This nasty asset-price correction is poised to gather speed

Prepare for a major reset as factors such as higher inflation and slowing global growth force the unwind of overvalued assets such as equities and property

PUBLISHED : Tuesday, 06 February, 2018, 11:10am
UPDATED : Tuesday, 06 February, 2018, 10:42pm

Since my last column, there have been even more disturbing signs of overvalued markets. These include residential property, the US dollar, bonds, equities, and now even industrial commodities, though I see resources relatively less euphoric given the sound supply and demand fundamentals. Still, there is a possibility of resources being driven higher by expectations of a further round of currency devaluation, particularly in the US dollar. If so, then I am afraid even resource prices may turn into a bubble, which may trigger unpredictable consequences for overvalued paper assets.

The world is likely on course for higher inflation. Manufacturing and mining utilisation rates in many places have risen conspicuously, a result of a shortage of mining and manufacturing capital expenditure especially in debt-ridden developed countries, where excessive money printing leads to more speculation instead of much needed capacity investment. Much higher oil prices will soon exacerbate inflation.

The recent rise in US dollar index futures open interest was triggered by opposing views of certain wrong-footed money managers. Both non commercial longs and shorts increased by about 5,000 contracts, so the net longs remain fragile.

The value of the US dollar against hard resources and other currencies is determined by the US federal budget deficit, which I believe will grow sharply in light of already slowing receipts and rising outlays.

The worsening US trade deficit even as the US dollar softens says it all.

Unrestrained budget deficits, exacerbated by tax cuts, will translate into trade deficits, a worsening external position, and more devaluation. This amounts to a negative domino reinforcing itself.

The Hong Kong stock market looks very overbought, for all the fundamental reasons I gave in my last column. These include peak export growth, slow earnings growth, the low return on equities, overvaluation relative to bonds, and very high real Hibor which may even turn positive.

2018 is likely to be a serious year of reckoning for the global economy

Moreover, fund flows don’t bode well. Hong Kong banking net external claims in October were close to HK$2.4 trillion (US$306 billion), which historically is a significant threshold.

Meanwhile, US equities appear stretched. One worrying sign is the sharp drop in non commercial net longs, which may indicate a loss of confidence among money managers in the ability for the rally to last much longer.

Net external banking claims can be seen as a measure of liquidity flowing out of Hong Kong, mostly for trade and speculation.

History shows when it exceeds the HK$2.5 trillion threshold, a sharp deceleration of exports and probably an exodus of capital follow, manifested as a sharp shrinkage of net external bank claims, which means Hong Kong corporate earnings growth will decelerate, while equities and properties are probably deemed too expensive by the rest of the world.

It is noteworthy that the Hong Kong dollar recently traded at the lower limits of the linked exchange rate, while official reserve growth stalled abruptly. With the Hang Seng Index close to 33,000, any sign of slowing exports, declining leading indicators, sharply rising interest rates, and tumbling of bonds could trigger outflows.

In addition, watch Hibor closely. If it surpasses the inflation rate, currently at 1.7 per cent, and holds above that level, then the era of negative real Hibor will end, and so will artificially expensive equities and properties. The argument that asset prices will be supported by inflows of Chinese hot money might turn out to be wishful thinking as China cannot afford to turn up its money spigot again.

The recent gains in copper prices could be a signal the market is out of touch with reality. Investment in Chinese power plants and power grids have stalled amid a sharp slowdown in power demand growth, and signs that peak grid utilisation has dropped. Chinese production of copper intensive goods like refrigerators, coolers, air conditioners, automobiles, have literally stalled at paltry growth. These are very disturbing signs, especially if growth cannot pick up again.

Meanwhile, world upstream copper ore stockpiles have surged above their long term average. This comes as Chile and Peru are ramping up their spending on copper mines, seemingly attracted by higher prices. Copper needs a correction, and the market agrees. The Comex producer and merchant net shorts – or bets that prices will fall – have risen beyond the 30 per cent open interest threshold. These traders are considered the smart money, whereas money managers are now euphorically on the long side. Yet, open interest has remained close to new historic high, a very resilient sign.

As expected, oil is rising on solid fundamentals. In addition to a subtle decline in world oil reserve life, demand in the US has soared to 20 million barrels per day, depleting petroleum stocks to 1.9 billion barrels from a historic peak of more than 2 billion barrels. In terms of inventory life, supply has shortened to 90 days from 113 days.

Moreover, new well output among US shale oil producers has shown signs of erosion. Alarmingly, production at existing wells has been falling at a rapid rate.

A drop in the contracted shale rig count and a rise in the number of unfinished shale oil wells implies that the low hanging fruit has already been taken, and that new resources will be sourced from harder to access fields. Oil producers do not see high output growth any more, and so are not motivated to develop more new wells.

That means shale oil production may slow sharply by the end of the year.

However, world oil demand this year may gain by more than 1 million barrels per day, outpacing gains in refinery capacity. In summary, further gains in oil prices shouldn’t be ruled out.

For crude oil futures traded on Nymex, commercials, made up of producers and merchants, are long 800,000 contracts, a level that has historically warned of a peak oil price. They seem to be hesitant to increase their longs beyond threshold.

However, their counterparts, the commercial shorts, have literally gone through the roof, hitting some 1.4 million contracts. Producers and merchants are those who use oil, who really understand oil, so that means both crude oil users and producers are now extremely cautious of the oil price. A correction is probably due, but sound fundamentals will cushion any downside shock.

Meanwhile, US Treasury bonds are signalling a stark warning of an imminent economic slowdown. The spreads between the longest tenors and the shorter ones have shrunk sharply. For example, the 10-year to 2-year spread has collapsed to as low as 0.5 per cent. Historically, this signal has often preceded an acute recession, especially if these spreads turn negative. This time the spreads have reached ultra-low levels but remained positive, so probably a period of slow economic growth awaits.

It appears likely that slow economic growth will be met by higher inflation.

A painful scenario called stagflation – which slow economic growth is met by higher inflation – is forming.

It may not be the end of the world, given insufficient capital expenditures around the world, and rising utilisation across multiple industries.

On the positive side, demand in the developing world will eventually help to deplete excess inventories, eventually helping to underpin an economic rebound.

But until then, a nasty correction across several major asset classes can be expected, especially for those using aggressive leverage.

Henry Chan is head of research at Caitong International Securities