Hi guys, welcome back to pt.2 of the current macro picture.
In my last article I mentioned how everything is interconnected; but more importantly how markets catch fire in rapid succession. The domino effect.
Zone in as we talk:
The importance of commodity’s in global macro & the implications on central bank policy
The Dollar rally vs EM performance
“When the commodities go up and the cost of transportation is going up, and the value of the dollar is going down, it's all going to translate to an 8 to 10 percent rise in food prices.”
— John Catsimatidis, American Businessman
Commodities. A crucial part of any global macro framework and investment thesis. It is well known that commodities are heavily linked to any period of expansion or contraction; from my recent tweet, we know that access to credit drives both periods within an economy. Commodities are the building blocks of everything we consume, start off with China, the country that drives synchronised growth, as credit flows into China, the demand for commodities globally strengthens significantly. Even as consumption becomes more digital, we still require commodities to make that digital consumption both possible and available through smarter designed chips which require key elements such as copper.
Just for your notes, here are the commodities that you’ll want to keep an eye on during reflationary periods such as 2020:
Reflation is controlled inflation, an act of stimulating an economy by increasing money supply, usually a policy driven process. (increase money supply, lower interest rates and boost infrastructure spending)
Using 2nd order thinking, what else would benefit from high demand for commodities?
Shipping rates! During 2020 we saw shipping rates benefit from a period of relation but majorly shortages within the space. A story for another day. Hopefully you get the point now, commodities are the foundation of everything we have today and will have tomorrow.
So why do commodities have a fundamental impact on central bank policy?
Glad you asked.
We’ll start here. From figure 1, we can gauge how elevated commodities are in the current environment we’re in; coal prices are up 91.6% YTD!! The commodities shown in green all play a direct part into what we see in CPI prints, I’m sure you can connect the dots but let’s go ahead and do so anyway.
Starting with agricultural, demand for Wheat currently outweighs the available supply, so what are producers forced to do charge more. Following this chain of goods inflation by the time it reaches our local stores they’re forced to either take a hit on margins due to higher supplier costs or pass this inflation down to the consumer. Meaning CPI can only go higher. That’s only component of inflation, then take a look at energy which has been one of the biggest contributors to double digit inflation within the UK, Europe & multi decade high inflation in the U.S. We’re seeing a minimum of 15.0% price increase across the energy sources required to heat our homes, produce electricity and more.
Hopefully you’re starting to get the picture. YTD we have seen equities sell off deep into the red (-28.0% NDX), yet the Fed and central banks around the world haven’t stepped in to save our portfolio’s through a pause in rate hikes and QE. For the past decade markets have been accustomed to central bank support via quantitative easing; however this is the new territory for risk-assets where they’re having to weather the storm of global liquidity tightening, higher interest rates and higher inflation.
Commodity prices need to crumble in order to help central banks, particularly the Fed, ease up on their monetary policy approach. If commodities don’t retreat to prior average levels then risk-assets will remain under pressure as central banks are forced to keep financial conditions restrictive. A wild statement, but in this period, a recession isn’t enough, commodities need to retreat, as inflation prints shown deflationary like symptoms then we can expect slowdowns and a pivot in central bank policy.
Whilst writing this up I took it one step further to compare U.S CPI YoY(consumer price index) against the S&P GSCI index (a benchmark for the commodity market), also the CRB index (a benchmark index for the commodity market) and finally the S&P 500. From Figure 3 you can see the near perfect correlation with both commodity index’s and the CPI rate of change throughout this year; during periods where commodities experienced serious price inflation CPI unsurprisingly followed suit.
If we want to see the global macro picture return to normality, commodities must fall sharply. This leads directly into a trade idea I’ll be eyeing up over Q4, shorts on Crude Oil ETF.
We have a major level of support in the highlighted region between $62.00 per barrel and $72.00 per barrel, I’ll be eyeing up shorts as the opportunity presents itself, potential holding period not yet disclosed but as this matures I’ll keep you guys in the loop.
Let’s talk dollar.
The current macro environment we’re in has sent the DXY to 110.00, up 12.67% for the year.
A number of factors have led to this dollar rally:
Risk-off sentiment in risk assets have led to increased dollar demand (capitulation)
Widening interest rate differentials between the U.S and G-7 central banks
Ongoing war within Russia-Ukraine
Credit risks across the Uk & European markets
Now, a strong dollar can be good at times; however the flip side of a strong dollar has inflicting effects on the global macro environment.
Let’s take a mini tour:
One of the main markets affected by a strong dollar is the emerging market.
Emerging markets tend to issue debt securities denominated in U.S dollars in order to attract greater breadth of investors since there’s minimal currency risk or exposure when compared to the emerging market local currency.
The most critical issues at hand within emerging markets are risks of external debt or balance of payments, countries such as Mozambique, Mongolia, Bolivia and Tunisia are most vulnerable to the risks aforementioned.
Since writing this piece CPI for the States came in (yesterday) at 7.7% vs 8.0%. Equities and crypto experienced a boost in risk appetite as investors reacted to the lower than expected inflation print which saw inflation slowing; giving hope that we’ve experienced the peak of U.S inflation which would lead to a relaxation in Fed policy.
In our finale, the trilogy, we’ll look at the domino effect I’ve been mentioning time and time again & also the cracks appearing in crypto markets and now transitioning to wider markets in general.
Thank you for getting to the end!
I won’t lie, as I write this, it’s currently 01:26 in the morning — the beauty of studying macro’s ; )
So I’d appreciate you sharing this in your network, social media and close friends!
Tuesday we come back again, pt.3
Until next time