Chief Investment Strategist
Last week saw the 15 asset classes in our universe declining 0.7% on average which is in itself an unusual week driven by the higher-for-longer narrative on policy rates. Broader commodities were down 1.9% after being the best-performing asset class this quarter. The setback for commodities correlated with weak emerging market equities down 3.1% as the official Chinese PMI figure for the manufacturing sector suggested a contraction. As one of our main macro theses remain that of higher inflation for longer due to factors such as geopolitics, fragmentation of supply chains, demographics, and lack of investments in physical world, we continue to believe commodities should play a role in a diversified and balanced asset allocation portfolio.
Economic growth has moved into a period of acceleration with Fed Dallas Weekly Economic Indicators (measuring real time GDP growth) hitting 2.2%, Redbook Weekly Same Sales up 6.3% YoY, and Eurocoin Growth Indicator (real time GDP growth) hitting 0.18% QoQ in May. Overall, the economy is looking fine in the US and Europe although the “two-lane economy” is a real thing with some parts doing extremely well (AI and obesity drugs) and other parts being hit by high interest rates such as real estate and consumer discretionary items like cars. The “two-lane economy” is the challenge facing central banks in the developed world. Can they alleviate the financial pressure on the parts of the economy sensitive to interest rates without causing problems with inflation longer term? ECB has decided for now that the risk-reward is in favour of a policy rate cut on Thursday, but the market’s reaction in long-term bond yields will be crucial for understanding how the market is thinking about a rate cut in Europe as the economy is bouncing back.
What is remarkable about industrial metals and energy which are the two most important segments of the global commodity market is that level of capital expenditures (CAPEX) deployed in those two sectors is very low. Adjusted for inflation the CAPEX into mining and energy is still below the levels prior to the pandemic suggesting no appetite for investments despite broad energy prices being up 34% and industrial metals up 62% from levels prior to the pandemic. The signal we are getting from commodity markets is that we need higher prices for commodity companies to invest in more supply suggesting that the long-run “super-cycle” in commodities might still find itself in its early years.
Almost regularly headlines are popping up in another non-classical part of the commodity market which is the electricity market and how AI is causing a lot of pressure on electricity markets due to the surging demand from datacentres. We recently wrote about electrification and how investors could position themselves towards this trend. To understand the challenge facing US electricity markets today’s WSJ article on the subject is a good read. Here Goldman Sachs is quoted for predicting a 160% increase in datacentres power demand by 2030. In Europe other challenges exist with the largest amount of negative electricity prices recorded in a single year up until the end of May. This Electricity Insights note explains the dynamics behind the rise of negative power prices in Europe and hints that energy storage is the only solution to alleviate the problems.
More and more policymakers are joining our thesis on Chinese exports that it might supress goods inflation in the short-run, but longer term it will be higher because of this “pushing on a string” trade policy. Two things are happening as China is pursuing its export strategy through heavy subsidies:
The harder China pushes on exports to backstop its economy, the more global manufacturing will be reshored pushing up inflation on goods longer term.
It seems likely that Modi’s has been re-elected in India and so far the market reaction has been overwhelmingly positive adding to the strong momentum Indian equities have enjoyed for so long. Our main thesis on emerging market equities is that it is not a homogenous asset class and the countries where there are “compounding effects” from a growing middle class combined with positive demographics are the most interesting. Emerging market countries that fit these characteristics are Mexico, Brazil, India, Vietnam, and Indonesia. For more insights into India and the things to consider before getting exposure to India read our note India: Investing for the Next Decade by Charu Chanana.
In Mexico, the general election has given the left-wing ruling party a resounding victory set to win both houses of congress and close to have a two-thirds majority with its two allied parties which is what it needs to pursue constitutional changes. The initial reaction from markets has been less positive than what was seen in India.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
