Indexology^® Blog

Copper is reputed to have earned a Ph.D. in economics because of its ability to predict turning points in the global economy.  This is since copper is so broadly used across industries from building construction, machinery, power generation and transmission, electronic product manufacturing and in transportation vehicles. As the demand for copper rises, its price likely increases and suggests a growing global economy. Conversely, declining copper prices may indicate sluggish demand and an imminent economic slowdown.

Given the recent drop in the S&P GSCI Copper, down 3.7% on Friday March 7, bringing the YTD loss to 7.5%, might that be an indicator of China’s slowing economy?  It has been shown that (lagged) copper has a correlation of roughly 0.4 with world GDP growth, which can be considered moderate at best. Further, while copper returns appear highest in the strong expansion phase and lowest in the strong recession phase, what is interesting is that returns seem to hold up quite well during periods of weak recession. Please see the chart below from my colleague, Daniel Ung, published in this paper on the S&P GSCI Cash Copper.

Further, below is a chart of yoy% GDP growth from the U.S., China and the U.K. with the S&P GSCI Copper lagged one year, which again shows some relationship but not a super compelling case that copper should earn a Ph.D. from predicting turning points in the economic cycle.

Unfortunately, the idea that the of the economy can be predicted by the demand reflected in the price of copper, is not the full picture of health. The supply side of the price equation is just as important and economic theory dictates that demand strength does not automatically translate into price hikes. Instead, it is the lack of an adequate supply response coupled with a rise in demand for supply-inelastic products, such as copper, that results in price inflation. It follows from this, that in many ways, supply is arguably more important than demand in explaining the recent behavior of the copper market.

This assertion is borne out by statistics. Over the last decade, according to World Bureau of Metal Statistics (2012), primary mine production grew by a meager 1.8% per year compared to demand, which rose by 2.4%. The copper market was in supply deficit for seven years in the last decade.

Below is a chart of the S&P GSCI Copper versus the roll yield, which is a measure of the term structure indicating a shortage or backwardation with a positive return and an excess or contango with a negative return.  Why it is more interesting than the chart above that shows copper versus GDP, is that it shows the the relationship of copper to its inventory situation. Copper was one of the few commodities with strong shortages prior to the financial crisis, but eventually the demand decline was too strong for the shortage to have an impact. Eventually the inventories caught up to and surpassed the demand as suppliers had rushed to bring more copper to the market. By the time the worst of the crisis passed, there was significant contango or excess inventory despite the rise in copper price.

However, unlike stocks that recovered well after their dip in 2011, copper can’t seem to comeback.

This might change though despite the reports of worries about the Chinese economy in light of the first default on a bond from a company traded in mainland China, and also after the official manufacturing PMI in Feb fell to an eight-month low of 50.2, just above the 50 level that separates contraction from expansion.

China accounts for 40% of global copper consumption, and even a small drop in demand could leave the market awash in extra metal.  However, given there has been a shortage (as shown by the roll yield) for 4 months straight now, it is possible copper could rebound.

As I have mentioned in prior notes, there are great opportunities for individual commodities now from the shortages that create low correlations across the spectrum.  It may or may not be time for copper but what is certain is that its supply shocks differ from the current shocks of agriculture and energy.

Puerto Rico general obligation bonds tracked in the S&P Municipal Bond Puerto Rico General Obligation Index have rallied 13.67% this year ahead of the planned $3 billion bond sale by Puerto Rico this coming Tuesday.  Yields of bonds in the index have dropped 122bps to end March 7th 2014 at 7.12%.  The success of the pending bond sale and the yields investors are willing to accept in return for the taking on the risk of lending their money to Puerto Rico will be very telling. This is Puerto Rico’s first new bond issue since it was down graded by all three ratings agencies to below investment grade last month.

On the eve of such a large sale of bonds a few things are going in Puerto Rico’s favor.  The municipal bond market has absorbed large bond issues in the past.  The triple tax-exemption on the interest earned on most bonds issued by Puerto Rico has, in the past, added to their value proposition. This deal is designed for institutional investors and those investors have been demonstrating they are willing to take on risky assets paying higher yields. Yield remains a powerful driver for investors. Average yields of these bonds have peaked at over 8% during the last two months which has attracted the attention of these yield hungry investors.

The last several weeks have illustrated the extent of that demand as yields for Puerto Rico G.O.’s have finally come back below the yields of CCC and below corporate bonds.

The graph below charts yield to worst of bonds in the S&P Municipal Bond Puerto Rico General Obligation Index vs. the yield to worst of bonds in the S&P U.S. Issued CCC & Lower High Yield Corporate Bond Index.

Source: S&P Dow Jones Indices LLC. Data as of March 7, 2014.

The recent steep decline in yields have pushed bond prices up resulting in Puerto Rico out performing the rest of the municipal bond market and other bond market segments so far this year. This new issue will tell us a lot about the depth of the market along with what price investors are willing to pay for the risk.

The table below highlights select fixed income asset classes and their year-to-date performance.

Source: S&P Dow Jones Indices LLC. Data as of March 7, 2014.

Central Banks persist in fighting inflation. The Fed is tapering and talking about tighter money. The European Central Bank won’t cut interest rates. Only in Japan, where the Prime Minister is pushing the Bank of Japan is there a hint of a different approach.

Inflation rates in most developed markets are below central bank targets of 2%.   In the US the Personal Consumption Expenditures deflator – the Fed’s preferred measure – puts inflation at 0.9% over the four quarters of 2013.  The Eurozone consumer price index is a touch lower at 0.8% for the year ended in February.  Japan is the surprise leader with consumer prices up 1.1% after spending 2-1/2 years in negative territory.  All this raises two questions: what is so bad about deflation and why aren’t central banks doing something?

Deflation is falling prices – not just gasoline at $4 a gallon or the cost of health insurance – almost every price falls.  Deflation leads to stagnant economies and depression.  The problem is the prices that don’t fall.  In most economies wages and salaries rarely adjust downward.  Whether by convention, union contracts or competition for workers, wages are sticky.  As prices fall, employers face rising real (inflation adjusted) labor costs. One reason why job growth is still weak five years after the recession and many new jobs offer very low wages is that with inflation almost zero, the relative cost of labor is higher than it used to be.   The second problem is debt.  With deflation  the real value of debt rises, paying off debt becomes harder and defaults multiply.   The housing crisis was a limited example – home prices fell, incomes were stagnant and mortgage defaults rose. When the amount of money and credit in the economy collapse, prices and economic activity collapse.  That was the fall of 2008.  Despite the Fed’s timely response to pump  money and credit into the economy, we are still on the edge of deflation today.

Central banks could be more aggressive about deflation, but are more concerned with far distant future inflation.  Economic policy is, hopefully, based on good economic analysis; it is also based on primal fears and (re)fighting the last war. The first hand history of monetary policy in the US that economists and bankers can personally recall goes like this: 1970s saw rampant double digit inflation, Paul Volcker saved the economy and the Fed by ending inflation with a deep recession, setting the stage for two decades of economic growth and all was fine until home price inflation spooked the Fed and led to the financial crisis. The last war was the end of inflation in 1979-82.  Forgetting that lesson would a terrible thing.

In Europe the primal fear is Germany’s hyperinflation in the 1920s lead to Depression and the Second World War. For sixty years Europe was committed to preventing another inflation – either successfully in Germany or with frustration in other countries. This is why the Bundesbank, Germany’s pre-euro central bank, is held up as the model for the current European Central Bank.

Muddling along on the edge of deflation leaves the economy with more risk of collapse and too little growth.  The answer is not for the Fed to stop tapering and introduce QE4.  A better approach is fiscal policy – both spending and tax reform. The economy can afford some fiscal stimulus, especially to rebuild basic infrastructure like roads, bridges and airports.

Buybacks do not increase S&P 500 Index earnings-per-share (EPS), the Dow is a different story. On an issue level, share count reduction (SCR) increases EPS, therefore reducing the P/E and making stocks appear more ‘attractive’. SCR is typically accomplished via buybacks, with the vital statistic being not just how many shares you buy, but how many shares you issue.  In the most recent Q4 2013 period we saw companies spend 30.5% more than they spent in Q4 2012, though they purchased about the same number of shares.  The reason is (in case you didn’t notice), that prices have gone up, with the S&P 500 up 29.6% in 2013, and the average Q4 2013 price up 24.7% over Q4 2012.

Many companies, however, appear to have issued fewer sharers, and as a result have reduced their common share count. The result is that on an issue level it is not difficult to find issues with higher EPS growth than net income (USD) growth.  A quick search found that over 100 issues in the S&P 500 had EPS growth for 2013, which was at least 15% higher than the aggregate net income.  The result for those issues, were higher EPS and a lower P/E. On an index level, however, the situation is different.  The S&P index weighting methodology adjusts for shares, so buybacks are reflected in the calculations.  Specifically, the index reweights for major share changes on an event-driven basis, and each quarter, regardless of the change amount, it reweights the entire index membership. The actual index EPS calculation determines the index earnings for each issue in USD, based on the specific issues’ index shares, index float, and EPS. The calculation negates most of the share count change, and reduces the impact on EPS.

The situation, however, is the opposite for the Dow Jones Industrial 30.  The Dow methodology uses per share data items. So if a company reduces its shares, with the impact being a 10% increase in earnings (as an example) with a corresponding 5% increase in net income, the Dow’s EPS will show the increase in EPS.  Again, the impact would be mostly negated in the S&P 500. This is not to say that buybacks don’t impact stock performance, and therefore the stock level of the indices (and price is in P/E).  It is only to say that the direct impact on the S&P 500 EPS is limited, even as examples on an issue level are becoming easier to find.

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A large number of emerging markets currencies declined en masse during the period from 30 April 2013 through 31 January 2014, with many observers applying the moniker of contagion.  Over the whole period many emerging market currencies were clustered in the range of losing between 9% and 22% of their value against the US dollar, with a few remaining stable, and some losing much more.

Our research argues that the emerging market contagion was driven by asset allocation shifts.  That is, expectations for relative risk-adjusted returns went dramatically against the emerging markets, and the Fed’s QE tapering had nothing to do with the FX activity.

Starting with risks in the political arena from the spring of 2013 onward, developments went against emerging market.   The Syrian Civil War was complicated by the nerve gas attacks and related US-Russian diplomacy.  There were demonstrations in the plazas of Turkey over development plans as well as a scandal reaching high into the Government.  Middle class residents were taking to the streets of Brazil to demand improved government services, even as the Government was spending generously on the infrastructure for the upcoming World Cup in 2014 and Olympic Games in 2016.  In Thailand, political unrest was threatening the electoral process.  India’s election campaign was heating up, with the possibility of a major change in political power.  Argentina experienced significant inflation, a currency devaluation and overall political confusion.  Ukrainian political tensions became violent.  Some of these tensions eased while others gained momentum over the year, but they all combined to create the impression that the riskiness in many emerging market countries was rising, and that spillover effects in various regions were not only possible, but likely.

From a performance perspective, the interesting development was in the US.  US equities rallied almost 30% in 2013 even as the US 10-Year Treasury yield went from less than 1.7% at the end of April 2013 to a new range, 2.7% to 3.0%, a full 100 basis points higher than before the “Taper Talk”.  The ability of US equities in 2013 effectively to ignore the coming policy change at the Fed to taper QE while US bonds were selling-off aggressively strongly suggests to us that QE was not responsible for the emerging market contagion.

The relative equity out-performance of the US was a two-way street and had at least a part of its roots in the deceleration of economic growth in many emerging market countries.  For example, economic growth in the four largest emerging market countries of Brazil, Russia, India, and China has been slowing with weighted average real GDP growth of 8.2% in 2010 declining to an estimated 5.5% in 2013 and a forecasted 5.1% for 2014.  (See “Decelerating BRICs Face Structural Challenges”, by Samantha Azzarello, December 9^th 2013, http://www.cmegroup.com/education/featured-reports/decelerating-brics-face-structural-challenges.html).  The growth slowdown was accompanies by equity declines in many countries, with the MSCI Emerging Market Index losing 5% of its value over 2013.

The juxtaposition of a powerful rally in US equities set against decelerating economic growth and rising political risks in many emerging market countries, we would argue, provided the foundation and incentives for many global asset allocators, such as pensions, endowments, sovereign wealth funds, etc., to shift their asset allocation policies in the direction of US equities and other mature industrial markets, and away from emerging market countries.  This asset allocation shift hit both emerging market equities and currencies.  We are definitely not in the camp that thinks the Fed’s QE tapering debate and decision was a primary cause of the contagion.