How sustainable is the commodity rebound?


Author Cam Hui

Posted: 29 July 2013

I have seen some buzz and excitement among technical analysts and in the blogosphere about a rebound in the commodity sectors of the stock market. While these sectors were highly oversold and a bounce was not unexpected, my analysis suggest that the sustainability of a rebound is unlikely. The more likely scenario is a sideways consolidation to digest the gains from the tactical rally.

Here is the chart of the metal stocks relative to the market. The group has rallied out of a relative downtrend, which is constructive, but faces some overhead relative resistance. My best guess is a period of sideways consolidation going forward:

Here are the gold stocks against the market. I’m not sure why people are getting so excited here. Sure, the short-term relative downtrend has been broken, but the longer term relative downtrend remains intact.

Here is the relative chart of the energy sector. It bears some semblance to the metals – rally out of a relative downtrend and exhibiting a consolidation pattern.

Longer term, I just get very excited about this sector unless it can show some sustained relative strength to break the pattern of lower relative lows and lower relative highs:

Here is the long term relative chart of Materials. The same comments that I made about energy applies to this sector as well:

The same thing goes for the metals. Well, you get the idea.

Tactically, I also like to watch the high-beta small cap resource stocks relative to their large cap brethren to measure the “animal spirits” of the market to give me clues as to the sustainability of this rebound. Here are the junior golds (GDXJ) relative to the senior olgds (GDX). Unless the juniors can show more strength to break the relative downtrend, it suggests to me that this rally is likely to be brief and fleeting.

Up here in the Great White North, I monitor the relative return of the junior TSX Venture, which is weighted towards the speculative junior resource names, to the more senior and more broadly diversified TSX Index.

Nope. No rebound in animal spirits here either.

The dreams of gold bugs
I also saw some analysis that is supportive of a strong gold rally, but upon further analysis I believe that the analysis could be interpreted in different ways and it is not necessarily supportive of a bullish position in gold. Consider this chart showing the relative performance of the Amex Gold Bugs Index against SPX, which has been rattling around in the blogosphere:

It was pointed out that we are experiencing bullish divergences on the 14-week RSI and in the past three occasions, the HUI/SPX ratio has rallied strongly in favor of HUI. Moreover, the ratio is sitting at a major relative support level and, given the highly oversold conditions and the bullish RSI divergences, conditions are highly suggestive of a strong rally for the golds.

While I would not rule out a tactical rally in gold and gold stocks, I question the sustainability of any bullish thrust. I would point out that the highlighted bullish RSI divergences occurred in a secular bull market for gold and other commodities. It is questionable whether gold remains in a secular bull today. Consider the occasions on the left had side of the chart, where oversold RSI conditions occurred in the HUI/SPX ratio in a bear market. On those occasions, the rebound was only a blip and the downtrend continued soon afterwards.

The key issue to the analysis that underlies the above chart is the question of whether gold is in a bull or bear market. Choose your interpretation and your own conclusion.

As well, there is the Commitment of Traders report showing an off-the-scale reading in the net gold positions of commercials, or hedgers:

The COT report seems highly supportive of a bullish impulse in gold, but consider what happened in 2008 when we saw a similar reading. The COT “buy” signal report date was September 16, 2008. Soon after, the gold price proceeded to tank, though it did recover for several months,

Oh well, back to the drawing board.

Fundamental backdrop is not constructive
It’s not just technical headwinds that the commodity sectors face, the macro fundamental backdrop does not scream sustainable rebound for these late cycle sectors. Walter Kurtz of Sober Look highlighted this chart from Credit Suisse showing the relative performance of cyclical vs. defensive sectors by region. The US and eurozone ratios are fairly flat, while Japan shows a minor uptick and China, which is the major marginal buyer of commodities, is going south.

Can the commodity sectors rebound strongly in the absence of Chinese demand and a so-so performance from the major developed markets?

The signals from China are clear. The new leadership is intent on re-balancing the  economic growth from an export and infrastructure driven model to a consumer drive model. While the government appeared to have blinked last week when Premier Li Keqiang asserted that growth would not be allowed to go below 7%, it seems that any stimulus measures would be highly targeted and localized. In fact, Bloomberg reported that the government ordered 1400 companies to cut capacity in a highly targeted move to shift the focus away from infrastructure spending:

China ordered more than 1,400 companies in 19 industries to cut excess production capacity this year, part of efforts to shift toward slower, more-sustainable economic growth.

Steel, ferroalloys, electrolytic aluminum, copper smelting, cement and paper are among areas affected, the Ministry of Industry and Information Technology said in a statement yesterday, in which it announced the first-batch target of this year to cut overcapacity. Excess capacity must be idled by September and eliminated by year-end, the ministry said, identifying the production lines to be shut within factories.

China’s extra production has helped drive down industrial-goods prices and put companies’ profits at risk, while a survey this week showed manufacturing weakening further in July. Premier Li Keqiang has pledged to curb overcapacity as part of efforts to restructure the economy as growth this year is poised for the weakest pace since 1990.

Does this sound like a government that is panicked about growth falling below 7% and is anxious to stimulate at all costs? Do these measures sound like they are supportive of a short-term spike in commodity demand?

In short, the rebound in gold and other commodity prices appear to be temporary and the bear trend will likely re-assert itself after a short rebound. This does not look like the start of an intermediate term uptrend.

For commodity bulls, the current environment is like the unfortunate case of being locked up by the secret police and having your interrogator go home for the evening. You may think that the torture is over, but the beatings will continue when he returns in the morning.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The bear case for equities


Author Cam Hui

Posted: 11 June 2013

I have been fairly bullish in these pages and I remain cautiously bullish today. However, successful investors and traders look at the other side of the coin to see what could go wrong with their thesis. Today, I write about the bear case, or what’s keeping me up at night.

The signal from emerging market bonds
James Carville, former advisor to Bill Clinton, famously said that he wanted to be reincarnated as the bond market so that he could intimidate everyone. The message from the bond market is potentially worrying. In particular, emerging market bonds are selling off big time. The chart below of the emerging market bond ETF (EMB) against the 7-10 year Treasury ETF tells the story. The EMB/IEF ratio broke an important relative support level, with little signs of any further support below the break.

Technical breaks like these are sometime precursors of a catastrophic event, much like how the crisis in Thailand led to the Asian Crisis. For now, the concerns are somewhat “contained”. Yes, junk bond yileds have spiked…

On the other hand, the relative performance of high yield, or junk, bonds against 7-10 year Treasuries remain in a relative uptrend, which indicates that the trouble remains isolated in emerging markets.

Here is the relative performance of emerging market bonds against junk bonds. They have been in a multi-year trading range. Should this ratio break to the downside, it would be an indication that something is seriously wrong in EM that smart investors would be well advised to sit up and take notice of.

For now, this is just something to watch.

Are European stocks keeling over?
The second area of concern is Europe. Despite my bullish call on Europe (see Europe healing?) European stocks have been performing poorly in this correction. As the chart below of the STOXX 600 shows, the index has fallen below its 50 day moving average, though the 200 day moving average has been a source of support in the past.

The 200 dma is my line in the sand.

Faltering sales and earnings momentum
In the US, high frequency macro indicators are showing a pattern of more misses than beats, as measured by the Citigroup Economic Surprise Index.

Ultimately, a declining macro outlook will feed into Street sales and earnings expectations for the stock market. Ed Yardeni documented the close correlation between the Purchasing Managers Index against revenue estimates.

Viewed in this context, the PMI “miss” last week is especially worrying. Indeed, Yardeni showed that the Street’s forward 52-week revenue estimates are now ticking down. Unless margins were to expand, which is unlikely, earning estimates will follow a downward path and provide a headwind for equity prices.

As Zero Hedge aptly puts it, this is what you would believe if you were buying stocks right now:

My take is that the downturn in high frequency economic releases a concern, but it is something to watch and it’s not quite time to hit the panic button yet. I agree with New deal democrat in his weekly review [emphasis added]:

After several weeks of more positive signs, last week we returned to the pattern of gradual deterioration that began in February. This week most indicators remain positive and there were fewer negatives…

Last week I said that for me to be sold that the data is actually rolling over, I would want to see a sustained increase in jobless claims and a sustained deterioration in consumer spending. That wasn’t happening as of last week, and it certainly didn’t happen this week either. The economy still seems to be moving forward – but in first gear.

In summary, most of these concerns are on the “something to watch” list to see if any of these risks turn out to be more serious. My base case, for now, is that the market is undergoing a typical rolling correction, with leadership shifting from interest sensitive issues to deep cyclicals (see my recent postCommodities poised for revival). Until the late cycle commodity stocks roll over, there is probably more upside to stocks from these levels, but I am still looking over my shoulder and defining my risk parameters carefully.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned. 

Would you short this?


Author Cam Hui

Posted: 10 June 2013

Look at this four-year weekly chart. Would you buy, sell, or hold this?

I will write about what it is on Monday and discuss it further.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Commodities poised for revival


Author Cam Hui

Posted: 07 Jun 2013

Yesterday’s stock market selloff was an event that we haven’t seen in some time, as major averages fell over 1% across the board – and globally. Nevertheless, I saw a glimmer of hope for the bulls, as commodities were performing well despite the carnage. If a deep cyclical sector like that is displaying rising relative strength, it suggests that the end of this correction may not be too far off.

Commodities unloved and washed out
Simply put, the commodities complex is unloved, washed out and showing signs of investor capitulation. The chart below from BoAML shows the aggregate large speculator (read: hedge fund) net position from the Commitment of Traders report in the CRB Index. Large speculators have liquidated their net long positions from a near crowded long level to net short. Moreover, readings are consistent where declines have halted in the past.

Here in Canada, the junior resource companies are beyond washed out. The chart below of the relative performance of the junior TSX Venture Index against the more senior TSX Composite is at all-time lows – and below the level of the capitulation lows seen following the Lehman Crisis.

Here in Vancouver, which is the heart of junior mining country, I personally know of scores of well-qualified people who are in the industry who are struggling with the difficult environment.

Green shoots
In the midst of this bleak landscape, I am seeing nascent signs of recovery for the sector. What is encouraging was the positive performance shown during yesterday’s ugly selloff. One of the top recent performers has been industrial metals, which has:

  1. Rallied through a downtrend;
  2. Staged an upside breakout through a wedge; and
  3. Staged an upside breakout through a resistance level yesterday – which was impressive given the headwinds provided by the risk trade.

At the same time, gold seems to have made a temporary bottom and it’s starting to grind upwards as the precious metal is displaying nascent upside strength.

I am watching carefully the Brent price, which is a better proxy for world oil prices, for signs of an upside breakout through a downtrend. We almost achieved the breakout yesterday, but not quite.

The relative performance of energy stocks against the market is starting to show positive relative strength, which is another early warning of shifting leadership.

Macro and market implications
While I understand that commodities and commodity related stocks are unloved, washed out and poised to rally. These combination of sold-out sentiment and early signs of rising relative strength are pointing to a recovery in these sectors.

From a macro perspective, the recovery of deep cyclical sectors like these are consistent with a relatively upbeat outlook for growth economic growth. In that case, the environment for equities is encouraging and any correction should be relatively shallow – barring any macro surprises,

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Watching silver for the bottom in gold


Author Cam Hui

Posted: 26 Apr 2013

In a recent post (see What to do about gold?) I suggested that a tradable bottom for gold may be near, but to wait for some signs of price stabilization:

Personally, I would be inclined to step aside for now and watch how this trade develops. Gold could have great upside potential once it bottoms, but prudence calls for waiting for some signs of stabilization before getting long. I would rather miss the first 10-20% move than lose another 50% should I get long prematurely.

It appears that we are seeing signs of a panic bottom and some signs of stability. The chart of GLD is showing the classic signs of a capitulation bottom:

The same goes for GDX:

As much as my inner trader is itching to jump onto the long side with both feet, a falling silver/gold ratio is flashing a caution signal. The chart below shows the silver/gold ratio as the solid line and the gold price as the candlestick chart. If silver is the high-beta version of gold, i.e. the poor man’s gold, why is the silver/gold ratio continuing to fall here?

In the last couple of instances where gold had bottomed, the silver/gold ratio bottomed at about the same time. Here is the 2008 bottom:

Here is 2004:

The most charitable explanation that 2013 corresponds to the 2001 gold bottom, where the silver/gold ratio continued to fall. As the gold price stabilized, rallied and then fell back to test the bottom, the silver/gold ratio stabilized, though it was several months late in confirming the start of the secular gold bull.

The markets in 2011 and 2013 may not be directly comparable. 2001 was the end of a multi-decade secular gold bear market. Today, the price of gold peaked out in late 2012 and fell back below important technical levels after a long bull market.

Bottom line: We are likely seeing a short-term bottom for gold here. On the other hand, don’t be so sure about the intermediate term trend. There may be more downside to come. We’ll just have to watch and wait to see how some of these technical patterns resolve themselves.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Commodity weakness is likely localized


Author Cam Hui

Posted: 25 Apr 2013

The old Cam would have been freaking out. The first version of my Inflation-Deflation Trend Allocation Model depended solely on commodity prices as the canaries in the coalmine of global growth and inflationary expectations. The chart below of the equal-weighte Continuous Commodity Index is in a well-defined downtrend. The weakness isn’t just restricted to gold, but other commodities like oil and copper are all falling.

However, we found with further research that adding global stock prices to commodity prices as indicators gave us a better signal, in addition to giving us a more stable signal.

Equities not confirming weakness
The three axis of global growth are the US, Europe and China. I am finding that signals from all three regions are not really confirming the signals of weakness given by falling commodity prices. Consider, for example, Caterpillar’s earnings report yesterday. The company, which is a cyclically sensitive bellwether, reported punk sales, earnings before the opening bell and revised their outlook downwards [emphasis added]:

We have revised our outlook for 2013 to reflect sales and revenues in a range of $57 to $61 billion, with profit per share of about $7.00 at the middle of the sales and revenues outlook range. The previous outlook for 2013 sales and revenues was a range of $60 to $68 billion and profit per share of $7.00 to $9.00.

“What’s happening in our business and in the economy overall is a mixed picture. Conditions in the world economy seem relatively stable, and we continue to expect slow growth in 2013,” said Oberhelman.

“As we began 2013, we were concerned about economic growth in the United States and China and are pleased with the relative stability we have seen so far this year. In the United States, we are encouraged by progress so far and are becoming more optimistic on the housing sector in particular. In China, first quarter economic growth was slightly less than many expected, but in our view, remains consistent with slow growth in the world economy. In fact, our sales in China were higher in the first quarter of 2013 than they were in the first quarter of 2012, and machine inventories in China have declined substantially from a year ago,” said Oberhelman.

“We have three large segments: Construction Industries; Power Systems; and Resource Industries, which is mostly mining.While expectations for Construction Industriesand Power Systems are similar to our previous outlook, our expectations for mining have decreased significantly. Our revised 2013 outlook reflects a sales decline of about 50 percent from 2012 for traditional Cat machines used in mining and a decline of about 15 percent for sales of machines from our Bucyrus acquisition,” said Oberhelman.

In other words, CAT remains upbeat on US housing. China is weak-ish and mining is in the tank. It seems that much of this negative outlook has been discounted by the market. While the stock fell initially, it rallied to finish positively on the day on heavy volume.

For now, the US economy look OK. I agree with New Deal Democrat when he characterized the high frequency economic releases as “lukewarm”. We are not seeing gangbusters growth, but there is no indication that the economy is keeling over into recession either. The preliminary scorecard from the current Earnings Season is telling a similar story. The earnings beat rate is roughly in line with the historical average, although the sales beat rate has been somewhat disappointing.

Risk appetite rising in Europe
Across the Atlantic, Europe is mired in recession. However, there is little sign that tail-risk is rising. I have been watching the relative performance of the peripheral markets in the last few days as stocks have weakened. To my surprise, European peripheral markets have been outperforming core Europe, indicating that risk appetite is rising. Here is the relative performance of Greece against the Euro STOXX 50:

Here is Italy:

…and Spain:

Well, you get the idea.

Weakness in China?
What about China? Chinese growth has been a little bit below expectations, such as the March Flash PMI released overnight. Shouldn’t weakness in Chinese infrastructure growth would be negative for commodity prices? Isn’t that what the commodity price decline is signaling?

Well, sort of. Maybe. We have seen a great deal of financialization of commodities as an asset class. An alternate explanation of commodity weakness is the unwind of the long positions of financial players . Indeed, analysis from Mary Ann Bartels of BoAML shows that large speculators have moved from a net long to a net short position in the components of the CRB Index:

One key gauge I watch of Chinese demand is the Australian/Canadian Dollar cross rate. Both countries are similar in size and both are commodity producers. Australia is more sensitive to Chines growth while Canada is more sensitive to American growth. As the chart below shows, the AUDCAD cross remains in an uptrend in favor of the Aussie Dollar, though it is testing a support region.

In conclusion, the preliminary verdict from the market is that commodity weakness is localized – for now. Barring further weakness in commodity prices and the other indicators that I mentioned, the implication is that US stock market action will be choppy because of the uncertainty caused by commodity weakness and Earnings Season, but any downside will be limited. As the point and figure chart of the SPX below shows, the S+P 500 remains in an uptrend and I am inclined to give the bull case the benefit of the doubt for now.

So relax and chill out.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Something’s not right about this rally


Author Cam Hui

Posted: 2 Apr 2013

OK, so the SPX made a new high. Many of my momentum models are bullish, but my relative strength work (see my previous post on combining momentum with trend following techniques) is making me scratch my head.

To explain, my work based on a paper by a team of researchers at Cass Business School entitled The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation suggests that when the market is experiencing an uptrend, you should go for broke and buy the “hot” sectors of the day. On the other hand, when the market is falling, buying the “hot” sectors is a recipe for disaster.

A risk friendly market trend
First of all, my trend following and momentum models is pointing to a risk-on market. Consider the relative returns of SPY (stocks) against IEF (7-10 year Treasuries) below. Unquestionably, we are seeing an uptrend in the risk trade:

The risk-on trade isn’t just restricted to stocks vs. bonds. The same effect could be seen in the credit market, where junk bonds are outperforming:

Defensive leadership
Here is what’s bothering me. We are obviously seeing an uptrend in the stock market, as evidenced by the new highs. However, sector leadership is gradually shifting away cyclical sectors to defensive sectors and industries. Take a look at what the leadership is today.

The chart below shows the relative returns of Financials (XLF) against the market (SPY). Financials are in a well-defined relative uptrend against the market.

Here are the Transportation stocks, which is a small cyclically oriented industry. These stocks are also in a well-defined relative uptrend.

OK. So far so good. Now here comes the surprises. Look at the relative strength in Healthcare:

…and the turnaround in the relative strength of Utilities:

Commodity cyclicals lagging
I have written that cyclical sectors are displaying a pattern of relative sideways consolidation after an uptrend (see An uncomfortable bull). I won’t repeat myself, but you can click on the link and see the charts there.

What’s bothering me is that commodity related sectors are lagging badly. Consider the equal-weighted Continuous Commodity Index, which is in a minor downtrend. Though it doesn’t seem disastrous and commodity prices have firmed somewhat in the past three weeks, the price action of the commodity complex is not exactly signaling a robust global recovery.

On the other hand, the price action of industrial metals look downright ugly.

Here are some price relative charts of commodity sensitive stock markets against ACWI, or the MSCI All-Country World Index. Australia looks ok, but it’s the exception.

Canada, on the other hand, is in a relative downtrend and has been underperforming since last November.

Here is Brazil. Enough said here:

Here is the relative chart of South Africa (in black), though its relative performance may be linked to the relative performance of gold stocks (in orange):

The relative performance of the cyclically sensitive South Korean market is not exactly inspiring either. South Korea remains in a relative downtrend, though it has staged a relative rally in the last week or so.

What’s going on?
Frankly, I am puzzled by the nature of the sector leadership when the market is making new highs. My momentum and trend following models are telling to stay long. My relative strength models are telling me to rotate into defensive sectors like Utilities and Healthcare. When I net this all out, I wind up in a fairly neutral position.

Something’s not right about this rally. Mohamed El-Arian of Pimco pretty much said the same thing when he indicated that the Markets are sending unusual signals [emphasis added]:

The rally reflects slowly-improving economic conditions, relatively robust corporate profitability and anticipation of stronger domestic and foreign inflows into the equity market. Yet this is far from the whole story.

Investors need only look at where some other benchmarks ended the quarter to get a feel for the unprecedented and artificial nature of today’s capital markets.

Few would have predicted that the impressive equity performance would be accompanied by a 10-year U.S. Treasury rate as low as 1.85 percent, a 10-year German government bond (bund) rate as low as 1.29 percent and gold as high as $1,596 an ounce. Think of this as the markets’ way to signal to investors some key issues for the quarters ahead.

More on this topic in subsequent posts.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Gold Equities Likely Disappointed Today


Author Larry Berman

Posted: 1 Aug 2012 re-posted from etfcm

If historical patterns repeat, and we know they do, gold equities are likely to be disappointed for a few days following the FOMC not adding more QE today. Although most economists surveyed think they will add more QE at some point, the Bernanke has clearly stated that they want to see things get a bit worse before they act.

World oil process weakened again yesterday as WTI struggles to hold above $90 while the XEG put in a notable bearish reversal pattern, perhaps capping the near-term upside for the TSX. If gold and energy look weaker, it is hard for the TSX overall to do much on the upside.

 

China, beyond the hard/soft landing debate


Author Cam Hui

Posted: 11 July 2012

Imagine a country where a sector has dominated that nation’s economy and is deemed to be “systemically important” to growth. Insiders of that sector have made obscene profits from the growth. One day, we wake up and find that that sector has gotten in over the heads. The “logical” free-market solution is the let that sector go down and allow the economy to re-balance, but sector insiders have a cozy relationship with the government. If leading companies in that sector goes down, the collapse will surely take many in government down with them. What country am I referring to? What sector? What is the most likely course of action for the government?

One obvious answer to the first two questions is the finance sector in the West (see my last post Another test of the banking lobby’s powers). It’s a good guess, but I am referring to State Owned Enterprises (SOEs) in China.

The roots of China’s growth
The China miracle was fueled mainly by two factors:

  1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and
  2. The CNYUSD currency peg.

While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America’s monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called A Model of China’s State Capitalism (h/t Michael Pettis) that shows that the dominance of SOEs and their superior growth is largely attributable to their monopolistic or semi-monopolistic positions in the Chinese economy, e.g. telecom, oil refining. etc. John Hempton called this arrangement a kleptocracy because Party insiders have become enormously wealthy at the expense of the ordinary citizen.

Negative interest rates also meant very low or negative cost of capital. As Japanese companies found out in the late 1980’s, it’s easy to make money when your cost of capital is that low. You borrow as much as you can and invest in something, anything with a positive real return. If you are positioned properly, you can make obscene profits – and they did.

Currency peg = Financial repression
The biggest loser in China, on a relative basis, was the household sector. The ordinary Chinese who worked hard and managed to squirrel away savings had few places to put their money other than the banking system. The Chinese bond market is not sufficiently large. The stock market is very small and undeveloped compared to major industrialized countries and is regarded mostly as a casino. The household sector was forced to put money into the banking system at negative interest rates. Carmen Reinhart calls that financial repression. Here is the definition from Wikipedia:

Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:

1.Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2.Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
3.Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4.Government restrictions on the transfer of assets abroad through the imposition of capital controls.

John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can’t invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money and savings poured into it. In effect, the CNYUSD peg was indirectly responsible for China’s property boom.

Where we are today
Fast forward to today. China’s growth has hit a slow patch. One of the objectives in the Party’s latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector). Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

SOEs, the vehicle of wealthy Party insiders, have been hit hard:

State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.
SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.

Xie also echoed Hempton’s kleptocracy claims, though in a less dramatic fashion:

Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.

In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment Ominous signs from China). Left unchecked, it could have the potential for a crash landing, i.e. negative GDP growth, which is not in anybody’s spreadsheet model.

What will the government do?
In the face of the cracks exposed by a slowing economy, what should the Chinese authorities do?

The textbook answer is that growth has been overly unbalanced towards large infrastructure projects and tilt growth toward the household and consumer sector. The Chinese consumer needs to rise. The latest five-year plan specifies this objective in a clear fashion.

The problem with that solution is that it gores the SOE and Party insiders’ ox. For the household sector to rise, household income needs to rise. Wages need to rise. Returns to household savings need to rise. For this to happen, financial repression needs to end.

Ending financial repression would mean that real interest rates would need to rise, which would squeeze the cost of capital of Chinese enterprises – SOEs in particular. Would the Party cadres go along with that? This may be a case of where the leadership dictates a course of action but the bureacracy doesn’t go along.

The good news: A soft landing
Under the circumstances, the most likely course of action is a “more of the same” stimulus program. Already, we have seen a surprise rate cut, which does nothing for the returns of the household sector. We are likely to see more infrastructure stimulus. Already, we have seeing signs of a growth revival and signs of real estate revival.

The good news is that such a policy course will mean a soft landing in China. The bad news is that it will mean more unbalanced growth and it just kicks the can down the road. The next time the economy turns down, it will be that much harder to revive.

Bad news: End of the commodity supercycle
What’s more, such a growth path would mean the end of the commodity supercycle. The principal argument for being long-term bullish on commodities (which I have made before here) is rising household income in emerging market economies like China’s mean rising resource intensity. Greater household income mean that consumers want more stuff, e.g. cars, TVs, etc. This is shown by this analysis from the Council on Foreign Relations.

If financial repression continues and the household sector continues to get repressed, then where is consumer demand coming from? Moreover, there are indications (via FT Alphaville) that resource intensity may not rise despite greater infrastructure spending:

Nomura analysts Matthew Cross and Ivan Lee looked at China’s urbanisation rate and concluded that it can keep progressing at its current pace for years without needing an increased rate of steel consumption. In fact, they argue that China’s annual steel needs won’t increase at all in 2012 and 2013 — and that’s with new government stimulus.

Also see this chart (via FT Alphaville):

This is where I depart from commodity bulls like Jeremy Grantham. Even long-time commodity bull Jim Rogers has become more cautious on China.

More importantly, while the world focuses on the China hard vs. soft landing debate, I am thinking about the longer path for Chinese growth. They will slow down. When the next downturn hits, we could see a classic negative GDP growth recession.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Can China hold things together?


Author Cam Hui

Posted: 03 July 2012

Recently, there have been a number of alarmist stories coming out of China. I had pointed out a number of concerns (see Focus on China, not Europe and Ominous signs from China). In addition, Patrick Chovanec had highlighted the rising systemic risks that could lead to a “crash landing” rather than just a “hard landing” in China:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

In that post, Chovanec went on to detail how the shadow banking system is unraveling:

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

He went on to detail how one credit guarantee company named Zhongdan had tanked and cratered the loan books of a bunch of banks. This account brings to mind the Cockroach Theory. Where you see one cockroach, there is probably more around. Now Chovanec followed up in a new post detailing further problems with the shadow banking system with a quote from this Caixin article:

The Zhejiang government is scrambling to settle a credit crisis threatening banks and financial institutions that altogether issued about 6 billion yuan in loans to scores of companies.

Sources say 62 companies, from furniture makers to import-export traders, have been affected to varying extents by the collapse late last year of Hangzhou-based property developer Tianyu Construction Co. Ltd.

The companies were financially linked to Tianyu through a province-wide, reciprocal loan-guarantee network. Tianyu’s sudden failure raised the specter of a domino effect of defaults taking down every network participant and devastating their lenders.

“After Tianyu went bankrupt, banks in Hangzhou started calling in loans to other firms guaranteed by Tianyu,” said the owner of a company tied to the network. “That had a ripple effect and affected a number of other companies.”

Other “cockroaches” are appearing. Bloomberg ran this story about the shaky finances of local governments, which depend on land sales to finance their budgets:

The finances of China’s county-level governments are unstable and unsustainable as the majority of their fiscal income comes from sources other than taxation, the nation’s top auditor said.

About 60 percent of revenue raised last year by 54 counties investigated by the National Audit Office wasn’t derived from taxes, Liu Jiayi, the head of the agency, told a meeting of the legislature yesterday, according to a transcript of his speech on the audit office’s website. Total fiscal revenue at those counties rose 17 percent to 112 billion yuan ($17.6 billion) last year, Liu said.

The Chinese economy appears to be slowing. With stories like this one from the FT about Chinese officials forced to sell cars, cracks are appearing all over and a shadow banking systems that appears to be teetering, can China hold things together?

Listen to the market
The problem with China is that it’s very opaque and economic statistics are unreliable. Outside investors have no idea of the size of the problem and therefore cannot gauge the impact of any problem. What we have left are anecdotes the like ones above that can be highly alarmist.

Under those circumstances, I prefer to watch market based indicators to look for signs of stress. Take, for example, the share prices of HK-listed Chinese banks, which are all acting reasonably well. If the markets were panicking over the state of either the official banking system or the shadow banking system, the stress should start to show up first in these banks:

  1. Agricultural Bank of China (1288.HK)
  2. Bank of China (3988.HK)
  3. China Merchant Bank (3968.HK)
  4. ICBC (1398.HK)

What about the trajectory of the Chinese economy? I look at commodity prices for signs of stress and I don’t find them there either. Even if we were to ignore Friday’s eurozone induced rally in risky assets such as commodities, the CRB Index appears to be trying to put in a bottom here:

Similarly, the AUDCAD cross is showing signs of a turnaround. This exchange rate is important because while both the Australian and Canadian economies are commodity sensitive, the Aussies are more levered to China while the Canadians are more tied to the American economy.

In short, despite the worrying stories coming out of China, Mr. Market is telling me that I shouldn’t be worried. In fact, Deutsche Bank (via Business Insider) believes that Chinese data may be understated:

To the contrary, we believe there are several reasons why recent yoy IP (industrial production) growth rates have been (marginally) understated:

1) China’s IP data published by the National Bureau of Statistics (NBS) only covers companies with annual revenue of more than RMB20m. Given that most heavy manufacturing firms (which perform worse than the overall economy due to the ongoing investment-led deceleration) are medium and large in size, the NBS tends to exaggerate the growth deceleration.

2) Direct electronic reporting of production data (from companies, rather than from local governments) to the NBS was implemented gradually from end Q1 this year. If there was a reason to believe local governments tended to overstate IP and other economic activity data under the old system, then the implementation of the direct reporting requirement should lead to an understatement of yoy IP growth in April and May (as there is now less over-reporting compared with a year ago).

Such developments must be regarded as being encouraging for the bulls.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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