Commodities And U.S. Equities: A Sustainable Divergence?

Commodities and U.S. stocks have diverged in level terms only twice over the past 10 years and in both cases the divergence lasted nine months. Is the current divergence more sustainable?

Commodities And U.S. Equities: A Sustainable Divergence?

B road commodity prices have fallen over 25% since their April 2011 peak, representing the largest non-recessionary sell-off since the bull market in commodities began a decade ago. Alongside commodities, stocks also peaked in April of last year, likely due to tensions in Europe. But while stocks recovered at the end of last year in anticipation of a policy response from the European authorities, commodity prices continued to decline as the pace of Chinese economic activity eased amid restrictive policy.

True, China recently started easing, but the scope of their stimulus is still not big enough to convince financial markets that a more pronounced slump in economic activity can be avoided. Concerns about Chinese growth and the escalation of the European crisis has pushed commodity prices into deeply oversold territory. The extent of the decline in commodities that has already occurred suggests that this asset class will not be able to diverge from stock prices beyond the near-term. A catastrophe in Europe or a riot point sometime by year end due to the U.S. fiscal cliff could force equities to follow the path of commodities.

An alternate scenario is that commodity prices begin to recover in the second half of the year as China’s soft landing comes into focus.

In either case, we deem it too early to play a reversal in commodity prices as the near-term backdrop in China, the U.S. and Europe is too uncertain.

FOMC: The Last Twist, But More Quantitative Easing Ahead

The Fed has extended Operation Twist through year end. But this will be the last Twist. Thereafter, if the economy deteriorates further, the Fed will need to employ additional non-standard tools to stay relevant for financial markets.

Operation Twist - FOMC, The Last Twist

I n the press conference yesterday, Fed Chairman Bernanke said that the Operation Twist announced would be the last of its kind and implied that the next step would be further quantitative easing – if warranted.

Indeed, the official release highlighted that the Fed is more cautious on the growth outlook, that inflation has eased and that it is “prepared to take further action as appropriate”. This new phrasing suggests policymakers are leaning heavily toward more action if the labor market does not soon improve.

The Fed does not (yet) target a specific unemployment rate, but does target a core inflation rate. Policymakers revised up their forecast for the Q4 2012 unemployment rate to 8-8.2% (previously 7.8-8%) and revised down their official Q4 2012 inflation projections to 1.7-2% (the target is 2%).

We have highlighted in the past that announcements of QE2 and Operation Twist both coincided with a drop in TIPS breakeven inflation rates at the long end of the curve to roughly 2.0%. These levels have not yet been breached, and probably was a significant reason why the Fed stopped short of QE3 at yesterday’s meeting.

Also important is that Chairman Bernanke was supportive of the Bank of England’s proposed “funding for lending” scheme and hinted that it is a possible course of action for the Fed, should economic conditions deteriorate.

Bottom line: The Fed is sending a clear message that policymakers are willing to act with credible force, which should be a near-term positive for risk assets.

Overweight US Corporate Bonds

The path of least resistance for corporate bond spreads is to tighten in the absence of a recession or a sustained and intense flight-to-quality episode.

Overweight US Corporate Bonds

I nvestors’ penchant for corporate bonds reflects excellent corporate balance sheet health and a wall of funds looking for yield. Our Corporate Health Monitor remains deep in “improving health territory”, despite showing some deterioration over the past couple of quarters.

What is somewhat more disconcerting is that both rating migrations and Moody’s 12-month trailing speculative grade default rate have increased in recent months. However, Moody’s expects that further upside in the default rate will be limited, rising to about 4%, before falling back below 3% by next May. This benign pattern is consistent with our own macro-based forecast of the default rate.

It is difficult to envisage a meaningful rise in the default rate anytime soon given low borrowing, an ample cash cushion, easing bank lending standards, and the terming out of debt.

As for ratings, downgrades have outpaced upgrades so far this year, but this appears to be a temporary blip, related to a flurry of downgrades in the banking sector. The difference between speculative-grade and investment-grade ratings changes has an excellent track record of leading the trend in overall ratings migration. This indicator has recently swung into improving territory, which historically has been correlated with periods of narrowing corporate spreads.

Bottom line: Corporate credit spreads, especially in the high-yield market, are attractive on a default-adjusted basis. Continue to overweight U.S. corporate bonds.

Gold Trying To Bottom

Fundamentals are still bullish for gold, but the main constraint remains the lack of policy response.

BCA Research | Gold Trying To Bottom

G old, silver and gold shares are below their falling moving averages, a rare development since 2009. However, signs of improvement have recently been accumulating.

Market positioning indicators have changed dramatically from when gold peaked at $1,900/oz in September last year. Currently, gold bullish sentiment and net speculative futures positions are at 4-year lows. Also, other measures confirm that market participants have shifted to a more sober perspective towards gold: ETF holdings are rolling over and gold coin sales continue declining.

Of course, none of these signs would help precious metals if the fundamentals were turning bearish. However, this is not the case since real interest rates are low or negative on most risk-free assets around the world, yield curves are upward sloped and quantitative easing is on many central banks’ agendas.

True, the dollar is rising, but it is hardly surging.

Our Commodity & Energy Strategy service believes that the main constraint on precious metals is the lack of liquidity as policymakers drag their heels, particularly in Europe. Any signs that policymakers are “catching up” should lead to higher gold prices.

Canadian Imbalances: How Big A Worry?

Canadian household debt represents a concern for policymakers, but our Global Fixed Income Strategy service argues that domestic imbalances may not call the Bank of Canada (BoC) to action yet.

Bank of Canada | Canadian Household Debt

T he BoC continues to worry about domestic imbalances, including household indebtedness and the possibility of a sharp housing slowdown. Indeed, Canadians now carry more debt relative to disposable income than Americans. However, despite the heavy debt load, the debt service ratio remains much lower in Canada than in the U.S.  Importantly, Canadians have substantial non-housing related wealth and a far larger share of Canadian homeowners do not carry a mortgage. This means that if home prices in Canada do contract, far fewer homeowners will find themselves in negative equity positions.

Bottom line: Household indebtedness and the housing market are not likely to call the BoC to action soon. A more dovish tone from the BoC at the last meeting means that the market has shifted from pricing in 50 bps of rate hikes within 12 months one month ago, to currently expecting no change in rates. The latter seems appropriate since it is unlikely the BoC will significantly front-run the Fed.

Remain neutral Canadian bonds in a hedged portfolio.