20

MARKETS & INVESTING

Tuesday March 18 2014

Fed drains punch bowl, but dont leave party yet

James Jim Paulsen Paulsen Insight
INSIGHT
Most believe since the Federal Reserve began tapering its quantitative easing programme, monetary policy has turned from friend to foe for the stock market. Indeed, a significant correction was widely expected once support from the Fed waned, leaving many baffled by the recent rally in the S&P 500 to all-time record highs near 1900. However, monetary policy is actually a joint effort implemented by both the Federal Reserve and the marketplace. Although the Fed may be starting to reduce accommodation, the market is ramping up stimulus. Consequently, whereas most seem to believe the monetary punch bowl is being taken away, investors should be mindful that other aspects of monetary policy remain supportive and may keep the party going. The Fed primarily controls reserve injections and the level of short-term interest rates, but these only represent two aspects of total monetary power. Bond vigilantes establish the level of long-term yields and, in combination with the Fed, determine the slope of the yield curve. Finally, the pace of money velocity (how fast the money supply turns over) is determined by collective private sector spending propensities. Some aspects of monetary policy have indeed recently become more restrictive: the Fed has slowed the pace of reserve injections and long-term yields have risen in the past year. Other facets, however, some of which were contractionary during much of this recovery, either remain supportive or have recently turned more stimulative. monetary restraint by raising the Fed funds rate. In this recovery, however, QE tapering has taken precedent, perhaps maintaining interest rate accommodation longer than in past cycles. Second, the Treasury yield curve (the difference in yield between the 10-year Treasury bond and the three-month Treasury bill) is more than 100 basis points steeper today than it was in early 2013. For decades, a steepening yield curve has been a leading indicator for both improved economic growth and a rising stock market. Until last year, with only a brief exception, the yield curve has mostly been flattening since 2009, thereby acting as a restraint on economic growth and a hurdle for the stock market. Third, for the first time since the recovery began, money supply velocity may be turning higher. Loan demands have recently accelerated. Total US consumer debt rose by the most in more than six years during the fourth quarter of 2013 and US bank loans have risen at more than a 7 per cent annual rate since year end. Quicker turns in the money supply are also often associated with heightened inflationary pressures. While inflation remains low, some indicators are flashing yellow. The CRB commodity price index has surged 12.5 per cent since early January to its highest level in nearly 18 months. Industrial commodity prices, those most sensitive to economic growth, have risen almost 7 per cent from November lows. Moreover, the core rate of annual producer price inflation (a leading indicator for core consumer inflation) has recently accelerated from a low of 1.2 per cent in August to 1.7 per cent. Finally, while overall money velocity is still declining, private sector velocity (ie, private sector GDP divided by the money supply) has risen in each of the past two quarters and is up year over year for the first time since the beginning of the recovery. the unconventional and panicky policies employed by the central bank have constantly screamed we are very scared and you should be too. By sticking with its tapering programme even as economic reports have been weakened by bad weather, the Fed is probably boosting private sector confidence by illustrating some itself. Overall, monetary policy may be more accommodative today than it was when the Fed was expanding its QE programme. The combination of a near zero shortterm interest rate world, a recent steepening in the yield curve, early signs suggesting money velocity has finally turned higher and recent confidenceboosting actions by the Fed are, at a minimum, keeping monetary policy quite stimulative. Investors are cautioned not to leave the party too early. The Fed may be starting to empty its punch bowl just as the market is mixing a new batch! James W. Paulsen is chief investment strategist at Wells Capital Management, a business of Wells Fargo Asset Management

Rates near zero

First, short-term interest rates are still near zero and remain uncommonly stimulative. Often the Fed initiates

Fed confidence
Fourth, by recently starting to taper its QE programme, the Fed is finally demonstrating confidence in the future of the economy. Throughout this recovery,

Blistering rally pushes up cost of full English

News analysis Unusual weather, the Ukraine crisis and disease are hitting a range of commodities, writes Emiko Terazono
A visit to a New York diner for an all-American breakfast, or to one of Londons greasy spoons for a full English, will soon leave you short of cash. Unusual weather patterns, the crisis in Ukraine and disease are among the reasons why prices for commodities ranging from coffee to pork and wheat have soared. And there is a little sign of let-up. This years blistering rally in food commodities follows a year of bumper crops and low prices. Though stocks are plentiful, a sharp rise in demand from emerging markets means that unless harvests and production break new highs, prices are vulnerable to the slightest negative news about output. These days, unless you have a rise in production, you will have a problem, says Abdolreza Abbassian, senior grains economist at the UN Food and Agriculture Organization in Rome. Financial investors, including hedge funds, have seized on such signals. Whereas industrial commodities such as oil and copper have underperformed, hit by worries about wilting Chinese demand, agricultural commodities have benefited from rising fund inflows. The mood is in sharp contrast to the end of the 2013, when bearishness prevailed. Huge volumes of grain from northern hemisphere harvests were hitting markets at full force, depressing prices. Funds had large short, or bearish positions, on sugar and coffee, pushing prices below the cost of production. The rush to cover those short positions at the start of this year exacerbated the buying of breakfast commodities. But the fundamental outlook has also changed dramatically, say analysts. That wave of investor demand has fuelled further gains. Indeed, net long, or bullish, positions have risen to their highest level in four and a half years, according to Kona Haque, commodities analyst at Macquarie. How long could this last? Loraine Hudson at commodities research firm Mintec says breakfast goods will continue to rise in the next three months. Some of the prices could be passed on to the consumer in the future, she says. The big gainer of the year so far has been coffee, with arabica, the higher-quality bean, rallying by more than 70 per cent due to drought concerns in Brazil. Prices rose to more than $2 a pound last week, and although rains have triggered some profit-taking, worries remain about the damage already wrought on this years crop as well as the quality of the harvest. Analysts expect higher coffee prices to filter through to consumers later this year. There should be some pull back in prices after the harvest in May, once more accurate crop estimates become available, says Ms Haque, although she expects prices to remain firm. The dry

Grubs up! Breakfast ingredients, price increase 2014 year to date

Rebased

Breakfast index

+8% +72% +18% +12% +21%

Cocoa

Coffee

Butter

Wheat

Milk

+12% +6%
Sugar

Orange juice

120

110

100

+42%

Pork belly (bacon)

90

Jan

2013

Price % change, 2014 year to date Coffee Lean Hog Milk Butter Gold Orange juice Wheat Platinum Cocoa Sugar -0.1 -3.7 -4.3 -13.8 -17.8
FT montage Photos: Dreamstime

Commodity prices

Lean hog, sugar, coffee, orange juice, cocoa, wheat, butter, milk Equal price weighting

Mar 14

72 42 21 18 14.2 12 12 8.6 8 6 WTI Brent Aluminium Copper Iron ore

FT graphic

Sources: Thomson Reuters Datastream; FT research

weather in Brazil has also boosted sugar, which has risen 6 per cent this year to 17.32 cents a pound. A twoyear bear market in the commodity has led to declining output, with EU sugar beet production expected to fall 9 per cent. Fears about dryness in India and Thailand, leading sugar producers, are also supporting prices. A jump in wheat prices could soon push up the cost of a loaf of bread. Strong export demand and concerns that Russias incursion into Ukraines Crimea

These days, unless you have a rise in production, you will have a problem
Abdolreza Abbassian UN FAO economist

region could disrupt grain shipments from Black Sea ports have driven prices higher. Cocoa has risen 8 per cent on the back of fears of El Nio hitting west Africa later this year. The region tends to become dry under the weather phenomenon, leading to smaller crops. The chances that El Nio will develop are increasing weekly, says Jonathan Parkman, co-head of agriculture at commodities brokers Marex Spectron in London. Orange juice production in Brazil was affected by the weather, but US prices, which are up 12 per cent in the year to date, have also been hit by citrus greening disease, which is not going to go away, says Jack Scoville, at the Price Futures Group in Chicago. Prices could rise as high as $1.80 to $2 a pound, he adds.

The price of bacon is likely to increase, too, especially with the US pork market hit by a virus, which has taken a toll on pig numbers. Lean hog prices have risen more than 40 per cent this year. There is considerable uncertainty in this years hog forecasts, says the US Department of Agriculture. In Europe, high demand for domestically produced pork is supporting prices. Dairy prices have been rising due to global demand for milk powders. Global dairy prices have jumped on the back of demand from Russia and China. The US milk price has risen by more than 20 per cent and butter prices by 17 per cent since the start of the year. The risk for 2014 is the low stock levels, which leaves the market exposed to adverse weather, according to analysts at Rabobank.

Bargain hunters drive inf lows into Russian stocks

EQUITIES

By Ralph Atkins in London

Moscows confrontation with the west over Crimea has been seized as a buying opportunity by bargain hunting equity investors taking advantage of this months steep falls in Russian share prices. Russian equity investment funds and exchange traded funds which allow investors to buy and sell exposures daily have seen significant inflows since early March, when Vladimir Putin, Russian president, escalated tensions between Moscow and Kiev. The buying has partly reversed the substantial outflows seen earlier in 2014 as tensions mounted, and

suggests investors globally believe the financial impact of sanctions imposed by either side in the conflict will be limited. The idea which we dont necessarily share seems to be that Russian equities could become attractive if sanctions are perceived as more token and much less stringent than the sort of tough economic sanctions that were imposed on Iran, for example, said Nikolaos Panigirtzoglou, strategist at JPMorgan. On March 3, when Russias incursion into Crimea threatened to become a regional war, Russian shares dropped almost 11 per cent the biggest daily fall since the financial crisis of 2008. But they have since

recovered some of their losses. The Micex index rose almost 4 per cent yesterday although it was still more than 11 per cent lower than at the end of February. The rebound suggests investors believed Russian shares had reached a low point and presented an investment opportunity. Russian equity ETFs saw inflows of more than $340m between March 4 and last Friday, with most of the inflows in the days immediately after Mr Putin first ratcheted up tensions, according to calculations by JPMorgan. The inflows, which followed cumulative outflows of $425m between January 1 and March 3, represented a big swing in an ETF uni-

verse that has a total size of about $2.3bn, said Mr Panigirtzoglou. ETF flows provide a quick snapshot of investor thinking, although they may reflect tactical shifts rather than longer term investment intentions. But a similar pattern was seen on inflows into Russian equity mutual funds tracked by EPFR, the data provider. Inflows reached almost $60m in the seven-day period ending March 5 and $133m in the following week, throwing into reverse this years pattern of continual outflows before the turnround. The weekly inflows were the strongest seen since May last year. Despite the popularity of Russian equities, signs of investor nervousness

remain about the stand-off over Crimea. The cost of insuring Russian five-year government debt soared yesterday to the highest since October 2011, according to credit default swap data provided by Markit. Meanwhile, Russian bond funds have seen outflows in recent weeks, according to EPFR data, following steep rises in yields, which move inversely with prices. Commerzbank analysts argued in a research note that Russian bank debt had been particularly badly hit but said the scale of the sell off does not seem justified by the fundamental risks. We believe current valuations offer attractive levels to re-enter the sector, particularly for investors with a longer term view.