Game-Changers in the Era of Dissonance

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Our chief economist's macro view of the economy (September 2012)

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Game-Changers in the Era of Dissonance

  1. 1. Game-Changers in theEra of DissonanceThe research views expressed herein are those of the author and do notnecessarily represent the views of the CME Group or its affiliates.All examples in this presentation are hypothetical interpretations of situationsand are used for explanation purposes only.This report and the information herein should not be considered investmentadvice or the results of actual market experience.Blu PutnamChief EconomistCME GroupSeptember 2012
  2. 2. Risk DisclosuresFutures trading is not suitable for all investors, and involves the risk of loss. Futures are aleveraged investment, and because only a percentage of a contract’s value is required to trade,it is possible to lose more than the amount of money deposited for a futures position. Therefore,traders should only use funds that they can afford to lose without affecting their lifestyles. Andonly a portion of those funds should be devoted to any one trade because they cannot expect toprofit on every trade.The Globe Logo, CME, Chicago Mercantile Exchange, and Globex are trademarks of ChicagoMercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board ofTrade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort aretrademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of CommodityExchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are theproperty of their respective owners.The information within this presentation has been compiled by CME Group for general purposesonly. CME Group assumes no responsibility for any errors or omissions. Additionally, allexamples in this presentation are hypothetical situations, used for explanation purposes only,and should not be considered investment advice or the results of actual market experience.All matters pertaining to rules and specifications herein are made subject to and are supersededby official CME, CBOT, and NYMEX rules. Current rules should be consulted in all casesconcerning contract specifications.© 2011 CME Group. All rights reserved 2
  3. 3. Game-Changers in theEra of Dissonance Rates: Lack of market confidence in the US and other mature countries Energy: Crude oil versus natural gas FX: Currency carry trades in a ZIRP environment Agriculture: Volatile weather, politics and global demographics Equities: Taking advantage of US core strengths Metals: Slowing demand from the BRIC nations© 2011 CME Group. All rights reserved 3
  4. 4. Lack of Confidence is Reflected in Long-Term US Treasury yieldsCurrently, there are essentially zero inflation-adjusted (real) yields on US Treasury 10-Year Notes.Zero real long-term yields in US Government securities underscores the lack of confidence in the economic leadership of the mature industrial countries and a fear of the economy moving back into recession and experiencing deflation.Zero real yields on long-term US Treasuries are not sustainable – either we spiral downward into deflation (very low probability) or the capital markets demand higher returns above inflation for taking long-term risks.© 2011 CME Group. All rights reserved 4
  5. 5. US 10-Year Treasury Inflation-Adjusted Yields How Low Can Inflation-Adjusted 10-Year Treasury Bond Yields Go? 12% 10% Real Percentage Yield: 10-Year Yield minus 8% Year-over-Year Inflation 6% 4% 2% 0% -2% -4% 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source: Data from the Bloomberg Professional.© 2011 CME Group. All rights reserved 5
  6. 6. Why is the Federal Reserve soconcerned about the economy?The US economy has reeled off 12 straight quarters of real GDP growth since Q3 2009 averaging 2.2% growth.The unemployment rate has fallen from its peak of 10% to just above 8%US large corporations are flush with very large cash holdings,.The US banking sector has recapitalized itself since 2008 and is now comfortably profitable.© 2011 CME Group. All rights reserved 6
  7. 7. Why is the Federal Reserve soconcerned about the economy?The Fed considers the current pace of real GDP growth (2.2% over the last 12 quarters) insufficient to bring down unemployment toward 6% (currently just above 8%, peaked in 2009 at 10%).The Fed is worried (as are many others) about the potential for a highly disruptive fiscal cliff in 2013 if the US Congress cannot agree a long-term budget compromise.The Fed is worried about the potential for global financial disruptions from fall-out from the European sovereign debt debacle.© 2011 CME Group. All rights reserved 7
  8. 8. US Real GDP Growth in the last 12 quartershas been in line with pre-crisis growth. US Real GDP Growth 6% Quarterly Real GDP Growth at Annualized Rate 3% 0% -3% 2.4% Real GDP growth 2.2% Real GDP growth for for 12 quarters during 12 quarters since recovery years 2005-2007 started in Q3/2009 -6% -9% Q1/2005 Q1/2006 Q1/2007 Q1/2008 Q1/2009 Q1/2010 Q1/2011 Q1/2012 Source: Bloomberg Professional (GDP CHWG)© 2011 CME Group. All rights reserved 8
  9. 9. Why has the US economy not grown morerapidly since the recovery started in Q3/2009?Global HeadwindsUS Labor Force Challenges© 2011 CME Group. All rights reserved 9
  10. 10. Global Headwinds• Europe is somewhere between recession and stagnant as it copes with its sovereign debt debacle – Germany and France struggling to grow slowly – Spain and Italy in recession• China’s growth is slowing as it copes with decelerating export growth (20% of its exports go to Europe) and attempts to shift from an infrastructure-building growth model to a consumption model.© 2011 CME Group. All rights reserved 10
  11. 11. US Labor Force ChallengesLabor force growth is much slower than it was in decades past.The average age of the labor force is higher than it was in decades past.The relative cost of labor has risen substantially compared to the cost of capital over the last 30 years or so.Technological change over the past 25 years has improved labor productivity while making it possible for corporations to use less labor when they expand and modernize.© 2011 CME Group. All rights reserved 11
  12. 12. Slowing US Labor Force Growth Smoothed Trend in Year over Year Percentage Change in Civilian Labor Force 3% Year over Year Percent Change in 5-Year Moving Average of Civilian Labor Force 2% 1% Should this deceleration in Labor Force growth have come sooner (delayed by Tech boom and then the housing boom) or is it an aberation caused by the Great Recession of 2008-2009? 0% Source: Civilian Labor Force (CLF160V) from the FRED Database of the Federal Reserve Bank of St. Louis© 2011 CME Group. All rights reserved 12
  13. 13. Consequences in the US of Rising RelativeCost of Labor Compared to Capital Job Growth Coming Out of Recessions Has Been Declining for 30 Years 6% 4% Year over Year Percent Change in US Payroll Emmployment 2% 0% -2% -4% -6% 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source: Data from the Bloomberg Professional.© 2011 CME Group. All rights reserved 13
  14. 14. US Policy UncertaintyUnless the US Congress acts, taxes will rise in 2013 (expiration of Bush-era tax cuts) and government spending will be cut sharply (sequestration related to previous Congressional legislation designed (unsuccessfully) to force a long-term compromise.The Federal Reserve’s policy of quantitative easing, operation twist, and near-zero rates for the foreseeable future is now hurting the economy and risking long-term damage.The first round of Quantitative Easing (QE-1) in late 2008 and early 2009 helped prevent a financial crisis turning into a depression.QE3, continued Operation Twist, and guidance that the federal funds rate will stay near zero into 2015 may be depressing confidence and hindering faster economic growth.© 2011 CME Group. All rights reserved 14
  15. 15. Problems with Extended EmergencyPolicies from the FedUS Treasury and related rates markets face a distorted yield curve with long-term yields not offering any return over inflation.Investors in search of yield are potentially creating a bubble in high yield bonds that presents serious long-term risks to the economy.Savers and pensioners have had to cutback consumption since they depend in part of the yields from their (conservative) fixed income portfolios. This also impacts the younger generations that may need to assist their elders.Low long-term Treasury yields further advantage capital relative to labor, so even if corporations expand, they will favor labor-saving technologies.Low rates do not stimulate corporate investment plans – confidence in the future and a willing to take risks is what is required.© 2011 CME Group. All rights reserved 15
  16. 16. Energy Sector ChallengesRising Supply Meets Slowing Demand and Infra-Structure Bottlenecks© 2011 CME Group. All rights reserved 16
  17. 17. Natural gas offers an extremely low costper BTU of energy Natural Gas and WTI Crude Futures 5-Year Curves as of 31 August 2012, US$ per 1 Million BTUs 18 Price of 1 Million BTUs Equivalence 16 14 NYMEX WTI Crude Oil Futures 12 Will the BTU price gap 10 be narrower in 5 years? And which 8 price might adjust NYMEX Natural Gas Futures more quickly? 6 4 2 0 Source: Settlement Prices from Bloomberg Professional.© 2011 CME Group. All rights reserved 17
  18. 18. Energy Demand: A Tale ofTwo DecadesFrom 2001-2010, Emerging Market nations grew at superlative rates and drove global commodity and energy demand higher.In the 2011-2020 decade, Emerging Market nations will still lead the way, but the pace of growth is likely to slow dramatically from the previous decade.© 2011 CME Group. All rights reserved 18
  19. 19. Economic Growth Divide (Last Decade)© 2011 CME Group. All rights reserved 19
  20. 20. Economic Growth Divide (Coming Decade) Cumulative Real GDP Growth Projection for 2011-20 Japan Euro-Zone UK US Brazil India China 0% 50% 100% 150% 200% Source: CME Research Estimates.© 2011 CME Group. All rights reserved 20
  21. 21. FX in ZIRP WorldThe central banks in the US, UK, Euro-Zone, and Japan are all committed to extended periods of near-zero short-term interest rate policies (ZIRP).The mature commodity producing countries, such as Australia, and the emerging market nations, from Mexico and Brazil in Latin America to India to China are likely to maintain interest rates between 3% and 6% (or more) above those in the US, UK, Euro-Zone, and Japan.This makes investments in the currency carry trade very attractive, even relative to the substantial risks. However, when market fears (i.e., Europe debt crisis, US fiscal cliff, etc.) dominate, risk-off trading will close these positions down. These carry positions will get reestablished as global market fears calm.© 2011 CME Group. All rights reserved 21
  22. 22. FX and Rates Example of Tools and Goals:The Volatility Balloon with US and Brazil US Federal Brazil Funds SELIC Rate Rate Joint Interest Rate & Exchange Rate Market Volatility Spot Forward BRL/USD BRL/USD FX Rate FX Rate© 2011 CME Group. All rights reserved 22
  23. 23. China & BrazilExchange Rate Paths Comparing Paths of the Renminbi and the Real (Falling line indicates strength versus the US Dollar) 160 RMB per USD & BRL per USD Indexed 140 Chinese RMB - Managed FX to May 2002 = 100 120 100 80 Brazilian Real -- Managed 60 Rates, Volatile FX 40 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Brazilian Real (BRL) and Chinese Renminbi (RMB) from the Bloomberg Professional.© 2011 CME Group. All rights reserved 23
  24. 24. Agriculture, Politics and WeatherChanging food demand from growing middle classes in emerging market countriesWeather – droughts, changes of ocean temperatures and currents, increased volatilityPolitics swing away from subsidizing bio-fuelsHigh likelihood of continued volatility and upward price trends across the agricultural sector© 2011 CME Group. All rights reserved 24
  25. 25. Source: NOAA© 2011 CME Group. All rights reserved 25
  26. 26. Equities: Taking advantage of US core strengthsFor over 35 years, the US has led other nations by having the highest average age groupCompared to the Japan, the UK, and Euro-Zone nations, the US has been best of class in important categories: Best real GDP growth rate over last 12 quarters (since recovery started) Best capitalized and most profitable banking sectorStrong potential for the S&P500 to outperform peers, as well as for sector rotation to gain traction as an investment approach for the coming years.© 2011 CME Group. All rights reserved 26
  27. 27. Metals: Slowing demand from the BRICnationsThe phenomenal growth of the emerging market countries led by the BRIC nations in the past decade fed the rise in metals prices. One cannot build a country without copper, for example.Now the BRIC nations are slowing.There is likely a secular decline in long-term real GDP growth rates toward more sustainable paths, andThere is also a further temporary deceleration due to the financial turmoil in Europe and not helped by the fiscal cliff uncertainty in the US.© 2011 CME Group. All rights reserved 27
  28. 28. Slowing BRICs BRIC Real GDP Growth is Slowing Year over Year 9% Real GDP Growth (Percentage Change Q4/Q4 Basis) 8.1% 6.5% Forecast 6% 5.3% 3% 0% 2010 2011 2012 Source: Real GDP data from the Bloomberg Professional, CME Economic Research for Aggregation of Growth Rates and Forecasts© 2011 CME Group. All rights reserved 28
  29. 29. Metals OutlookGold is supported by zero rates in the US, UK, Japan, and Euro-Zone. Gold demand is dampened to the extent of economic slowdowns in India and China – major gold buying nations. With near-zero rates as far as the eye can see from the Federal Reserve and the ECB, any recovery in BRIC nation economic growth in 2013 and beyond has the potential to push gold higher, albeit with considerable volatility.Copper demand stems from infrastructure building. China is critical. China slowed infrastructure spending plans in 2011 and 2012, but there are signs that China will start spending again to get the economy moving faster 2013. Copper is likely to be very volatile, and China is the country to watch.© 2011 CME Group. All rights reserved 29
  30. 30. Game-Changers in theEra of Dissonance Rates: Lack of market confidence in the US and other mature countries Energy: Crude oil versus natural gas FX: Currency carry trades in a ZIRP environment Agriculture: Volatile weather, politics and global demographics Equities: Taking advantage of US core strengths Metals: Slowing demand from the BRIC nations© 2011 CME Group. All rights reserved 30
  31. 31. Game-Changers in theEra of DissonanceThe research views expressed herein are those of the author and do notnecessarily represent the views of the CME Group or its affiliates.All examples in this presentation are hypothetical interpretations of situationsand are used for explanation purposes only.This report and the information herein should not be considered investmentadvice or the results of actual market experience.Blu PutnamChief EconomistCME GroupSeptember 2012

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