Watching Alejandro Iñárritu’s harrowing survivalist drama The Revenant is an excruciating, visceral experience. For some, however, watching the mauling in the oil market over the last few years was even grislier. Yet 2016 has provided a respite from the thrashing – oil, the wider commodity complex, and resource-driven currencies have returned with a vengeance. For commodity bears like us, this revenant-like performance has inflicted some short-term pain. Where to next?
We remain steadfast that oil and commodities are in a “lower-for-longer” phase. Yes, stability may have finally arrived. However, a renewed bull market is unlikely.
Prices went through a very typical secular phase – rising demand amidst constrained supply in the early 2000s was met with a prodigious surge in capital spending. This imbalance ensures that commodity bear markets are longer-running affairs: Persistent oversupply imposes a ceiling on prices for years.
After the carnage
Looking ahead, global investors should learn to love low oil prices. But investors have been treating the price decline as a leading indicator of weakness in global demand. This is evident in market action. Incongruously, correlations between oil prices and the U.S. stock market reached their highest level in more than two years in late February (Chart 1).
This could not last. In fact, correlations are already changing, falling from 0.67 on Feb. 26 to 0.52 on March 22 (using daily returns). For perspective, correlations have averaged 0.13 and 0.07 over the past 20 and 30 years, respectively.
As investors begin to look past the initial impact of lower oil in the sector itself, the second-order effects will become apparent. In commodity-importing countries, consumption, investment, and liquidity will benefit (even in the U.S., which remains a net oil importer).
Investors are also extrapolating weak profit trends well into the future. Earnings revision ratios have been lower only during the Asian (1998) and the financial crisis (2008) crises. To be sure, aggregate sales for S&P 500 firms fell 4% year-over-year, and profits tumbled 7.5% (figures as of the fourth quarter of 2015). However, a big driver of the decline can be attributed to the energy sector. Sales in the same period dropped 34%, while profits plunged 73%.
The second-order question is whether U.S. companies more broadly will benefit given the general boost to consumption. While difficult to isolate, consumption patterns are becoming clear: Households are spending the difference. The personal savings rate has not risen materially. U.S. corporate sales will start to reflect this windfall directly ahead.
New leadership set to surge
Viewing these trends more globally, where to next? Volatility spiked in the first six weeks of 2016 as renewed global recession fears surfaced. Now visibility is increasing. Importantly, a U.S. and wider-world recession looks highly unlikely this year (more about this in my February article).
Emerging from this volatility is more discrimination. Correlations are rapidly declining. And new leadership is underway. A likely candidate to provide the lead is commodity-importing Asian countries – nations like India and Vietnam, which can be accessed via the Shares MSCI India ETF (NYSE: INDA) and the Market Vectors Vietnam ETF (NYSE: VNM) (Chart 2).
In addition to the benefit from lower oil prices, three other key macro positives exist within the Asian region.
1. China’s policy fog is finally lifting. Its global image – assiduously promoted by the world’s ubiquitous bears – is of a failing economy beset by a collapsing currency, panicked capital flight by investors, and a banking sector teetering on the brink of disaster.
That narrative may sell newspapers, but what sustains and supports that story is, among other things, an almost blind faith. “China must crash” has become not so much a well-researched assertion as a theological one. How could a command-style economy ever create lasting value? A fair question, but the answer – of course – is complex.
The more important development is that China is not crashing (with a foreign trade surplus of $63 billion in January alone and soaring household income – rising 9% last year), and better policy communication is emerging. This type of progress is crucial to attract flows to other Asian countries that have been indiscriminately sold off on China-driven fears.
2. Trends in the U.S. trade deficit. Importantly, the U.S. ex-energy, ex-China trade balance shifted from a surplus to a deficit in 2015, sending $150 billion to the world. Historically, a widening of the deficit has always provided a boost to global growth via an upturn in trade and liquidity. Emerging markets (EMs) – which tend to be net exporters and do much of their financing in U.S. dollars – stand to benefit the most.
3. A strong U.S. dollar head wind looks to be abating (see my recent article, "Peak dollar theory"). The chronically rising dollar has been a destabilizing force globally, as concerns about U.S. competitiveness and EM solvency have steadily increased. A change in regime would most benefit EM corporates, with high levels of financing denominated in U.S. dollars (which peaked last year at $6 trillion).
Volatility as a signal of transition
Director Iñárritu’s film is a haunting piece of cinema. Several unnerving, gaze-averting scenes litter the script. “But there is no gratuitous violence,” the director says. Perhaps. Global investors, on the other hand, have definitely endured an unwelcome, volatile script in 2016.
However, this always occurs when a significant transition is happening.
Looking ahead, investors should stay focused on longer-running macro themes. China is critical here. Its labor force grew by 200 million people in the 10 years spanning 2002 through 2011, and average annual GDP growth was 10% during that period. That era is now over. Unsurprisingly, investments that did well during China’s rapid industrialization years are faltering.
Now, the environment is changing – Leonardo DiCaprio finally got his Oscar for The Revenant, and commodity-importing Asia looks set to lead.
Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article originally appeared in ETF.com. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at firstname.lastname@example.org.
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