty”) returns.

There is an exception: small-cap U.S. stocks.  Interestingly, they may be last on Santa’s list, but may benefit from a January effect, instead.  Otherwise December’s returns are better in the “Nice” column for every market.

Naturally, that begs the question of how the markets have been doing.  This is answered in final column of Exhibit 2 – and the good news is that every each market is showing positive return year to date.  So, pat yourselves on the back and tuck into your Christmas parties!  Let’s raise a glass to momentum and seasonality. And hope Santa has noticed.

Below are some quotes from the latest Oil Market Report from the IEA that may overpower Chinese slowing demand growth – even with a surprise interest rate cut.

“there is a degree of opacity”

“The Chinese administration does not routinely disclose information… thus little up‐to‐date official information is available”

“A particular uncertainty concerns the division between commercial and government storage”

“unreported stock building could be occurring at unreported commercial sites”

What are these quotes referencing? The Strategic Petroleum Reserve (SPR). Although China does not report what analysts are seeing as strategic buying on the oil price dip, (S&P GSCI Brent Crude is -31.2% off its peak Jun 19- Nov 21, 2014), the IEA guesses China added 13.5 million barrels in September as extra cargoes from Saudi Arabia, Kuwait, Iraq and Oman were imported.  This brings the 2014 YTD total to an estimated 105 million barrels of unreported stock build that is far more than the 89 mb posted in 2012 when a portion of Phase 2 SPR capacity was filled.

Now the question remains how much more capacity does China have to fill up their strategic reserve sites. Construction delays may inhibit imports but if oil prices remain low, the government may put extra resources toward speeding up the build of reserve sites.

However, it is not all about oil. China has a powerful capability to stockpile commodities and deploy resources when they need them by taking off inventory or increasing production where possible. Especially in non-perishable commodities like cotton, nickel, lead, zinc and copper.  It is easy to blame the commodity price drops (as shown in the chart below) on slowing Chinese demand but by examining a few commodities that have fallen far from their peaks, the secret becomes apparent.

Source: S&P Dow Jones Indices LLC. All information presented prior to the index launch date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Past performance is not a guarantee of future results. Please see the Performance Disclosure at http://www.spindices.com/regulatory-affairs-disclaimers/ for more information regarding the inherent limitations associated with back-tested performance.

Chinese supply is a key factor, especially in an inventory sensitive environment that is mean reverting.  Nickel, which was coined the new gold for the year, is now down 21.5% from its peak. It’s not from slowing Chinese demand nor is it from Indonesia lifting its ban. The metal is pouring out of Chinese warehouses into the LME system, and what no-one expected was that the Philippines would partner with China to lift production and exports to the extent that it has.

Also, according to the LME (London Metal Exchange), the latest zinc data suggests while demand is positive that there may be unreported stock building and that China is the key wild card. Further, they report that China is responsible for keeping the aluminum market in surplus. Last, the growth in refined output of copper is said to be driven by capacity additions and start-ups in China that is projected to lead China to have the lowest net imports in 2015 since 2008.

The end of last year saw Canada’s CPI move up from the October level of 0.7 to a 1.2 for December.  Since then it has stepped up in 2014 peaking at 2.4 in June before trending back down to September’s 2.0.  In light of this, the October report of 2.4 came as a surprise to the markets.  The economy may be running faster than the central bank originally thought.

Inflation has exceeded the 2% target rate set by the central bank for 5 of the 10 months reported this year.  Given the broad nature and speed of the price increases, market participants are contemplating the timing of a central bank rate increase.  Higher interest rates slow inflation because the action reduces the amount of money in circulation.

The Bank of Canada feels confident that low interest rates are needed and that inflation is not a threat at this time.  Although reassuring, this would be something global and local investors with investments in Canada will be watching closely in the near future.  To date, the S&P Canada Sovereign Inflation-Linked Bond Index has returned 0.45% month-to-date and 13.9% year-to-date.  The index’s real yield is a 0.45% while its yield with an inflation assumption is 2.51%.  The largest year-to-date return since 2004 was the end of 2011’s return of 17.75% when CPI levels rose from 2.3 to 3.7 during the course of the year.  For the 10-year period, the index has returned 5.99%.

Source: S&P Dow Jones Indices, data as of November 21, 2014