If you’ve ever been the designated driver for a group outing, then you know how the night typically unfolds. It starts out amusing enough watching how idiotic your friends become after they’ve thrown back a few cocktails. Your sobriety amidst the drunkenness makes you aware of things you’ve never noticed before. For instance, your friend Sally thinks she dances like Beyoncé, but really she dances like Elaine from Seinfeld. Your friend Bob thinks he sounds exactly like Jon Bon Jovi when he sings “You Give Love a Bad Name,” but really he sounds like maimed wildlife. As the night pours on, you reach a rare level of bewilderment at the spectacle of grown people acting this way.
I frequently find myself feeling like a designated driver as I watch investors toss back the latest narrative-driven Jäger bomb and then proceed to make poor investing decisions. When it comes to markets, I’m always the “DD” (data dependent). My dependency on data leaves me bewildered by the decisions narrative-driven investors make, and how quick they are to take another shot even though they know it’s going to lead to a hangover.
Investors were pounding 3T Jäger bombs last week, having been completely absorbed by tariffs, trade wars and Trump. While they were dancing badly and bouncing tone-deaf tunes off the walls, those of us who are data dependent spotted the most critical development in months occurring in the Land of the Red Dragon.
Raise the Rates
Many rainforests were destroyed printing stories of the 3Ts, but little ink was spilled discussing the PBOC rate hike on Thursday. Beyond the fact that this policy action means that one more (major) central bank has joined the tightening party, it’s the timing of this policy decision that is the critical development.
I’ve been discussing the slowing Chinese economy and liquidity-draining PBOC actions since last July. My most recent piece on China is here, if you need to get up to speed. In summary, Chinese economic growth is slowing while both core and consumer inflation are ramping to multi-year highs. This specific economic equation has historically equaled a crash in Chinese equities. However, now that the PBOC has proactively raised rates into slowing economic data, a crash in Chinese equities is all but guaranteed. I’ve made my bearish stance on Chinese equities very clear, but the bearish impact of this action goes well beyond equities: commodities are on the chopping block, too.
Here’s an NZT-48 moment for you: when central banks raise rates while economic growth is slowing, it typically causes a recession. The U.S. data backs up this smart pill, because the Fed most recently did the same thing back in December 2015.
Cause and Effect
In December 2015, the Fed raised rates for the first time in a decade, in the midst of a U.S. economy that had been slowing for three consecutive quarters.
The subsequent six months is when things got real interesting. Few people realize that during those six months, the U.S. experienced an industrial recession. This is the story that wasn’t told because the S&P 500 gained 5.5% in the first six months of 2016, and the recession didn’t spread beyond the industrial and manufacturing areas of the economy.
For starters, U.S. industrial production was in outright contraction every month during 2016. Manufacturing production slowed until August, spending 8 of the 12 calendar months in outright contraction. The Composite PMI, which combines both manufacturing and service sector activity, went into outright contraction in February 2016, and meandered sideways until October. Manufacturing activity slowed every month until it finally bottomed in May, just above outright contraction.
The economic impact of the policy error the Fed made by combining raising rates with slowing economic growth tremored through industrial and manufacturing-linked asset classes and equities.
Specifically, base metals got hammered during this stretch. Here’s just a sample of the maximum drawdowns experienced during the first six months of 2016:
1. Copper experienced a maximum drawdown of −13.1%
2. Nickel experienced a maximum drawdown of −17.3%
3. Aluminum experienced a maximum drawdown of −12.9%
4. S&P Metals and Mining stocks experienced a maximum drawdown of −20.3% (CRASH)
This time around, it was the PBOC’s turn to make a huge policy mistake with crash-worthy implications.
Base Metals are as Ugly as Homemade Sin
Since 2010, China has been through three regimes lasting at least five months when growth slowed while inflation accelerated: December 2010–September 2011, December 2012–November 2013, and May 2015–April 2016.
During those three regimes, the returns and drawdowns experienced from the three primary industrial metals looked like this:
1. Copper averaged a −21% return in each regime, along with a −31% maximum drawdown.
2. Nickel averaged a −31% return in each regime, along with a −43% maximum drawdown.
3. Aluminum averaged a −19% return in each regime, along with a −28% maximum drawdown.
It’s not just commodities that get schlacked; the S&P Metals and Mining stocks index averaged a −15% decline in each regime, and experienced a −43% maximum drawdown.
This time around, these commodities are already feeling the Chinese pinch, with copper, nickel and aluminum all down more than 9% from their January highs. The SPDR S&P Metals & Mining ETF (XME) is down more than 12% from its early 2018 high.
Behavioral Gravity Says What?
I’m fond of saying that human beings are hardwired to do the exact wrong thing at the exact wrong time, especially when it comes to financial matters. We call this DNA-driven propensity to make financial errors “humanness,” and this humanness is on full display right now.
Despite the almost double-digit drawdowns across the base metals space, institutional and retail investors continue to pour money into these commodities. They are blissfully unaware of the bearish implications of raising rates while growth slows.
Retail investors continue to add money to the SPDR S&P Metals & Mining ETF (XME) and the PowerShares DB Base Metals Fund (DBB), despite the fact these ETFs have declined −12% and −8% from their January highs, respectively.
The smart money isn’t behaving … well, smart. Institutional investors are currently holding the highest long positions in the last twelve months across copper, aluminum and nickel! What’s more, their positioning hasn’t changed a bit in the last month despite a rapid deterioration in the Quantitative Gravity for these markets. In Whaley Global Research speak, these markets are now as bearish as Yogi and Boo-Boo.
When the Chinese economic equation equals growth slowing plus inflation ramping, metal commodities (and related equities) get monkey hammered. Combine this with the PBOC’s proactive tightening of financial conditions, and you have the perfect cocktail for a commodity crash.
Let everyone else continue to throw back the narrative-driven Jäger bombs; you can remain the DD. Data dependency enables you to position yourself to benefit from the opportunities that other investors create when they let their humanness drive their decision making.