Aussie and US markets v oil and resources

Before we get onto the main theme of this report, one of the more interesting aspects of this week’s trading activity in the US was the announcement by S&P that it had downgraded the outlook for US debt from “stable” to “negative”, with a warning of a potential formal downgrade to below “AAA” within the next 2 years unless there were major changes in policy. While this may not be a big deal for many economies, it should have been a major psychological blow for the world’s premier monetary economy. The result was a 1.1% drop in the S&P, but the issue had been ignored by the following day, and the market ended well up by 1.3% for the week thanks to Apple and Intel’s 1^st quarter results, which seem to have been considered far more important to the market.

While this is consistent with the fact that the market effectively ignored the poor rating for the US in the Stanford survey that we discussed last week, the serious question is, can markets continue to effectively ignore this kind of issue indefinitely (as it tried to do with the problems in the US residential market for over a year prior to the GFC), or may it ultimately “come home to roost”?

It is also interesting that it came at a time when Portugal succumbed to the need to accept an €80bn financial rescue package from the EU and IMF, when the risk of Ireland defaulting on its debt has risen to the point where it is being priced at the sovereign-equivalent of “junk”, and where Spain is on the verge of a similar capitulation (growth last year was 0.6%, half that of Portugal; unemployment, at 20.5% is twice that of Portugal; and its budget deficit as a % of GDP is greater than Portugal).

Like many issues since the GFC, the US market seems to react for a day or two, and then power on, as it has with Egypt, Libya, etc, but these aren’t going away that easily. This is a worrying trend, and is making us extremely nervous about the US market.

The main issue that we wanted to look at in this report is the link between commodity prices and the stock market, and it was prompted by comments made during the past week by the Saudi oil minister. With oil prices surging, and the potential consequences that that could have on costs and profits in the US and globally, when asked, he replied: “"The market is overbalanced ... Our production in February was 9.125 million barrels per day (bpd), in March it was 8.292 million bpd. In April we don't know yet, probably a little higher than March. The reason I gave you these numbers is to show you that the market is oversupplied," Ali-al Naimi told reporters. Similar comments were made by his counterparts from Kuwait and the UAE. Generally, you would expect that if anyone knows what is going on with the supply-demand balance in the world oil market, it would be these guys, particularly given that OPEC has been keen to keep prices well below the current level! But then, compare those comments with the chart to the right: it hardly reflects a global oversupply scenario, with prices surging to well over US$100 bbl.

This raises a serious question about the influences on traded commodity prices that we have raised in the past. Futures prices don’t appear to be reflecting global supply and demand forces, if the OPEC members are to be believed, but instead, are reflecting financial asset speculation. In order to illustrate the point, it is interesting to look at the performance of the S&P500 versus the WTI oil price.

The correlation seems extraordinary given the fact that only a relatively small percentage of the S&P500 is represented by energy stocks. In fact, higher oil prices are net-negative (by a long way) for the S&P500 due to the cost issues for manufacturing and service industries which dominate the stocks listed.

So why, then, are the two moving so closely together?

The only explanation that seems to make sense is that the excess supply of cheap funds that the Fed is pumping into the US economy is doing very little but create demand for financial assets, regardless of what they are, and that we are seeing the start of a real bubble, where commodities, stocks and bonds are rising in price for the simple reason that there is ridiculously cheap money available to buy them with. This was our theme in the previous Investment Report, but the data shown above seems to suggest that the “cheap Fed money” issue is not just a theoretical problem now, but is getting to the point where it is starting to set things up for a real bubble-bursting crash. When that is going to happen, we will have to wait and see, but when markets are dismissing major issues like downgrades in bond ratings for the US, political stalemates in addressing US budget spending, financial bailouts of major European countries, etc as being no more important than a 1 or 2 day blip in the upward move in prices, things are getting concerning.

It is also interesting if we bring the resources issue back to the Australian market, but in many ways, the opposite applies. We are a market that is dominated by resources and resources-related stocks, and yet the interesting aspect is that the resources sector has not performed particularly well, relative to the rest of the market.

Below is a chart of the performance of the ASX200 Resources sub-sector versus the main Index since the outbreak of the GFC. We have also included the A$ equivalent of the CRB Index mentioned above.

There are a number of points of interest here:

1.     the resources sector hasn’t outperformed the general market by nearly as much as may have been expected, given the “resources boom” that we have been in;

2.     there was no outperformance until mid last year at all, which would appear a surprise, except for the fact that the rising A$ saw prices rising less than in US$ terms;

3.     the “resources boom” hasn’t resulted in an overall rally for the market, with the ASX200  now lower than it was in November 2009, and effectively back to where it was at the end of September, 2009. Given that our market is more than 40% resources and energy, this is somewhat of a surprise, with the clear indication that the other 60% of the market has performed poorly. But what is also surprising is that the big resources plays (BHP, RIO, WPL and STO in particular) have struggled to perform in-line with the overall market over the past year, which should be a surprise. So what we are having is a resources boom that seems to be excluding the main stocks that should be benefitting from such a boom. Instead, it is the “punting stocks” with little in the way of earnings. It seems strange.

As a final comment, it was interesting to note the head trader at NAB made the following comment during the week as the A$ continued its surge: "We continue to believe that the market is under-pricing the likely degree of RBA official interest rate increases this year, which could provide a trigger for further AUD gains as traders ratchet up their rate-hike expectations." We made a similar point a few weeks ago, largely due to the importation of inflation from China. We are also likely to have the added impact of the floods in Queensland, Victoria and northern NSW that will effect inflation and GDP data for the first quarter. Higher interest rates remain our biggest concern for the market later in the year.