Global unease, from commerce to currencies, rattles raw materials

Are the worst fears now priced in?

THEY make an intriguing posse: about 160 “scouts” in jeans and muddy boots, jumping out of cars with ropes in hand, plunging deep into corn (maize) and soyabean fields across the American Midwest. They are not just farmers. They include commodity traders and hedge-fund managers. Their quest: to predict this year’s harvest by using ropes as a measure and counting, to the last ear of corn and soyabean pod, the yield in a given area. “We have a really beautiful crop. I think this is going to be a record,” says Ted Seifried, a market strategist at Zaner Group, a commodities brokerage in Chicago, during a stop in Nebraska on August 21st. The mud on his boots is a reassuring sign of ample moisture in the soil.

But when he gets back into the car with others on the Pro Farmer Midwest Crop Tour, the talk turns to darker subjects, such as trade tensions, collapsing currencies and what he calls the start of an “economic cold war” between America and China. “While we’re driving the 15-25 miles from field to field, we certainly have a lot to talk about. By and large the American producer thinks the fight with China is just. But it’s very much affecting the pocketbook.”

From the midwestern farm belt to the commodity markets of Chicago, New York, London and Shanghai, this is a tricky time to be producing and trading commodities. Americans may relish their stockmarkets soaring. But a rising dollar, higher American interest rates, sliding emerging-market currencies and fears of a tariff-induced blow to exports to China have taken a toll on commodity prices in recent months (see chart 1).

In the background lurks climate change, fears of which have grown with the heat and drought battering Europe’s wheat crop this summer. European grain prices have surged as a result. But those of many other commodities are sagging. On August 22nd a pound of arabica coffee fell below $1, less than the cost of a takeaway brew and the lowest in 12 years. Raw sugar was also at ten-year lows. Both have been hit by oversupply in Brazil, as well as a slide in the value of the real, the Brazilian currency, which makes it more compelling to sell crops, priced in dollars, rather than store them.

The previous week, prices of copper fell into bear-market territory, down by more than 20% since June, on fears that protectionism would dampen global growth, especially in China, whose efforts to crack down on financial leverage are another drag on expansion. Oil prices have dipped for seven straight weeks, also because of concerns about lacklustre demand in emerging markets and because a strong dollar makes it dearer for those with weak currencies to buy crude. Gold has developed a strange habit of sliding in sync with the Chinese yuan.

American corn and soyabean prices, meanwhile, continue a long streak of weakness caused mainly by harvests that get more bountiful by the year. The Department of Agriculture is forecasting a record corn yield this year and the biggest harvest of soyabeans ever, something the crop tour is likely to validate, Mr Seifried says. But that is lousy timing, given that China, which was America’s biggest buyer of soyabeans, raised retaliatory tariffs on the crop in July. Farmers hope to sell more in Europe, where soyameal for animal feed is in high demand because of the high cost of wheat. But the slide in the real also makes Brazilian soyabeans more competitive.

Optimism flickers from time to time. Many commodities rallied in the run-up to the latest trade talks between American and Chinese officials, which were due to end after The Economist went to press. The dollar fell, bolstering some commodities, after President Donald Trump said in an interview with Reuters on August 20th that he was “not thrilled” with the Federal Reserve’s policy of raising American interest rates. Progress in talks on the North American Free-Trade Agreement would also be good news (see article).

But BHP, the world’s biggest miner, issued a blunt assessment of the longer-term dangers to its products during its otherwise promising year-end results on August 21st. It said protectionism was “exceedingly unhelpful” for broad-based global growth, adding that Sino-American trade tensions could weaken both countries’ GDP growth by a quarter to three-quarters of a percentage point, absent counter-measures. Both America and China imposed another tranche of tariffs, on a further $16bn-worth of each other’s goods, on August 23rd.

Analysts point to two main ways in which these tensions hurt commodity prices. The first is because of the rising importance of emerging markets to demand. In a report in June, the World Bank calculated that almost all the growth in the past 20 years in global metal consumption, two-thirds of the increase in energy demand and two-fifths of the rise in food consumption came from seven countries: Brazil, China, India, Indonesia, Mexico, Russia and Turkey. This group now exceeds the Group of Seven industrial nations in consumption of coal and all base and precious metals, as well as of rice, wheat and soyabeans. Commodity prices are therefore far more sensitive to these countries’ fortunes than they used to be. Hence their walloping last week when the plunging Turkish lira gave a shock to other fragile currencies.

The second is speculation. Ole Hansen, head of commodities strategy at Saxo Bank, says that fears of a trade war have clobbered prices of the most globally traded commodities, notably copper, as short positions by speculators have surged (see chart 2). China accounts for half the world’s demand for copper, the same share as its consumption of steel. Yet steel prices have fared much better because the most liquid steel contract is in China, which is much more affected by domestic supply and demand factors than big global bets. A steel-futures contract in Shanghai touched a seven-year high on August 22nd.

As ever, demand from China remains the biggest swing factor for commodities. BHP reckons China will use fiscal and monetary expansion to help offset the impact to its exports from the trade conflict, which could benefit commodities. But even if the worst is now priced in, plenty of volatility lies ahead. As Mr Seifried quips from the cornfields of Nebraska, “predicting the future is a son of a bitch”.

The Big Weakness in the Buyout Funding Chain

The risky loans that fund private-equity deals are more reliant on money from complex vehicles than ever

By Paul J. Davies

The boom in risky lending to fund private-equity deals and other takeovers has been fed by complex vehicles that sound a surprising echo from the most-recent debt bubble.

The good news: these so-called collateralized loan obligations, or CLOs, aren’t part of such a fragile chain of structured finance as in 2008. But they might still fall from favor as central banks end their bond buying programs. And that would be a major problem for private-equity deal makers who have hundreds of billions of dollars waiting to be invested.

The CLO investors to watch are banks and Japanese buyers: both may switch to traditional bond investments as yields recover to more normal levels. Both have been big buyers of the safest AAA-rated bonds issued by CLOs, although their exact share of the market is hard to track.

These senior bonds matter because they provide about 60% of a CLO’s funding, while hedge funds and specialist investors provide the rest through riskier bonds and equity. These bonds have attracted investors because they pay a better return than many government bonds, but have historically proved very safe: there have been no defaults in 20 years on AAA-rated CLO bonds, according to Standards & Poor’s, the ratings agency.

But other things affect demand too. For Japanese investors, favorable pricing of dollar-yen swap rates has been a big part of what makes CLO yields appear even juicier.

Japanese buyers have paused after recent currency and interest rate moves.
Japanese buyers have paused after recent currency and interest rate moves. Photo: kim kyung hoon/Reuters 

Recent currency and interest rate moves have seen Japanese buyers pause, which might help explain why CLO funding got more expensive in recent weeks. But analysts at Bank of America Merrill Lynch say the all-in return is still attractive and Japanese investors will be back.

Banks own senior CLO bonds for a bit of extra yield on money they would normally keep in liquid assets. However, CLOs don’t count toward the minimum liquid assets that regulators demand they hold, so banks will likely reduce or stop buying once true liquid assets pay a decent yield again.

The loans inside CLOs are by some measures worse quality than those before the most-recent crisis and investors worry that eventual defaults will lead to greater losses. But senior CLO bonds may still do well because all the riskier slices of CLO funding must be wiped out before they lose a cent.

However, we have heard this kind of story about subprime mortgage bonds and other structured credit before 2008. For safety-conscious investors, CLOs may just seem unnecessarily complex as soon as they no longer really need them to boost yields.

And given that they now buy more than half of leveraged loans, any interruption for CLOs will bring a major funding headache for deal-hungry private-equity firms.

The Ahistorical Federal Reserve

J. Bradford DeLong

BERKELEY – Economic developments over the past 20 years have taught – or ought to have taught – the US Federal Reserve four lessons. Yet the Fed’s current policy posture raises the question of whether it has internalized any of them.

The first lesson is that, at least as long as the current interest-rate configuration is sustained, the proper inflation target for the Fed should be 4% per year, rather than 2%. A higher target is essential in order to have enough room to make the cuts in short-term safe nominal interest rates of five percentage points or more that are usually called for to cushion the effects of a recession when it hits the economy.

The Fed protests that to change its inflation target even once would erode the credibility of its commitment to ensuring price stability. But the Fed can pay now or it can pay later. After all, what good is credibility today when it means sticking tenaciously to a policy that deprives you of the ability to do your job properly tomorrow?

The second lesson is that the two slope coefficients in the algebraic equation that is the Phillips curve – the link between expected inflation and current inflation, and the responsiveness of future inflation to current unemployment – are both much smaller than they were back in the 1970s or even in the 1980s. Then-Fed Chair Alan Greenspan recognized this in the 1990s. He rightly judged that pushing for faster growth and lower unemployment was not taking excessive risks, but rather harvesting low-hanging fruit. The current Fed appears to have a different view.

The third lesson is that yield-curve inversion in the bond market is not just a sign that the market thinks that monetary policy is too tight; it is a sign that monetary policy really is too tight. The people who bid up the prices of long-term US Treasury bills in anticipation of interest-rate cuts when the Fed overshoots and triggers a recession are the same people who are now on tenterhooks wondering when to start cutting back on investment plans because a recession will soon produce overcapacity.

The Fed today has a “habitat theory” about why this time is different – that is, why the preferences of investors for particular maturity lengths imply that a yield-curve inversion would not mean what it has always meant. But 2006, just before the financial crisis hit, was supposed to be different, too. (And there were plenty of times before then that were supposed to be different, too.) History suggests that this time is highly unlikely to be different – and that it will not end well if the Fed continues to believe and behave otherwise.

The fourth lesson similarly reflects developments extending back further than 20 years. Back in the 1980s, it was not unreasonable to argue that the next large shock to the US macroeconomy was likely to be inflationary. It is much more difficult to reasonably argue that today. For the past three and a half decades, the principal shocks have not been inflationary, like the 1973 and 1979 oil crises, but rather deflationary, like the US savings and loan crisis in the 1980s and 1990s, the 1997 Asian crisis, the 2000 dot-com bust, the terrorist attacks of September 11, 2001, the 2007 subprime collapse that began in the US, and the 2010 European debt crash.

Former Fed Chair Janet Yellen told me back in the 1990s that, in her view, conducting the Fed’s internal debate within the framework of interest-rate rules had greatly increased the ease of getting from agreement about the structure and state of the economy to a rough consensus on appropriate policy.

But, at least as I see it, right now the Fed’s process of getting from a realistic view of the economy to an appropriate monetary policy does not seem to be functioning well at all. Perhaps it is time for the Fed to place its internal discussions in a more explicit framework. One can imagine, for example, the Fed adopting an “optimal control” method, whereby monetary-policy settings are established by running multiple simulations of a macroeconomic model using different combinations of interest rates and balance-sheet tools to project future inflation and unemployment.

The problem for optimal control methods is that the real world is not some closed system where economic relationships never change, or where they change in fully predictable ways. The most effective – and thus the most credible – monetary policy is one that reflects not only the lessons of history, but also a willingness to reconsider long-held assumptions.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

Why Value Investors Don’t Have to Wait for Mean Reversion

By Matt Wagner, Research Analyst     

When will value turn around and outperform growth? Over the past several years, this arguably has been one of the most hotly debated questions in index investing. Investors are now undoubtedly familiar with some sort of graph that shows the outperformance that growth has experienced over the past 10 years, punctuating the question around value mean reversión. 

With live performance available for many of WisdomTree’s Funds for the past 10 years, some investors may be surprised to see outperformance, particularly in the small- and mid-cap segment, from some of our most value-tilted strategies. In this blog post, we utilize our Index Performance Attribution tool to explain the key drivers of outperformance of our mid-cap earnings Index over the past 10 years.
Quantifying Value: Earnings Yield Attribution
The tendency for inexpensive companies, using a ratio such as price-to-earnings (P/E), to outperform expensive companies over longer periods of time is one of the more generally accepted principles in factor investing. Research such as this contributed to the creation of WisdomTree’s earnings-weighted family that rebalances back to core earnings on an annual basis to reduce valuation risks.
By segmenting the WisdomTree U.S. MidCap Earnings Index and the Russell Midcap Index into earnings yield quintiles, we can review how the least expensive stocks have performed relative to the more expensive stocks in real time, and how this helped contribute to 266 basis points (bps) of outperformance for the WisdomTree Index as of June 30, 2018:
  • First Quintile (Lowest P/E): The WisdomTree Index had an active weight of 10.75% in this quintile, which was also the best performing in the benchmark quintile. This quintile was the biggest contributor to outperformance, adding 112 of the total 266 bps of outperformance.
  • Fifth Quintile (Highest P/E): The WisdomTree Index was under-weight in the most expensive quintile by 12.85%, the largest absolute active weight of all the categories. This quintile was the worst performing in the benchmark, underperforming the Russell index’s total return by nearly 200 bps. By tilting away from these expensive stocks, the category contributed 42 bps of outperformance.
 Quantifying Quality: ROE Attribution

Return on equity (ROE) is a key metric of profitability for equity investors, and one that is helpful to utilize in deconstructing the impact of our earnings-weighted methodology on returns. Similar to what was done for earnings yield quintiles, the two indexes are segmented into ROE quintiles, as well as a category for negative return.
  • Top Two ROE Quintiles: Over short periods of time, we can see any of the commonly accepted factors go out of favor. One surprise of 2018 thus far has been how well negative earners have performed in the mid-cap segment. Negative earners have outpaced all other ROE quintiles in a junk-led rally, resulting in a headwind for the WisdomTree Index’s year-to-date returns. Over the 10-year period, the outperformance of the highest ROE quintiles has been definitive. The WisdomTree Index had a combined 14% over-weight in the top two quintiles, contributing 113 bps to outperformance.

  • Negative Return Category: What we have consistently seen when dipping down in market cap size is this negative return weight becomes more prevalent for market cap-weighted indexes, creating a greater exposure to companies more at risk of bankruptcy due to a lack of profitability. The WisdomTree Index had roughly 2.8% weight in this bucket, with over twice this exposure for the Russell index, which had 7.3% allocated there. This was the second-worst-performing category for the benchmark, which contributed 32 bps to outperformance.                         

Don’t Sleep on Value

While one would expect an index that has outperformed its benchmark by 266 bps over 10 years should have stretched valuations, the design of WisdomTree’s Index instills a selling discipline to mitigate any such valuation risk—an important consideration for investors in this aging bull market. As of June 30, 2018, the valuation discount for the WisdomTree Index is about 30% on a trailing P/E basis, a discount that could portend even greater opportunity for outperformance going forward should value finally come back into favor.

WisdomTree U.S. MidCap Earnings Fund (EZM): Beating 98% of Its Peers since Inception

The Fund tracking the WisdomTree U.S. MidCap Earnings Index, EZM, has proven its competitiveness up against both passive and active managers, beating 98% of Morningstar Category peers based on total return since inception. The combination of value and quality exposures, which we have highlighted through the earnings yield and ROE attributions, has helped this Fund rise toward the top of its peer group despite the headwind of value over this period.



You walk into a casino and try to figure out whether or not it is rigged. You notice that 1% of the people are winning 20% of all the money. Does this mean that the casino is rigged? It might seem a little suspicious but, then again, talent is not distributed equally, and some people are always luckier than others, so it is not necessarily surprising that a small fraction of the people get most of the winnings.

While looking at the casino’s record books you find that 40 years ago the top 1% were only winning 10% of all the money. This seems more suspicious. Are they that much more talented now or does luck matter that much more? You might also notice that in other casinos in Europe and elsewhere the top 1% is taking more like 9-14% of all the money.  

In an attempt to strain the metaphor of the American economy well beyond where it should go, you come back to the casino a generation later and find that the children of the bottom 20% of winners in the previous generation have only a 7% chance of being in the top 20% today, again suspiciously less than in many other countries.

If this casino had a roulette wheel and the house was winning more than about 10% of the money you would infer it was rigged even if you could not observe exactly how it was rigged or who was doing the rigging. Similarly, the outcomes in the American economy are prima facie evidence that it is tilted towards societal elites.

We can, however, observe many of the ways the economy systematically favours the wealthy and powerful. For most people inequality begins at birth. In America one-fifth of four- and five-year-old children do not go to school, putting us 29th in the OECD in this regard—below much poorer countries like Mexico. When the child does eventually enter school, the amount spent per pupil varies from over $28,000 per pupil in rich areas to less than $8,000 per pupil in poorer ones because America has chosen to primarily fund schools at the local level and thus further perpetuate local inequality. A game where the participants have purposefully been given radically different amounts of preparation could be fairly described as rigged.

Then there is the fact that, as Adam Smith observed nearly 250 years ago, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” The fewer businesses engaged in the same trade, the easier it is to collude, either tacitly or explicitly and illegally.

And in most trades there are many fewer businesses today: hospitals, beer, railroads, trucking, retail, technology, airlines, and most other categories of the economy. In certain industries this may have been a natural outgrowth of economies of scale, but it is hard to not also see that increased government-sponsored monopolies, through stronger intellectual-property protections, and reduced antitrust enforcement have also played an important role.

The result can be higher prices or worse service for consumers. Witness the cases of air travel and broadband internet. Or it can be lower wages for workers. Witness the illegal collusion that has taken place to lower the wages of nurses and software workers or much more extensive but legal practices, such as non-compete agreements, which help to keep those wages down.

The less cited second half of Smith’s quote is no less important: “[the law] ought to do nothing to facilitate such assemblies; much less to render them necessary. A regulation which obliges all those of the same trade in a particular town to enter their names and places of abode in a public register, facilitates such assemblies…” The regulations that facilitate collusion and the perpetuation of economic rents do not just come from nowhere. They come from the beneficiaries of those gains.

These regulations manifest themselves as overly strong intellectual-property protections, occupational licensing that requires a florist to undertake extensive certification work, or land-use restrictions that keep housing prices high and make it more difficult for more people to move to areas with better jobs, schools and amenities.

Capitalism does not exist in a vacuum. It requires laws that establish property rights, adjudicate disputes, fund public infrastructure and finance all of these inputs. If you look at how elites currently shape the operational rules of capitalism, the outcome of these rules in terms of inequality and low levels of intergenerational mobility, or observe the many specific policies that establish and perpetuate inequality. It is clear that capitalism today could fairly be described as rigged in favour of elites.

Jason Furman, Harvard Kennedy School

Monopoly? Its prevalence is greatly exaggerated. It survives chiefly in protection from illiberal governments exercising their own super-monopoly, of violence. Since 1800, or 1900, monopoly has fallen, not risen. The railway, the bicycle, the automobile, the internet have steadily eroded local market power. Liberalisation of trade has given us twenty brands of auto to choose from, as against three in the closed economies 1930-1970. Entry rules. Ask your former “monopolist” of a department store in Leeds.
“Capitalism” encapsulates a scientific mistake. It is not capital accumulation that made the economic world since 1800. It’s innovation. What made us astonishingly rich, from £4 a day per person rising to over £80 in Britain, was an explosion of bright ideas. The source was an entirely novel liberalism of inclusion, 1776 to the present, encouraging ordinary people to have a go. The go-ers were in succession poor men, non-conformists, Catholics, Jews, slaves, women, Irish people, other colonial peoples, women again, immigrants, teenagers, gays, Chinese, Indians, and on and on in a widening gyre. Capital and labour and institutions and the other intermediate factors followed the good ideas, such as railways or containerisation or the internet. They did not cause them.  

People caused them. Poor people such as the blacksmith John Harrison (marine chronometer) or the son of a weaver John Dalton (atomic theory, among other ideas) or the seamstress Coco Chanel (business attire for women) were permitted for the first time in history to innovate. Investment followed, yielding a Great Enrichment more important than the somewhat routine event 1760-1820 called the Industrial Revolution. You might better call what happened in the two centuries after 1800 “innovism,” or less snappily “commercially tested betterment for all and sundry.”
For all and sundry, I say, not merely for an elite. In countries that adopted liberalism the average person’s real income per head increased after 1800 by a factor of 30. Not a mere 100%, or 200%, understand, but fully, to be more accurate than such rough truths allow, 2,900%. Or more. Sweden, Japan. Now Botswana and India and China and Singapore.  

The poor, the ancestors of us all, benefited the most. True, the elite acquired another diamond bracelet or two. Vulgar, yes. Important for the outcome, no. In its unprecedented magnitude the innovism after 1800 yielded to the poorest among us adequate food, housing, education, health. Not nirvana. We can and should do more. But a Great Enrichment nonetheless.  

Yes, there are still poor people, especially in places like Zimbabwe or Venezuela that have turned against liberal ideas, or among the numerous victims in rich societies of proliferating illiberal policies, such as prohibiting Uber and Lyft, closing occupations, regulating street food.  

But in 1800 practically everyone in the world was poor, at about £2 a day. The age of shocking inequality was not 1900 or 2000, but any of the other centuries back to the invention of agriculture. During the Middle Ages a half of national income was paid for land rents to the already rich. Labourers lived in squalid conditions, unimaginable nowadays unless you have seen the favelas and townships. The share of such places in world population diminishes yearly, as governments discover liberalism and let their people go. Admittedly, many populist tyrants have recently re-discovered an illiberalism suited to killing growth, and people. But viewed internationally, as a non-nationalistic ethic would require, individual inequality has fallen in the past forty years like a stone. Innovation did it.

Why have the poor benefited? After all, you might believe that the fat cats get the first bite. The answer in a word is entry. When Sam Walton, running a little faux-Woolworth’s in his home town, innovated the use of bar codes to control inventories, revolutionising US retailing, other retailers were not slow to notice. The economist William Nordhaus reckons that innovators get 2% of the social value of their innovations. It’s a good deal. Sam’s children became obnoxiously wealthy. But we got by competition the 98%.

Be of good cheer, then. The poor shall inherit the earth.

Deirdre McCloskey, University of Illinois at Chicago