The US dollar rally has barely paused for breath since getting underway in February. Late last week, it took its toll on commodities. Oil fell nearly 3%. Iron ore fell 3.7%, while aluminium declined 0.7%.
I mentioned a few weeks ago how strength in the greenback was making life difficult for emerging markets. At the time though, it had left commodities largely unscathed.
But on Friday it did some damage, mainly via a hit to energy markets. Putting things into perspective though, oil and the commodity sector have had a strong run over the past year or so. Last week’s sell off was the first in a while.
To see what I mean, take a look at the chart of the ishares GSCI Commodity-Indexed Trust Fund ETF [AMEX:GSG]. It’s been trending higher for most of the past 12 months. And from the February low, it rallied 17%. So a pullback shouldn’t come as a surprise.
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But given the strength of the greenback (an anti-commodity asset), it’s likely that, at the very least, commodities will now go through a consolidation period.
The question is, just how deep and lengthy will the consolidation be? Or is this a top for commodities? With another US interest rate rise nearly upon us, is the global economic expansion at or past its peak?
We can only know the answers to these questions with hindsight, of course. But you should at least consider them. Global equities may have been in a bull market since the start of 2016 (and a secular bull since March 2009), but the world is still awash with debt.
Debt works wonders when the global economy is in an expansion cycle. That’s because after you account for interest payments, the remaining growth accrues to equity. Because the global economy is highly leveraged, equity gets a big boost when times are good.
On the other side of the coin though, equity will take a hit when growth slows, especially if it slows to the point where interest payments absorb most of that growth, leaving little left over for equity.
That’s why the question of where we are in the economic cycle is so important. You have to keep your eye out for clues.
A rising US interest rate cycle is one clue. Rising interest rates have preceded nearly all post war economic slowdowns/recessions in the US. The US Federal Reserve simply pushes interest rates too high, which causes a slowdown and/or recession.
In fact, the problem is the Fed nearly always pushes interest rates too low. This sows the seeds of future inflation, which in turn results in the Fed raising interest rates too high to combat the inflation they caused.
You generally see the effects of this tightening phase on the periphery first. That is, in emerging markets. This is when ‘hot’ money moves out of emerging markets and back into US dollars as the cost of credit starts to increase.
This is why you’re seeing the US dollar rally.
In Europe too, there are issues on the periphery. Italy and Spain are again in the headlines. As the Financial Times reports:
‘Mounting fears about political instability in Italy and Spain sent tremors through the eurozone’s two largest peripheral debt markets on Friday with investors dumping the sovereign bonds of both countries and sending European bank shares sharply lower.
‘A two-week sell-off of Italian debt accelerated after the two populist parties poised to govern in Rome failed yet again to get presidential approval for a slate of ministers, with leaders divided over whether to appoint an arch-Eurosceptic as finance minister.’
Italian government 10-year bond yields surged 23 basis points this week and are at their highest. Italy has the largest public debt pile in Europe, with the debt-to-GDP ratio sitting at more than 134.1%. A renewed global slowdown would not be good for Italy….and that would not be good for the Eurozone.
Again, while this isn’t a big deal right now, it’s worth keeping an eye on. Perhaps the bond market is beginning to see a cyclical slowdown and its impact on the Italian economy?
As far as Australia is concerned, apparently it’s all good. From The Australian:
‘A sharp downturn in the Chinese economy would have only a modest effect on Australia, provided it did not turn into a broader financial crisis, an International Monetary Fund modelling exercise has found.
‘Australia’s other trading partners in Asia and the US would pick up much of the slack left by a collapse of exports to China, helped by a depreciation of the Australian dollar.
‘The IMF’s new study of the links between the Chinese and Australian economies comes amid a fresh bout of concern about China’s ability to manage its high level of corporate and local government debt as the economy slows.’
Here’s my wild guess. A sharp slowdown in the Chinese economy would have a big impact on the Aussie economy, and an even bigger impact on the Aussie stock market.
Who knows what model the boneheads at the IMF are using? It’s certainly not based on the slowdowns experienced in 2012 and 2015, as China tried to contain its credit boom.
I’ll look at China and its impact on Australia in more detail tomorrow.
Editor, Crisis & Opportunity