Commodity Correction Intensifies
The Digger's and Dealers conference kicked off this week in Kalgoorlie, Western Australia. Unlike last year though, not all miners are having a good time of it. And as we are painfully aware, not all investors in mining stocks are having a good time of it either.
We have mentioned the likelihood of a solid correction across commodities markets in recent weeks and we are now right in the midst of a nasty pullback. The deflationary force of the contracting credit market has now exerted a deflationary force on the real economy and commodities in general.
We are firmly of the view that this is a correction within a longer term bull market. How long will the correction last? Leaving aside the fact the individual commodities are in their own price cycle and will display different recovery paths (see FAT384) in general the answer is unknown.
Let's take a look at a chart of the CRB Commodity Index. The Index is currently correcting lower, following strong gains over the prior 18 months. Since the January 2007 major low of 285, the Index had rallied as much as 66 percent, reaching a high of 474 in July.
Following such extensive gains, the current correction is not surprising. In our opinion, this retreat is likely to terminate in the region of 395 to 363. As visible on the weekly chart, this range encompasses a 50 percent retracement of the prior 18-month rally and the major high of May 2006. While holding above 365/363, we believe that potential remains for a revival of the broader upward trend.
These are certainly testing times for resource investors. But bull markets are designed to throw investors off and carry as few along for the ride as possible. Our advice: try and hold on to the bull.
The quote that perhaps best sums up the situation as we see it was provided by former Oxiana boss Owen Hegarty, speaking at the Diggers and Dealers conference yesterday. The comment was reproduced in today's AFR:
"There's lots of prophets of doom, gloom and despondency out there at the moment. But make no mistake, we are in a period of long term expansion. Don't be...depressed about short term blips on the screen."
We agree, but the problem for investors is that the short term blips look like nose dives to financial oblivion while they are being experienced. The 'blip' is only recognised as one in hindsight. That's where conviction comes into play. And we retain our conviction in the long term commodities story.
The Interest Rate Debate:
One month of poor retail sales numbers and weak credit growth data has turned the interest rate debate upside down. The consensus is now for sharply lower rates. We don't think the RBA will be as quick to lower rates as some believe.
There is no doubt that our economy is slowing. A slowing economy usually brings about lower inflationary pressures. So yes, the interest rate cycle has probably peaked. But the adjustments we are now seeing (weaker consumption and credit growth) are exactly what Glenn Stevens was trying to achieve with his tightening policy.
Even if the Reserve Bank wanted to slash interest rates to fire up domestic consumption and credit growth, we think the discipline of the global markets might make such a move difficult.
Why? Well, Australia has a current account deficit of 6.5% of GDP (gross domestic product). We also have foreign debt of $616bn and net foreign liabilities of over 65% of GDP. In other words, our borrowing requirements are quite large. Keep in mind this is all private sector borrowing. From a public perspective, our credit is sound.
But the point is when you have a large debt (and you don't issue the world's reserve currency) your creditors tend to require more in the way of security in order to continue lending to you. That is, they require a higher interest rate.
Much of the $616bn in foreign debt is a result of our spending binge on housing over the past decade or so. To provide the (until recently) huge demand for housing related credit, banks have to borrow in offshore, or 'wholesale' markets.
Because housing is an unproductive asset, this huge rise in our borrowing and servicing requirements has done nothing to ease the build up of inflationary pressures in the economy. Inflation is a result of productivity (supply) not keeping up with economic growth (demand).
Demand growth has been driven to a large extent by consumption growth flowing from the wealth generated by rising property prices. So a rise in the value of an unproductive asset has fuelled demand growth. If we had invested that money into productivity enhancing infrastructure projects years ago (instead of housing) the current environment would look very different.
So now Australia finds itself with an inflation problem (last reading 4.5%) and a slowing, heavily indebted economy. This means the required interest rate cuts are likely to be tempered by concern over the Aussie dollar. Textbook economics says that a falling currency is inflationary (as import prices rise) so the RBA will be conscious of this point.
The bottom line is that interest rates look like declining in the months ahead. But the aim of tight monetary policy in the first place was to reduce the demand flowing from strong credit growth, so the RBA won't want to see a return to past growth.
They will want to see the weakness in consumption offset by growth in commodity exports. This will reduce the current account deficit and provide support for the dollar.
Just on the Aussie dollar, it has already fallen against the US dollar considerably since the change in interest rate sentiment. This is because interest rate markets still expect an increase in US rates and are now factoring in an interest rate reduction in Australia.
From a high of 98.49 US cents in mid-July, the AUD has corrected sharply lower, and recently traded below 93 US cents. While the AUD remains below 95 US cents, there is a growing risk of a deeper correction toward the 90 US cents mark.
Not that you'd know it from recent market action, but a falling Aussie dollar is good for the resource sector. This is because commodity markets are USD denominated. When selling goods in USD, the currency translation back into a weaker AUD provides a revenue uplift.
But this is not really the point. We have always viewed commodities as a separate asset class. Whether the AUD is strong or weak, we believe commodity prices are going higher.
But right now we have to tough out this correction. We've mentioned before that in dealing with the market, it's best to be counter-intuitive. Right now, it feels like the easiest thing to do would be to sell-up and walk away. But when it comes to the market, what feels right is rarely the right thing to do. Please consider this point carefully, it's an important one.
With the short term picture very blurred, let's take a look at what the charts are telling us. Below we show a chart of the ASX200. The weakness in the market today (Tuesday) has seen ASX200 break below the 16 July low of 4787.5 to hit 4758.5, before closing at 4825.
Although potential remains for further near-term consolidation between the current low and 5000, the risk of a deeper retreat is high. Tuesday's break below 4787.5 now targets 4680, as marked by the highs of September and November 2005.
On the topside, initial resistance lies in a band between 5000 and 5200 - and above here we would expect rallies to initially struggle in the 5300 to 5500 region. A sustained push above 5500 would improve the broader outlook, however that seems a few months away.
The painful conclusion is that this market is still looking to find a bottom. Today's heavy selling of the resource sector has more than offset the tepid recovery we're seeing in the interest rate sensitive stocks. There's no doubting that this is a deep, nasty bear market. We believe the strategy we have been espousing is the correct one and those who tough it out will be rewarded in due course.
IMPORTANT: This message, together with the Fat Prophets website and all its contents have been prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore talk with their financial planner or advisor before acting on any information present on this message or the Fat Prophets website. Performance is hypothetical and based on recommendations made in the Fat Prophets report. The table is updated monthly. Transaction costs have not been taken into account. Past performance is not a reliable guide to future performance, and investors should be aware that returns can be negative. For a full explanation of the performance calculation methodology, please visit the Fat Prophets website.
We have mentioned the likelihood of a solid correction across commodities markets in recent weeks and we are now right in the midst of a nasty pullback. The deflationary force of the contracting credit market has now exerted a deflationary force on the real economy and commodities in general.
We are firmly of the view that this is a correction within a longer term bull market. How long will the correction last? Leaving aside the fact the individual commodities are in their own price cycle and will display different recovery paths (see FAT384) in general the answer is unknown.
Let's take a look at a chart of the CRB Commodity Index. The Index is currently correcting lower, following strong gains over the prior 18 months. Since the January 2007 major low of 285, the Index had rallied as much as 66 percent, reaching a high of 474 in July.
Following such extensive gains, the current correction is not surprising. In our opinion, this retreat is likely to terminate in the region of 395 to 363. As visible on the weekly chart, this range encompasses a 50 percent retracement of the prior 18-month rally and the major high of May 2006. While holding above 365/363, we believe that potential remains for a revival of the broader upward trend.
These are certainly testing times for resource investors. But bull markets are designed to throw investors off and carry as few along for the ride as possible. Our advice: try and hold on to the bull.
The quote that perhaps best sums up the situation as we see it was provided by former Oxiana boss Owen Hegarty, speaking at the Diggers and Dealers conference yesterday. The comment was reproduced in today's AFR:
"There's lots of prophets of doom, gloom and despondency out there at the moment. But make no mistake, we are in a period of long term expansion. Don't be...depressed about short term blips on the screen."
We agree, but the problem for investors is that the short term blips look like nose dives to financial oblivion while they are being experienced. The 'blip' is only recognised as one in hindsight. That's where conviction comes into play. And we retain our conviction in the long term commodities story.
The Interest Rate Debate:
One month of poor retail sales numbers and weak credit growth data has turned the interest rate debate upside down. The consensus is now for sharply lower rates. We don't think the RBA will be as quick to lower rates as some believe.
There is no doubt that our economy is slowing. A slowing economy usually brings about lower inflationary pressures. So yes, the interest rate cycle has probably peaked. But the adjustments we are now seeing (weaker consumption and credit growth) are exactly what Glenn Stevens was trying to achieve with his tightening policy.
Even if the Reserve Bank wanted to slash interest rates to fire up domestic consumption and credit growth, we think the discipline of the global markets might make such a move difficult.
Why? Well, Australia has a current account deficit of 6.5% of GDP (gross domestic product). We also have foreign debt of $616bn and net foreign liabilities of over 65% of GDP. In other words, our borrowing requirements are quite large. Keep in mind this is all private sector borrowing. From a public perspective, our credit is sound.
But the point is when you have a large debt (and you don't issue the world's reserve currency) your creditors tend to require more in the way of security in order to continue lending to you. That is, they require a higher interest rate.
Much of the $616bn in foreign debt is a result of our spending binge on housing over the past decade or so. To provide the (until recently) huge demand for housing related credit, banks have to borrow in offshore, or 'wholesale' markets.
Because housing is an unproductive asset, this huge rise in our borrowing and servicing requirements has done nothing to ease the build up of inflationary pressures in the economy. Inflation is a result of productivity (supply) not keeping up with economic growth (demand).
Demand growth has been driven to a large extent by consumption growth flowing from the wealth generated by rising property prices. So a rise in the value of an unproductive asset has fuelled demand growth. If we had invested that money into productivity enhancing infrastructure projects years ago (instead of housing) the current environment would look very different.
So now Australia finds itself with an inflation problem (last reading 4.5%) and a slowing, heavily indebted economy. This means the required interest rate cuts are likely to be tempered by concern over the Aussie dollar. Textbook economics says that a falling currency is inflationary (as import prices rise) so the RBA will be conscious of this point.
The bottom line is that interest rates look like declining in the months ahead. But the aim of tight monetary policy in the first place was to reduce the demand flowing from strong credit growth, so the RBA won't want to see a return to past growth.
They will want to see the weakness in consumption offset by growth in commodity exports. This will reduce the current account deficit and provide support for the dollar.
Just on the Aussie dollar, it has already fallen against the US dollar considerably since the change in interest rate sentiment. This is because interest rate markets still expect an increase in US rates and are now factoring in an interest rate reduction in Australia.
From a high of 98.49 US cents in mid-July, the AUD has corrected sharply lower, and recently traded below 93 US cents. While the AUD remains below 95 US cents, there is a growing risk of a deeper correction toward the 90 US cents mark.
Not that you'd know it from recent market action, but a falling Aussie dollar is good for the resource sector. This is because commodity markets are USD denominated. When selling goods in USD, the currency translation back into a weaker AUD provides a revenue uplift.
But this is not really the point. We have always viewed commodities as a separate asset class. Whether the AUD is strong or weak, we believe commodity prices are going higher.
But right now we have to tough out this correction. We've mentioned before that in dealing with the market, it's best to be counter-intuitive. Right now, it feels like the easiest thing to do would be to sell-up and walk away. But when it comes to the market, what feels right is rarely the right thing to do. Please consider this point carefully, it's an important one.
With the short term picture very blurred, let's take a look at what the charts are telling us. Below we show a chart of the ASX200. The weakness in the market today (Tuesday) has seen ASX200 break below the 16 July low of 4787.5 to hit 4758.5, before closing at 4825.
Although potential remains for further near-term consolidation between the current low and 5000, the risk of a deeper retreat is high. Tuesday's break below 4787.5 now targets 4680, as marked by the highs of September and November 2005.
On the topside, initial resistance lies in a band between 5000 and 5200 - and above here we would expect rallies to initially struggle in the 5300 to 5500 region. A sustained push above 5500 would improve the broader outlook, however that seems a few months away.
The painful conclusion is that this market is still looking to find a bottom. Today's heavy selling of the resource sector has more than offset the tepid recovery we're seeing in the interest rate sensitive stocks. There's no doubting that this is a deep, nasty bear market. We believe the strategy we have been espousing is the correct one and those who tough it out will be rewarded in due course.
IMPORTANT: This message, together with the Fat Prophets website and all its contents have been prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Individuals should therefore talk with their financial planner or advisor before acting on any information present on this message or the Fat Prophets website. Performance is hypothetical and based on recommendations made in the Fat Prophets report. The table is updated monthly. Transaction costs have not been taken into account. Past performance is not a reliable guide to future performance, and investors should be aware that returns can be negative. For a full explanation of the performance calculation methodology, please visit the Fat Prophets website.