My Trend Asset Allocation Model has performed well by beating a 60/40 benchmark on an out-of-sample basis in the last few years. The early version of the Trend Model relied exclusively on commodity prices for signals of global reflation and deflation. While the inputs have changed to include global equity prices, this nevertheless raises some concerns for equity investors.
For the second week in a row oil has declined, joining shipping costs and all commodities, not just industrial metals, in retreating from highs. Gas prices should follow suit within the next few weeks. Note that the BDI has fallen by more than -50% from a peak just one month ago. This suggests that the supply chain bottleneck has passed its peak. If so, one would expect the huge increases in house and car prices to begin to abate soon.
Indeed, easing commodity prices are likely to put a lid on the inflation hysteria that emerged after the hot October CPI print. Producer prices (red line) have led CPI upwards in recent months and any commodity price weakness will cool off CPI in the near future.
China weakness contained
As China is such a voracious consumer of commodities, I believe commodity weakness is mainly reflective of a slowdown in China whose effects have so far been contained in Asia The relative performance of the stock markets of China and her major Asian trading partners tells the story. All are in relative downtrends compared to the MSCI All-Country World Index (ACWI). Several have broken relative support. Japan rallied on the news of a change in the prime minister, but gave up all of its gains soon afterward.
Within the global materials sector, Chinese material stocks have plunged relative to their global counterparts in recent weeks, indicating greater weakness within the Middle Kingdom in that sector.
On the other hand, the Chinese consumer doesn’t seem to be hurting very much. Alibaba reported a record 540.3 billion yuan in Singles Day sales this year. Moreover, European luxury goods maker LVMH, which derives a substantial amount of its sales in China, is performing in line with other consumer discretionary stocks.
Markets in Europe and the US have mostly shrugged off any weakness coming from China. In the US, the relative performance of key cyclical sectors and industries appears constructive. Some are staging relative breakouts (semiconductors and transportation), others are range-bound (homebuilders, energy, mining), and one is bottoming (industrials).
In Europe, cyclical sectors like industrials and financials are not showing signs of relative weakness. However, basic materials are in a relative downtrend, which is unsurprising in light of a loss of commodity price momentum.
A decoupled China
In conclusion, weak commodity prices are signaling a slowdown in the Chinese economy. Although China Evergrande’s debt woes has not resulted in a Lehman 2.0 event in China, its debt problems have spread to other property developers. Yields on China’s USD junk bonds are soaring and the slowdown is manifesting itself in falling commodity demand.
However, we are seeing few contagion effects and there are some silvering linings to commodity price weakness. First, it should lead to better inflation prints in the coming months and alleviate some of the inflation hysteria gripping the markets. As well, falling commodity prices translate to lower input prices for manufacturers, which should improve operating markets and boost profitability.
Commodity and China weakness only represents a minor pothole in global growth. Topdown Charts recently pointed out that 90% of countries saw their October PMIs in expansion even as China weakened. This is what China decoupling and weakness containment looks like.
October PMI data was particularly encouraging last week. The data show that the proportion of countries with a PMI above 50 reached 90%. Most countries are seeing significant economic growth as the world fights off the final wave of COVID-19 (knock on wood).