Oil prices are dropping again as China's manufacturing PMI came in lower than forecast. The previous weeks Opec meeting mixed with light volume could also see renewed selling throughout the beginning of the week as traders return. short, medium, and long term factors are aligned to create this supply glut and prices of oil and oil companies have reacted to it. But like always in these types of scenarios there could be a far from equilibrium moment that occurs as too many participants are short or increase short positions as others confirm the bias. This trend will continue so long as traders and investors feel it will be untested. I feel the next test for this trend will have to come from oil producers announcing cuts to oil production and slashing capital expenditures going forward. This news of near term halts in production and depressed projections of supply in the long term could test the mass selling of oil companies and possibly put a floor in the decline of crude. The question is who will blink first and to what degree will the entire industry listen (we already know OPEC is not budging). I feel that the only other option to US cutting back on production is the OPEC countries getting to a point where the cartel cannot reach a consensus and certain countries start to break from the ranks out of their own political instability from growing budgets deficits.
The first in my real assets series: Gold
Geopolitics from a market perspective have been narrowly focusing on Isis and Ukraine. The effects are seen in the Rouble and Micex. I feel energy is not taken into account like it should be due to the direction of the move. Oil is declining as tensions are high between the west and Russia, which is counter to what market participants would expect. This reinforces the notion that the drop in oil is from an overabundance of supply and prices are dropping despite the tensions.
This does not discount the fact that oil prices are at play in the spectrum of geopolitical affairs at the moment. Looking at the current hot spots: Russian aggression in post soviet bloc nations, Iran increasing influence in the middle east, China asserting more power in the pacific and Japan becoming more militant. You can break these countries down into two groups, oil producers and consumers.
Much of Russia's budget is from oil revenue, and the price needs to be about $120 a barrel to balance the budget. Iran is in he same boat with the sanction imposed on it from the nuclear program. It is no suprise that these countries will try to exert more influence than give into western wants.
On the other end of the continent China is bolstered by lower oil prices, helping to keep the country near the projected growth rate. This helps to embolden the country as the resources that their growth requires are cheaper and more abundant.
The connection between these countries is with Russia and China signing more deals for oil and gas deliveries. With a cheap source of gas to China, they can feel more secure in their independence or oil imports while the deals could give Russia a sense of independence from the need to have European customers for its oil. Add in that Russia can veto sanction on Syria and Iran and you have a very unpleasant situation that is still affected by oil. While higher prices could see Russia try to increase is sphere of influence by economic means as opposed to military ones, this would put China and Japan into a position of weakness as major oil importers.
As of now the supply side story reigns supreme in the markets, but on the geopolitical front the price of oil is still a major factor adding uncertainty to Europe and Asia.
Current market sentiment seems to be at a crossroad and moves by global central banks are telling a different story than we are seeing in market prices. Assuming the current state of affairs holds true, embarking on a trail of more QE by Japan and a potential asset purchase program in Europe, the global economy will be able to pull itself from the disinflationary spiral we have seen in the past year. Should this occur the current state of asset prices, specifically real assets will come center stage as inflation starts to increase. This will cause a rethink on where to apply capital and what assets are able to outpace the rate of inflation and look attractive after interest rate increases.
This will lead to real assets being a choice class on many fronts. The rebuilding of infrastructure, resource acquisition, and inflation hedging will all become key support cases. What investors will look for is a generation of cash while having the ability to maintain pricing power in the global marketplace, many popular asset classes to date can't retain those conditions in a higher rate, higher inflation environment. Some of these asset classes will see more profound outflows than others and the shift from current allocations to the end state will have many tests and shocks along the way. This is why the move to real assets will be a measured one and will provide fertile ground to start a vine strategy to play out these markets moves.
Stocks: With stock markets near all time highs the relative success of overall markets will come down to the amount of real assets that the indices hold. This will leave some sectors doing better than others and could see developing markets (especially energy intensive ones) outpace the developed world. Sectors that have seen rallies based on hot money (QE money) could see selloffs unless Europeans and Japanese investors feel the same way about these investments. The energy sector, and utilities should see a renewed interest as stimulus starts to increase the demand for oil and gas to power the recovery, however supply side issues still prevail.
Bonds: Bonds have long been a beneficiary of QE and the subsequent volatile markets that have come from the end of stimulus. This has pushed hard currency bonds down to record lows in volatile times and a narrowing of spreads on all bonds in sanguine times. This trend supported US treasuries during the 3 quantitative easing cycles and could look the same for Japan and Europe. This time around that may not be the case as tightening will be starting to take place in countries such as the US and England. Unlike when the US was conducting QE, there will be more attractive assets abroad for Japan and Europe to buy with their increased liquidity. To diversify out of these positions investors can put money into real assets or emerging markets which provide a real return.
Commodities: Recently commodities have been shunned by many, with oversuppy meeting dropping demand. This has led major commodities to drop in value leading to negative annual return for sectors such as energy and metals for 5 years running. These declines are despite geopolitical tensions, sanctions on Iran and Russia, and a total shutdown of nuclear reactors in Japan. Much of the pressure on energy prices comes from the US shale boom, and the slowdown in China has depressed industrial metals prices.
Real Estate: The real estate market has seen a recovery in most parts of the world yet there is still attractive yields to be had in the sector. In terms of income generation REITs can provide a good source of revenue, even in a rising rate environment. While rates are set to rise in the US they are expected to be slow and calculated, in other countries that look set to stay low for some time. So long as the rate in which interest rates rise remain manageable REITs can provide good income generation that will be able to keep pace with expected interest rates.
Currencies: Currencies will depend on the current makeup of the economy. A commodity producing economy will no doubt see growth, inflation, and interest rates increase as a result of higher commodity prices and therefore see the currency rise. The real question is which currency to fund in. The Euro and the Yen are obvious candidates with perhaps the Dollar should the government look to stem recent strength (this is obviously a contrarian play and does not seem to be on investors radar at the moment). Longer term the currencies that become the recipients of excess liquidity from Japan, Europe, and even China will be the winners.
The bank of Japan has shown the markets that it still has the power to suprise. In the wake of QE ending in the U.S. the BOJ has laid out an 80tn yen a year buyback of government bonds, 10tn more than before.
Looking at the global marketplace it seems there is a split in the sentiment of the direction from here. Inflation seems dead, in fact deflations seems to be the real concern if taking your cues from the bond markets. QE is also being pursued in Japan and (hopefully) in Europe soon. The US Fed has struck a more hawkish tone in the us than was expected by investors meaning that they believe in sustained growth in the US economy going forward.
Taking the longer view, the move by central banks and the US economy should bring back growth, and inflation as a result. This would make a good case for owning real assets over this period as prospect will formulate and change sentiment towards higher inflation and a slower rise in rates than previous cycles.