The message is clear, if not contrarian: the US dollar, far from strengthening on the back of the US Federal Reserve’s expected rate hike, will start to weaken in Q1 2016. At the same time, commodities could start to climb out of what James Butterfill (pictured), Executive Director – Head of Research & Executive Strategy at ETF Securities, refers to as a period of “peak bearishness”.
Research would suggest that over longer time periods, commodities have tended to show a negative correlation to the USD, thereby offering a natural hedge to structural USD weakness. If, as Butterfill expects, the USD starts to weaken in Q1, industrial commodities could benefit. And yes, to extend the contrarian argument, even gold could rally on the back of a rate hike.
“We isolated four key periods when rates had been low for an extended period of time and then started to hike up: 1st December 1976, 16th December 1986, 4th February 1994 and 30th June 2004. What we noticed is that whilst conventional thinking assumes that the USD rallies, it doesn’t. It depreciates.
“For each of the four periods, the USD fell. Our belief is that the US dollar rallies before the rate hike occurs. That’s exactly what we are experiencing right now and that’s why we are seeing strong outflows in gold. However, after each rate hike, the price of gold has tended to rise (apart from in 1994) and the price of all commodities, on average, have risen by 12 per cent over the proceeding 12 months,” explains Butterfill.
Gold prices rose 22 per cent, 25 per cent and 11 per cent respectively in 1976, 1986 and 2004.
To further illustrate the point, the average year-on-year price rebound in industrial commodities has been 17 per cent following a rate hike.
Currently, traditional asset classes offer very few attractive valuations. Based on data stretching from 1954 to November 2015, cash is on the floor, yielding 0.5 per cent and way off its peak yield of 15 per cent. Equally, US Treasuries and even High Yield and Emerging Market bonds are trading at very high valuations. Within equities, if one looks at cyclically adjusted price/earnings using 12-month trailing data, the only sector that represents good value is Emerging Market equities.
Butterfill argues that alongside EM equities, commodities are the only other area of the market that look favourable heading into 2016 from an asset valuation perspective, despite commodities having experienced a five-year period in the doldrums.
“Nine out of the 13 main commodities are trading below marginal costs of production. It’s only a matter of time before we see commodities snap back,” suggests Butterfill.
Demand for commodities is likely to rise in 2016 as global growth outlook improves. Crucially, one of the key structural support factors for higher commodity prices is capital expenditure. Commodity producers tend to make decisions to cut their capital expenditure 12 months after prices have fallen. Clearly, this has been the case in 2015 and as such further capex cuts are expected in 2016. The upshot to this, according to Butterfill, is that a tipping could arise as supply starts to tighten.
“Twelve months after hitting a trough in capex, you tend to see a supply deficit. We are just at the point now where we might fall into an overall supply deficit for commodities. It’s only a matter of time before we start to prices recover, at least in those nine commodities referred to above,” says Butterfill.
If this contrarian stance proves correct, then two key drivers – tightening supply dynamics, and a weakening US dollar – could start to invigorate the commodities complex and move investor sentiment out of ‘peak bearishness’.
Another key support factor, for this to play out, will be global commodities demand.
China currently consumes around 40 per cent of global commodities so a lot of growth expectations are linked to the China demand story. Chinese industrial metals demand is still growing at 9 per cent year-on-year according to data from the World Bureau of Metal Statistics, and as Butterfill states: “We believe that the Chinese Government will throw everything in terms of its monetary policy in order to keep its economic growth target at around 6 to 6.5 per cent.
“At current levels, we should see 7 to 9 per cent consumption growth in commodities for the coming four years.”
The big risk to commodities price recovery in 2016 is that US monetary policy fails to get behind the eight ball with respect to inflation. At the time of writing (16 December 2015) the US Federal Reserve announced that it would raise interest rates by 25 basis points.
In the 1970s, the Fed’s policy was more reactive than proactive. In both 1976, and 1986, they engaged in an initial rate hike but then waited six months; at which point inflation became a real problem.
“There is a risk that they could make a policy mistake; that they don’t hike rates aggressively enough and it ends up creating too much inflation too soon. History has shown that when you hike rates every three months you are much better able to control inflation. This was seen in 2004 and 1994 compared to 1976 and 1986. If they don’t consistently hike rates it will be very positive for gold,” says Butterfill.
If inflation expectations are clearly set, the Fed should hopefully raise rates in a gradual manner and thereby avoid acting aggressively when inflation becomes untethered. Butterfill says that by Q1 2016, US headline CPI could rebound to 1.5 per cent. Over the medium term, the combination of rising inflationary pressure and a flattening US yield curve could see the US dollar decline as growth in real yield differentials turns negative.
“Gold is likely to perform better on the back of a policy error. However, if there is not a policy error, and real interest rates stay flat, gold will probably remain range-bound in 2016,” concludes Butterfill.
Click here to download the complete 2016 Outlook by the ETF Securities Research team.
