- Bond yields bottoming
- US$ rally failing?
- Equity markets renewed upswing
- Gold bull market resuming?
- Oil prices break 2008 downtrend
- Outstanding value in resources and resources small caps
Believe it or not this graphic is still on track! Look at the evidence.
The past two years have provided some major volatility in most markets and it would be fair to observe that high volatility is often present at major turning points. Something of a truism but you have to ask which market is living the turning point? It is not always what you think.
In my experience of watching markets I have noticed that there is often a fair degree of interconnectivity between markets but that needs to be qualified by noting that the interconnectivity is often not what you expect and is often between markets that you don’t always follow.
The market to watch today is that of the global bond markets. Outside of currencies, bonds (debt) are the world’s largest market and can be categorised simply into government bonds (from US Treasuries to the lowliest municipal bond) paying for expenditures that economies can’t immediately pay for and the corporate bond market where companies trade off their capital requirements between debt and equity.
The bonds are much bigger than equities so changes to this market, and the capital flows to and from, can have exaggerated impact on other markets. The results aren’t always what you might expect.
My understanding of bonds is that the largest holders are pension funds and insurance funds that have long term liabilities so can match income and return of capital at maturity with the actuarial requirements of retirement members or life expectancy. Central banks also hold each other’s bonds.
It has been interesting to note the strong demand for bonds in recent times with investors seeking to ensure income during weak economic periods and to observe how bond prices have been bid up so high and how yields have fallen.
My recollection of some published work a couple of years ago by economist and commentator Don Stammer showed that Australia had one of the largest per capita pension fund systems and one that had strong commitment to equity through shares and property (roughly 70%) and relatively low levels in fixed income and cash (The numbers for Australia were A$1,400bn at 30 June 2012 with the default portfolio having 51% stocks, 10% property and 15% fixed income plus another ~9% cash. The gross figures must be now closer to A$1,600bn after A$100bnpa inflow and +5% returns). Very many other countries had no established organised pension systems and many that did had an extremely high proportion of bonds and cash with very little equity.
This long term bond yield history below has been a sort of road map for me but the past seven years has been anything but a clear guide.
This Yield History for a composite of 20 years and 30 years (from 1977) maturity US Treasury Bonds covers what should be an entire cycle of about 70 years since the previous isolated verifiable low in yields in 1942 and asserting that the most recent low in July 2012 was indeed the next major cyclical low.
This chart has very significant ramifications if this analysis is correct. Note first the time frame. 39 years of rising bond yields (i.e., 39 years of bear market in bonds) to 1981. Then 31 years of falling bond yields (i.e., 31 years bull market in bonds) to 2012.
The graphic covers the periods of Inflation (1965-1980) with rising yields, Disinflation (1980-2008) with falling yields and Reflation (2009- ?)- where money supply growth has been large but inflation underreported – which are defined here for illustrative purposes as rising prices, falling prices and rising prices again respectively. The only period of deflation identifiable in the markets by methodology used here was from 1996 and into Dec Qtr 1998 which turns out to be the beginning of the current commodity bull market. You can observe the co-ordinated sell offs in all things commodity (A$, C$, Oil, copper, gold, coking coal) and a strong rally in US TBonds because of …of…of ……well, no reason I could find at the time or even today). Check out levels of LME inventories, metals consumption and A$ trade figures over this period. Now just when has that happened before? Surely not just now?
So coming back to T Bond prices the chart is suggesting that a change is now underway. The recent weakness in bonds has brought capital losses of 8-15% within just a very short time.
The bull run in bond prices is clearly very mature and the Euphoria period may have been in mid 2012 and has just passed by. This market is probably in the final `buy the dip’ period for one last rally before the market begins to unwind that 30 year uptrend and provides perhaps another 30 or so years of rising bond yields. But note that now commentators in the US are talking about the Great Rotation out of bonds and into equities.
It is obvious that central banks and governments have intervened in these markets and have brought short term interest rates down which have forced longer term yields down as well. Purchases of bonds out along the yield curve has helped to bring down rates.
The concentration of so much capital into this asset class is now probably quite dangerous.
The other aspect of the bond market is that of the underlying currency because government bonds are essentially currency with an interest rate coupon. With the peaking of bond prices and rising of yields some might consider that higher interest rates will attract more capital and so will push up the currency. Unfortunately history does not have much confidence in such considerations. The US$ Index here might lure some into thinking that a dollar rally is underway but it just might not turn out that way. These long term channels typically have strong long term technical influence.
History has generally shown that a weaker currency needs higher yields to keep it from falling further. And equity markets tend to rise with falling currencies to maintain international value. Let’s just watch these markets very carefully over the next few months.
So after this review of the roadmap that had been so helpful until about five years ago (when someone not only removed the signposts but the road as well!) it is now likely that the road has been found again and the signposts are visible and clear.
In presentations in 2011 and 2012 the theme was `follow the money’. Very large cash levels had been built up around the world by those with income and assets and by the very large injections of funds to support the world’s banking system. In Australia these funds as measured by RBA’s Total bank deposits and Household bank deposits of A$1,500bn and A$723bn respectively are very large compared to Australia’s GDP (~A$1400bn) so are not likely to keep growing there for too much longer. Australia could have a sort of Great Rotation of its own. From cash to equities.
This graphic from the brilliant `In Gold We Trust’ annual publication from Ronald Stoeferle of Incrementum shows total global financial assets at US$233,000bn with bonds at 53% (around US$123,000bn) and 43% greater than the equities. The US has US$17,000bn in T Notes alone plus municipal bonds and corporate bonds.
So when this bond market does decide that the best is behind it the flow of funds will become very interesting. The holders of municipal bonds in Detroit may be feeling uncomfortable and may now be considering to become part of the general exodus from the fixed income assets classes.
And could it be that these funds through this Great Rotation are already flowing into equities as evidenced by the all time highs in US and some other equity markets?
The performance of the small caps in the US has been impressive and offers and alternative view to the conventional wisdom of the rise in equities is driven by yield.
The strength of technology through NASDAQ and strong market breadth through the Wilshire 5000 would suggest earnings and asset growth.
So this brings the discussion to resources.
If the interest rate cycle is turning as the evidence suggests, the likelihood is that gold is still in a bull market is very strong.
Previous Dawes Points have highlighted the strong demand for physical gold from China and India (subject to recent import duties legislation that attempts to halt the inflow of gold that is upsetting India’s current account) alone in the June Half of 2013 has been greater than global mine production. This is no big deal given that total gold stocks of about 170,000tonnes dwarf 2700tpa mine supply but physical demand of 1400t from Asia more than offset 500t sales from gold ETFs.
The last Dawes Points on gold highlighted extremes in relatives of gold stocks against gold and gold stocks against general stocks and recent market action in gold and gold stocks suggests an important low has been achieved. And today gold is above US$1315.
What is also encouraging is GDX (note volume) and the $CDNX showing the first life in a year and a market pattern that strongly suggests a rally is now underway.
Now this is all very nice but look at some other things.
Like oil. Downtrend from 2008 highs broken.
And like iron ore. All the bears on iron ore and forecasts of sub $100/t – where are you now? The comment in the May Dawes Points that maybe a new high in iron ore prices was coming might not be so silly after all.
At these times it is always useful to recall one of he many quotes sourced to funds manager Sir John Templeton (1908-1998???)
- Born in Pessimism..
- Grow on Scepticism..
- Mature on Optimism.. and..
- Die in Euphoria
This quote clearly related to the moods of the markets and investor sentiment and turning these observations into market performance we can get
• Wave 1 Disbelief ..
– Little interest..false dawn.. value unappreciated
• Wave 2 Pessimism
• – Told you so…end of the world
• Wave 3 Optimism
– Increased participation…..climbing wall of worry
• Wave 4 Opportunity
– Market values known…soft markets say buy the dip
• Wave 5 Euphoria
– Taxi driver tips and wacky market action…overleverage
This graphic was developed and has been included in many of my presentations since presented at Mines and Money in November 2008 at the bottom of the GFC for resources and at a time when market actions, price falls and abandonment of value made no sense. Much like now for that matter!
Note that this graphic is only for the Resources Sector so it may be out of sync with other non-resource markets.
An idealised graphic of course but let’s look at it in reality.
First let’s look at it in terms of commodities…
Looks good there.
We have already seen oil and iron ore above. So how about copper? Yes, it still looks OK.
And amongst the stocks, Exxon-Mobil and other major oil companies are even leading this market whilst the Non-ferrous Metals are like copper and lagging a little.
And the All Ordinaries is looking the same!!
So much for the bigger indices and stocks but what about the Australian Resources Sector?
Well for ASX Metals and Mining (XMM) it still fits OK.
The Wave position still looks good. Even after the past year of misery.
But for small resources (ASX XSR) there has been a slight detour with a rally of Hope turning down into a fall of Despair.
And for the ASX Gold XGD it was even worse, DESPAIR IN CAPITALS.
So what is the conclusion.
For me the peaking in the bond market really means that the days of low interest rates and bond yields are coming to an end (may be one more cut in Australia) and that probably means the US$ will be weakening again. So if the flow of funds model is correct then the flow into equities will continue for quite some time yet.
How to play it?
Well, BHP and the leaders first and a strong commitment to oil and gas as described last week. Then the second liners but given this extraordinary time of savagely discounted small caps everyone should be looking at the penny dreadfuls with reasonable cash levels. These lesser stocks include operating mines with gold, copper, diamonds, iron ore, coal or a range of other commodities as well as oil and gas producers. Then there are numerous opportunities in uranium, rare earths, fertilisers, tin, unconventional oil and gas, coal, iron ore, silver, technology metals and the industrial metals. The list goes on.
Certainly most of these companies are short of cash but Australia will soon have its own Great Rotation out of its cash stash into the capital-starved development sectors. And keep in mind that the record shows over A$800m was raised by MPS during the Disbelief stage with some outstanding results before the GFC in Dec Half 2008.
Fortunes are being offered to the astute.