A few weeks back I penned a discussion in these pages suggesting one of the most important issues for 2013 may be the potential for a shift in macro deflationary expectations among the investment community. Certainly such an event would have very important implications for multiple assets classes if it is to occur at all. I want to follow up on that a bit and look at some real world data points I hope are helpful monitor points as we move through the early part of the year. Maybe these data points can help us benchmark investor perceptions and how these perceptions are ultimately priced into the markets. I believe this is particularly important for the very simple reason that global central bankers have now again embarked on quite the meaningful reflationary campaign. Let’s face it, now that we have unlimited money printing promised by the Fed, to be soon joined by the BOJ, just how much more extreme can global central banker monetary expansion become in concept? It can’t. We’re there. The only variable now is magnitude. By the way, it will not be long until Europe joins the game as the Euro banking system is either recapitalized or bleeds out – choose one.
In addition to the impact of global monetary expansion in terms of helping to shape investor perceptions, as we start 2013 we are now also seeing a bit of renewed strength in emerging and otherwise “non-developed” economies. In part this is being driven by prior period stimulus. Without oversimplifying the issue, these economies are primary meaningful users of global commodities. Would stabilization and a pick-up in commodity prices essentially validate non-developed economy economic growth acceleration? In good part it would. And of course China is the poster child for this type of conceptual linkage. Asian PMI’s have picked back up as of late. And the message of the market is that for now, we have a trend breakout to the upside in the Shanghai market. Manufacturing numbers out of China have been stronger recently, but so have short term CPI numbers. But isn’t this what reflation is all about?
One note of importance. Even though I did not show this in the above chart, in late 2012 the Shanghai touched its 200 month moving average near 2000. Although I have not discussed this in quite some time and it seems to receive very little airplay on the Street, 200 month moving averages have been secular support and resistance levels over time for a number of headline global equity indices. The Nikkei has been held back under its 200 month MA for years (it has defined its long term bear market). The Nasdaq kissed its own 200 month MA after the early 2000’s tech bust. So for now, the Shanghai has just bounced off of a very important and very long term support level. We’ll see what happens from here.
Back to the matter at hand. As I step back and try to listen not only to the message of the markets, but also acknowledging what I’m seeing in terms of global money flows, it appears to me investors accept the fact that the major developed economies will grow slowly in 2013, but the emerging markets will once again pick up the pace, with China in lead sled dog position. Money flows early in 2013 have been very strong into the emerging equity markets. It also appears to me global investors seriously underweight in countries like Japan and even Argentina have had to chase spike like near term performance. Moreover, after close to a 10% decline from summer through the October/November period of last year, the CRB has stabilized along with the acceleration in emerging market equity indices. Finally, ten year US Treasury yields have climbed back to near the 1.9% range after bottoming near 1.4% in July of last year. So let’s quickly sum this up – rising US interest rates, rising emerging economy equities and accompanying money flows, and stabilizing commodity prices. And to top it all off we have central bankers advocating a moderate rate of systemic inflation. Does this sound like the pricing in of deflationary expectations to you? I think not. Remember, the KEY characterization here is perceptions and expectations.
So of course this naturally leads to the question, what does this mean for US equities broadly? Will the early year price strength continue if indeed the emerging economies can show us additional and sustained acceleration? Without belaboring the point, I believe looking over the very short term we need to carefully monitor the relationship of commodity prices to interest rates. This is a relationship that does not receive enough headline attention, but should. And it’s important now based on what you see in the chart below. Very simply in the top clip of the chart we’re looking at the relationship of the CRB index to the 30 year US Treasury price. What is important right now is that this price relationship just bounced off of a 30 year low bottoming area, an area this price relationship has now hit four times over the last decade and one half, which has been a period of meaningfully falling US interest rates in the absolute. Important relative price support? It sure appears that way. At least historically, post each occurrence of hitting the area of support, commodities have meaningfully outperformed US treasuries for a time. Again, if this were to repeat and occur once again over the short term, would investors be pricing in a deflationary or inflationary mindset or perceptual outlook?
Although commodities have not yet begun to meaningfully outperform interest rates, very near term this is exactly what I’m focusing upon. For the very important issue is the bottom clip of the chart. What it shows us is that really since 1980, whenever commodities have meaningfully outperformed US Treasuries over a short period of time, US equities (the S&P) have underperformed commodity prices. This should not be surprising at all as commodities doing better than interest rates is the reflection of investors pricing in higher inflationary expectations. And, of course, inflation is not the best friend of macro equity valuations. Academically the linkages all connect. So in our current circumstances, I’d strongly suggest watching exactly this ratio of commodity prices to interest rates.
If commodity prices zoom higher relative to interest rates, do we run from equities in aggregate? Not so fast. The potential swing, even if short term, in investor perceptions from a deflationary mindset toward pricing more inflationary expectations or perceptions actually has positive relative performance implications for Industrials and Materials equities – the exact sectors that ARE the emerging economy stories. I’ll leave you with two last relationships to monitor in conjunction with the above. Quite simply the relative underperformance of industrials and materials has coincided with the long prior two year slide in the Shanghai. As you can see in the two charts below, the performance of the industrials (XLI) and materials (XLB) relative to the aggregate S&P are highly directionally correlated with the CRB to US Treasury price relationship. History is whispering in our ears that if commodities outperform US bonds, industrials and materials should outperform the aggregate S&P. So for a while, even if inflationary perceptions and expectations accelerate, we can make a positive case for these two sectors. We just need to realize one thing, and that is as these near same set of circumstances played out in 2007 and 2008, it defined the end of cycle experience. One step at a time as we move into 2013.
