Welcome to Authers’ Note, in which I will attempt to provide some context and analysis on the world of investment each day, and provide you with a handy guide to the best coverage on offer, both here in the FT and elsewhere. All feedback is welcome, particularly of the constructive variety, as we try to get this right. (Email to email@example.com).
Jay Powell has his first opportunity to frame the inflation debate on the morrow. Whether deliberately or otherwise, Fed chairmen have often used Humphrey-Hawkins testimony before Congress to frame their ideas about monetary policy and to ready the market for changes. So the relative calm of the last few days as we await his words of wisdom makes sense.
While we await the grilling of Jay Powell, I would like to suggest a different exercise. Let us assume, for now, that you believe the inflationist scenario. Inflationary pressure is at last making a return to the world, along with economic growth. If you believe this, and you are confident about it, where should you invest? The answer, according to Larry McDonald of the Bear Traps Report, is agricultural commodities — with some commodity-sensitive emerging markets on the side.
Larry is never knowingly understated, and makes his case as follows:
In our view, inflation is far from dead. We believe a colossal transition is now facing investors, a moment where a widely embraced belief system gets turned on its head. The genie is out of the bottle, and there are inflationary forces oozing underneath the bond market, influences it HAS NOT had to deal with in decades. Animal spirits are playing an important role, but the structural catalysts of “demand” inside the US economy are changing. As we move through 2018 and capital flows surge out of bonds, the late cycle winners will be found in (soft) commodities. We are commodity bulls, they're a contrarian's delight.
He is right both that soft commodities make an interesting and direct play on inflation, and that they look very contrarian at present. This is how the Bloomberg agricultural commodities index has fared compared to the FTSE All-World equity index over the past decade:
Soft commodities are now below their worst levels of the crash of 2008. Interest in the sector has steadily drained away. If inflation does make a return and consumers start bidding up prices, it makes complete sense to expect that to show up, in a levered way, in the prices of agricultural commodities. The greatest risk, he concedes, would be a strengthening of the US dollar, which is possible if higher US rates attract funds to the dollar. Commodities are inversely correlated to the dollar, and reached a major peak ahead of the crisis in 2008 just as the dollar hit a trough.
Having recognised the dollar as a risk, Larry nevertheless suggests doubling down by investing in fertiliser stocks such as Mosaic. They were popular a decade ago and have been badly out of favour for a long time. He also suggests trying out commodity-driven emerging markets, such as Brazil, which have also head a dreadful time:
The market is going through a metamorphosis. A recipe of record US budget deficits (at this point in the economic cycle), a weaker dollar, rate hikes, and runaway global growth will tip the balance. US equities will no longer be the surefire source of gains, commodities will take the lead in 2018. Likewise, emerging market (commodity-rich countries) will ride the late cycle surge. This opportunity is found in recently forgotten corners of the market; emerging markets and their export-driven, commodity-tied currencies. We predict outperformance will abound in these foreign economies, and the upcoming countertrend bounces in the dollar and rates could provide a very attractive entry point into the bond-bear, commodity-bull theme of 2018.
One particularly interesting chart, which Larry produces with a flourish, comes from a JPMorgan research report, and shows that the average asset allocation to commodities has dropped all the way to 0.2 per cent. This is a far cry from a decade ago, when investors were pouring into commodity futures in search of uncorrelated gains.
If commodities were an overbought fad ten years ago (and they were) they look under-loved now. A further interesting twist would be fertiliser companies, another great geared play on agricultural commodities. Buying into companies like Mosaic or Potash would in many ways be like returning to the scene of the crime. Back in 2007 and 2008, as money poured into commodities and emerging markets amid an inflation scare, before the whole edifice collapsed, this is what happened to the share prices of these two fine and upstanding fertiliser groups:
The MosPots, as we might call them from their ticker symbols, had a ride to put even the contemporary Fangs to shame. Both have lagged behind the market painfully for years now, and might enjoy a similar kind of spasm if a true inflationary fear takes hold. I can at least see why Larry would recommend it as an interesting contrarian punt.
The ETF industry also has a range of options for those who want to buy exposure to agricultural commodities, and regular readers will be glad to know that they come with catchy ticker symbols. Larry suggests the DBA ETF, which covers a range of agricultural commodities, or the particularly exotic JO, an exchange-traded note based on coffee futures, which have been pounded. I would suggest MOO, which is based on a global index of agri-business stocks, including fertiliser groups, although it is not as exciting a contrarian call as a direct plunge into coffee futures:
A look at the amount of shares outstanding in MOO should make clear that the sector is now totally out of favour:
Beyond straightforward anticipation of an inflationary environment, Larry also points out that environmental considerations might also help out agricultural commodities. As he puts it:
Current (risk-reward) conditions in the agricultural markets are the best we've seen in eight years. Investors have been positioned bearishly, the major economies in the world are finally growing simultaneously, the dollar is trending weaker, and La Niña weather phenomenon could lead to reduced crop yields in the US and Latin America. The massive relative underperformance of "softs" (agriculture) to "hards" (metals) commodities has likely reached a climax. Even with continued strength in crops, the demand-side "late cycle" push in prices should generally be a very favourable environment for this under-loved asset class.
For those who are convinced that we are entering a reflationary regime, and who have the intestinal fortitude to make a contrarian stand, his arguments do seem good.
From Brics to CARBNs
Meanwhile, another way to play reflation involves more acronyms, and more reminders of the boom and bust of a decade ago. Back then, people got terribly excited about the Brics (Brazil, Russia, India and China). They did very well, until they didn't. Now, for those minded to back a hunch that inflation is back, there is a case for the CARBNs (Canada, Australia, Russia, Brazil, Norway, Colombia and South Africa). If you want to add the O for completeness, you could also insert Opec. These very disparate countries have it in common that their economies are to a high degree dependent on resource extraction. Their stock markets have it in common that they have performed terribly ever since commodities peaked and moved into a bear market. This is how the CARBN markets have performed, according to MSCI, since the commodity top in May 2011:
Absolute Strategy Research came up with the CARBN moniker in 2016, in a bid to come up with a more useful classification for emerging markets, which it suggested should be divided into Asia ex-Japan (largely buying commodities), and the CARBNs (largely selling commodities, and including some countries that are not emerging markets). Ian Harnett os ASR is keen to point out that he does not recommend buying CARBNs at present, but that they would indeed make an ideal investment for anyone worried about inflation.
The degree to which the CARBNs differ from the rest of world stock markets is indeed remarkably linked to commodity prices, as this chart from ASR makes clear:
And their performance is also remarkably closely correlated with inflation:
They do appear if anything to be under-performing at present, so again, if you believe that inflation should be our prime concern, now is the time to buy. And the fact that that means buying into Brazil ahead of its election, and Russia as it knuckles under for yet another term of Vladimir Putin, and South Africa as it is convulsed after the fall of its president, and so on, only goes to show what a great contrarian buying opportunity this might be.
Xi Xi Rider
All of this should be viewed in the context of by far the most consequential news of the year so far, the announcement that China's Xi Jinping appears to be able to amend the country's constitution so that he can stay in power as long as he likes.
In the long term, it is hard to view this as a positive development. If there was any lingering doubt that history has restarted, having famously ended in 1991, this would expel that doubt. In the short term, a dictatorial Xi has that much more power to think for the long term and make the changes needed to prevent the Chinese economy from crashing a few more years down the road. That means at the margin that tougher action to cut down on excessive leverage is likely, and earlier than previously seemed likely — and this is broadly good news for people in the rest of the world. It may well also be good news for Chinese and Chinese-exposed stocks and ADRs, which is why they all managed moderate gains today. This is not seen as a big news event for the Chinese corporate sector.
It is bad news for people investing in "hard" commodities, such as industrial metals, that have been almost exclusively underpinned by Chinese demand. That is part of the reason why Larry McDonald's investment call, mentioned above, concentrates on "soft" agricultural commodities, rather than metals.
Are markets right to be so sanguine about this? I find it hard to believe. One of the best pieces of analysis I have read so far comes from JP Smith of EcStrat, a veteran China-watcher, who has long emphasised the importance of corporate governance. In the short run, he concedes that tougher central control over local governments, who have been at the centre of excessive lending, could be positive. In the longer run, he lists a series of more negative points, which I will quote at length:
First, it confirms the new orthodoxy among the US policymaking establishment that China’s values and interests are becoming increasingly inimical to those of the US. This realisation is not confined to the ranks of the Trump administration (see 'The China Reckoning, How Beijing Defied American Expectations’; Kurt M. Campbell and Ely Ratner, published in the latest edition of Foreign Affairs for the best exposition of this shift https://www.foreignaffairs.com/articles/united-states/2018-02-13/china-reckoning).
Second, the gradual accretion of power by Xi Jinping increases the governance risks for investors further down the road, should China run into any serious economic and/or financial turbulence. The seizure of Anbang and several smaller instances of what appear to be forced debt-for-equity swaps and injections of private capital into state-controlled enterprises, should leave investors no room for doubt that Xi Jinping will take money from what are ostensibly privately controlled companies whenever it is deemed to be in the state’s interests.
Third, Beijing’s increased leverage and coercive power may have succeeded in stabilising outbound flows and hence the level of FX reserves since the start of 2017, but together with the so-called anti-corruption campaign, will also have increased the insecurity that the majority of wealthy Chinese feel around their wealth and hence the motivation to export capital whenever possible. The increased state control over the economy may also have brought some temporary stability, but at the likely cost of still lower productivity growth further down the road.
Finally, is an emerging market asset class which is increasingly dependent on an ever more authoritarian state really such a suitable investment for Western financial institutions which are increasingly concerned with ESG factors? MSCI is in the process of consulting on a potential reduction in the weighting of companies with limited or variable voting rights, a move which would ironically increase the weighting of China within the MSCI EM index even further, but the presence of state-controlled companies operating under an increasingly Authoritarian Governance Regime is an even bigger governance issue in my opinion. Against this backdrop and given likely opposition from the US, investors should not take future increases in China’s weighting in global bond and equity indices as a given.
I think that these are all very valid points. Certainly, if we are moving towards ESG investing, where the G stands for governance, then sending cash towards a country which seems to be moving towards dictatorship is an odd way to do it.
Most importantly, we really can forget about the peace dividend, in much the same way that we have already begun to scale back our hopes for globalisation. It is all a worrying throwback to the mid-1980s, when I was about to leave school, and when the number one song in the UK was this exciting ode to two tribes going to nuclear war. The video featured President Ronald Reagan in a wrestling match with Konstantin Chernenko of the Soviet Union:
There have been good reasons why the world has grown far more prosperous since the end of the cold war. If anything like a return to those conditions lies ahead, then world markets still have a lot of adjusting to do. I suspect we will all have to spend much more time analysing the new ascendancy of Xi Jinping.
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