Perspectives on commodities

Some recent eclectic thoughts from John Reade, of UBS Investment Bank:

• China will buy those commodities that it considers strategic (i.e. required to meet centralised growth plan) as well as those that it does not produce a lot of. Therefore, expect these commodities to trade at a premium (e.g. copper is required for infrastructure growth & China is a net importer).


• A suggested FX basket for playing commodities: NOK (oil), CLP (copper), AUD (iron ore) & BRL (oil, iron ore & aggregates).


• ZAR is not as much of a commodity play as other currencies since it is unable to increase its commodity exports.


• OECD industrial production (IP) is a good leading indicator for commodity demand. Expect IP to trough mid 2009.


• Excluding oil, China is consuming 20-30% of annual commodity production and its GDP is c. 10% of global GDP. China is therefore 'punching above its weight' in term of commodity consumption.


• Disagrees with peak oil theory since we are not yet at the point where there are no know exploitable oil fields.


• The marginal cost of production for oil is $70 bbl, driven by other commodity prices essential to extraction (e.g. steel, concrete...). When the prices of those commodities rise, so does the breakeven oil price.


• Having initially been a gold bear, he expects gold to average $1,000 in 2009 due to the sheer level of inflows into the commodity. Having initially benefited from risk aversion (see performance of gold versus TED spread or 2 year swap spreads), future performance likely to come from the inflation trade. However, he doesn't recommend buying gold yet, until scrap sales & risk appetite wane and jewelry demand increases. Ultimately, gold is a scarce asset and so only a small increase in demand is required for a large increase in price.

Little Wing Macro: April 2009 review

The portfolio rose +0.5% net of costs in April, which was disappointing given the 10%+ rally in equity markets.

Of the three risk 'buckets' - rates, FX & equity - equity was the only positive contributor. The portfolio's Chinese & UK equity call options rose 39% and 36% respectively. However, the decision taken at the beginning of the month to pre-empt "sell in May" with FTSE 100 June puts, reduced the equity contribution to the bottom line to c. +6%.

In rates, TBT (short 20+ year US Treasury ETF) turned around previous negative performance, adding 13% as Treasury yields went into reverse on renewed risk seeking. However, the portfolio's Gilt holdings offset this as Gilt yields rose above 3.5% on supply & debt:GDP concerns. With the 10 year Gilt yield at c. 3.7% and an additional £50 billion in the Bank of England's APF, the risk reward ratio appears skewed in favour of maintaining long Gilt positions. For further insight on the reassessment of the Gilt market, see Reassessing Gilts: don't panic Mr Mainwaring! and When in trouble, double!.

The portfolio's FX investments, namely long USDJPY and gold investments suffered at the hands of 'animal spirits' as save haven assets bore the brunt of the return of 'animal spirits'. However, the portfolio's USD hedge compensated as the Dollar fell 3% against Sterling, breaching 1.47 in the process.

Overall, it was a difficult month for the views expressed in the portfolio, although by no means a disaster since the portfolio was up on the month. Indeed, May is shaping up to be another good month with the portfolio up c. 4.5% month to date. Volatility declined over the month to 35%, and continues to do so, enabling the portfolio's risk budget to be increased. Short GBPNOK and extending Gilt duration look like possible candidates for implementation...

Wake up & smell the coffee! China goes short duration

When the largest investor in any asset aggressively reduces their exposure, it's time to reassess that investment.

With holdings of $744.2 billion, China is the largest foreign holder of US Treasuries. This amounts to 24% of foreign holdings.

However, in a recent research note, Standard Chartered note that:

"Although bulk buying of Treasuries has ended, China is not reducing its stock of US securities. It is reducing its holdings of agencies and maintaining growth in its holdings of Treasuries, but is switching from long-term to short-term securities (tenors of less than one year)... holdings of short-term Treasuries surged to USD 182bn in February 2009 from USD 19.87bn in September 2008."

In portfolio management terms, this equates to an aggressive short duration position - standard practice if you expect yields to rise. Perhaps the scale of this positioning (25% of their holdings in sub 1 year paper) is a measure of how much they expect yields to rise. Indeed, Chinese officials have recently been vocal about their concerns regarding Treasuries and the US Dollar.

Could this mark the reversal in the 20 year bull market for Treasuries? Dr. Marc Faber certainly thinks so...

"The asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

When in trouble, double!

Since the initial announcement and subsequent implementation of QE, Gilt yields have steadily risen (see above chart). Mervyn King has therefore lost money on his £52 billion of Gilt purchases. So, like any punter would do when faced with a loss, big Merv has doubled up.

At today's rate announcement, the Bank of England revealed that it will increase its existing QE facility by an additional £50 billion:

"The Committee also agreed to continue with its programme of purchases of government and corporate debt financed by the issuance of central bank reserves and to increase its size by £50 billion to a total of £125 billion. The Committee expected that it would take another three months to complete that programme, and it will keep the scale of the programme under review."

The 10 year Gilt yield fell 10 basis points. Could this be an inflection point in the 75+ basis point rise in Gilt yields?

Chaos theory: a pig flaps its wings in Mexico...

Swine flu is a sideshow, blown out of proportion by the media. Having rallied over 25%, equity markets were vulnerable and looking for an excuse to go lower even before the outbreak.

To date, and tragically, swine flu has accounted for 149 deaths in Mexico, a country of 111 million people. This represents 0.0001% of the population.

So, if swine flu is no more of a serious and lasting issue to world health than SARS or bird flu were, there are bargains to be had in those sectors particularly hit by pandemic hysteria.

Airlines, in particular, come to mind, as do other travel sectors such as hotels. However, these sectors were already struggling in the face of the global slowdown, and companies with stressed balance sheets may be at risk.

Reassessing Gilts: don't panic Mr Mainwaring!

In light of the 30-35 basis point back-up in the 10 year Gilt yield, pushing it above 3.5%, it is time to reassess the investment case for Gilts.

A tumultuous week for Gilts started with Alastair Darling's pre-budget speech, in which he announced the Government will borrow £220 billion this fiscal year, increasing the public debt:GDP ratio from 45% to 76.2% by 2013. This was followed by a Moody's report, How safe are safe havens?, which sent yields higher and Sterling lower, on concerns over the UK's credit rating. Finally, Q1 UK GDP came in worse than expected at -4.1% year-on-year, the worst since 1979.

So, which, if any, of these facts warrant higher Gilts yields?

Increased Gilt issuance

Economic s 1.01 says that, increased supply of a good results in a lower price unless there is a similar rise in demand. However, as the chart below demonstrates, there is little or no relationship between Gilt issuance and Gilt returns. Indeed, the 2008/ 09 financial year saw record gross Gilt issuance of £146.4 billion and the third highest Gilt 12 month total return of 6.8%.

Further proof that bond issuance and returns are not related comes from Japan, where a sustained increase in public debt has been accompanied with a fall in JGB yields.

Moreover, the supply-demand dynamic has shifted in favour of Gilts due the Bank of England's QE programme. The full £100 billion authorised by HMT for Gilt purchases represents 18% of the overall £543.9 billion Gilt market and 45% of the gross issuance this financial year.

These percentages are not small. Indeed, at the end of Q1 2009, the Bank of England had 'only' spent £12.9 billion on Gilts, out of a possible £75 billion. Mervyn King has plenty of firepower left at his disposal with which to mop up new issuance and force yields lower. Thus, to some extent, what the Chancellor giveth, the Bank of England taketh away.

Moody's report
Next, the Moody's report. For all the hysteria it generated, the essence of the report was not as bearish as the market reaction. The conclusion is summarised below:

"Moody's believes that Aaa governments' unconventional policies are defensive responses that are – at best – ratings-neutral if they succeed in kick-starting economic activity. However, if they lead to massive increases in public net debt and a permanent deterioration of debt affordability without tangible growth effects, Moody's cautions that they will be ratings-negative. In extremis, since confidence is not a linear process, these policies could potentially increase 'tail risk', and therefore also the (currently small) risk of sharp rating migration."

Indeed, a spokesman for Moody's confirmed, "the [UK] rating has not changed, and it's not under review for a downgrade. The outlook is stable."

UK GDP

GDP and Gilt returns have a negative correlation, meaning that as GDP falls Gilt returns increase. The chart below demonstrates this by comparing year on year GDP against the 12 month total returns of Gilts.

So, why then was worse than expected GDP cited as a negative for Gilts? The answer could lie in the relative position of the UK versus other developed nations. IMF forecasts for developed nations' GDP are as follows:

The economic outlook for the UK may not be good, but it is no worse than in others countries, indeed, with the exception of the US, it is the best of a bad bunch.

Conclusion

Therefore, it appears that, on balance, nothing has changed the medium term term outlook for Gilts. Yes, inflation is a risk for the longer term, but as the above evidence suggests, none of the developments last week appear to warrant higher Gilt yields.

So, in the immortal words of Corporal Jones, "don't panic Mr Mainwaring!".

George Soros interview with Bloomberg

The following are excerpts taken from a transcript of Bloomberg interview with George Soros on 6th April 2009...

The effect of the Western financial crisis on 'periphery' countries
After the bankruptcy of Lehman, the countries - the United States and the European countries - felt obliged to effectively guarantee their banking systems. And saying no other financially significant company will be allowed to go into bankruptcy. But countries at the periphery were not in a position to provide similarly convincing guarantees. And there was a flight of capital from the periphery to the centre. And that is what precipitated the crisis in Eastern Europe; and of course, in Brazil as well. So that was the unintended side effect of this artificial life support. And now that some support is extended by empowering the IMF, and also coordinating better the banking regulations.

China
China is now also simulating domestic growth. They have a pretty big stimulus package. And it is not enough. They are going to use more because not being a democracy, they know - the leadership knows - that their very survival, the avoidance of social unrest, requires them to generate growth. So they will - that’s for them the top priority. And they are in a position to do it. And so China is going to be coming out of their recession before the end of the year. And they will also try to maintain exports by providing credit to other countries. After all, they provided a lot of credit to us. Now they just made a swap agreement with Argentina. And they will similarly do the same with other countries in Africa, Latin America. And so they will actually restart their export industry, too.

Brazil
I think Brazil is another country that’s relatively well-situated. It was doing very well until the Lehman bankruptcy and the sudden collapse. And then you had a crash in Brazil. It did a certain amount of damage. But I think Brazil will also be a country that’s coming - will come out of the recession relatively soon. They have a big deal with China, I think invested something in the neighbourhood of $10 billion to develop the new oilfields there. China will be an avid buyer of Brazil’s soybeans and so on. And eventually will again buy their iron ore. So I think Brazil, actually - together with China, will be among the recovering countries. I don’t know about rapidly recovering, but I think the outlook for Brazil is better than for most other countries.

Oil
It’s very much a question of when does the economy recovery. Because when the world economy recovers, the price of oil will recover. And since the world economy suddenly collapsed, the price of oil collapsed. It hit a low below $40 from $140. And now it’s slowly climbing up. But the longer-term future deliveries never fell that far. And in fact now oil is about $50. And it will probably recover perhaps to $70 or so because the marginal cost of developing new oilfields is around $70. Maybe that will fall if prices fall. So it may be lower. But $50 to $70, somewhere in there.

You see, this is a clear example where you have that conflict between the short term and the long term. Because in the long term, there is no question that first of all, the cost of discovering oil is getting bigger and bigger. And the really large oilfields are getting exhausted. There hasn’t been that much new very large discoveries, except, let’s say, in Brazil in very, very deep and very far out waters. And as the Arctic ice melts, then under the Arctic Ocean, we will find oil. But that’s going to be quite expensive. So long term, price of oil has to rise. And we do have this very serious problem of global warming, which really requires us to develop alternative forms of energy, which are also initially, more expensive than the existing sources. The big difference between the new - the alternative sources that with time, their costs may decline. So right now, let’s say solar energy, is more expensive than natural gas. However, as you develop the technology, those prices may rise. So we have no alternative but to develop those. But the collapse in prices short term has really pulled the rug out from under all these alternative sources of energy. And that is directly counter to what we need in the long term. So here’s another example where the short term is directly contradictory to our long-term interests.

Banks & financial system
The banks are functioning. But they are weighed down by a lot of bad assets, which are still declining in value. So the banking system as a whole is seriously under water. The amount is difficult to estimate. But I think it’s in the region of maybe $1.5 trillion.

I am afraid that we are basically setting ourselves up on a route which will lead to preserving the banking system, preventing it from collapsing, but not recapitalizing them, but allowing them to earn their way out of the hole. And that is going to weigh on our economy for a considerable length of time and set - instead of providing new energy in terms of new loans, it will actually sap our energies by the banks charging heavy fees and restricting credit in order to improve their own earnings, in order to first of all survive so they don’t have to put themselves into hands of the government; and if possible, to buy themselves out by repaying the loans that they have got.

HSBC just raised $18.5 billion and I also subscribed.

On when to cut losses
If it isn’t working, I re-examine it. And it depends on the re-examination. It may be that I find nothing wrong and I can explain why its not working the way it’s supposed to. And I might actually increase my position. Or, I discover something that I left out of account,
and then I cut my loss. So - and I don’t cut my losses automatically. And sometimes, actually, I greatly increase my positions because the - I find the situation more attractive.

INTERVIEWER: So you still do your analysis and just - even if it’s going against you for a while, if the argument that got you there still working, you stick with it?

SOROS: Yes, yes.

Has the rally got legs?
I think it’s a bear market rally because we have not yet turned the economy around. What people don’t seem to understand, that something quite profound has happened. It doesn’t happen very often that the financial system actually collapses. So this is not a financial crisis like all the other financial crises that we have experienced in our lifetime.

The US Dollar's role as reserve currency
To some extent it has already been replaced because it’s not the sole reserve currency anymore. The euro is an important alternative. But there aren’t other alternatives. And the special drawing rights, which I think is a very good thing to use for other reasons, is not an alternative currency. Those are merely bookkeeping entries at the IMF. They can’t be used to buy goods. You know, to use them that way, you have to convert them into useable currency.

US fiscal deficit
You are not going to have a widening U.S. deficit, because there isn’t any more the desire to finance those deficits. And we are not in a – the households are not in a position to use the appreciating house values to savings. And so the savings rate of U.S. households will increase substantially. So the deficit is already falling, and it will continue to fall. So we will actually get back into closer to balance than we were. That’s not a very optimistic view because it’s very painful because it means that we are - economy will not grow that much.