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A Little Bit of History Repeating?

Historical patterns are among many indicators that can be helpful in the analysis of financial markets, since they can reveal valuable information of drivers or patterns pertinent to assets or events. It should be self-evident however that history only rhymes, so any historical analog has to be treated carefully in order to not jump to conclusions, which can be a costly mistake in financial markets.

One thing that caught our eye last year were the pronounced movements in oil prices, which dropped by over 50% year-over-year in 2014, only to retrace nearly all their losses starting in the first half of 2016. It was indeed an interesting movement, given that a 50% drop followed by an almost complete retracement of the losses has happened only once outside a recession over the last 35 years, namely between 1997 and 2000. Without going into too many details of what drove oil prices in the late 1990s—remember, history only rhymes, so we have to stick to the big picture—we looked at other indicators to better understand the consequences of such a move, including the “grease” in the financial system: liquidity.

The undisputed “central banker of the world” in the 1990s was the United States, whereas now the marginal provider of liquidity might very well be China, as my colleague Anujeet Sareen pointed out. So how do liquidity conditions of those two periods compare? Taking the fed funds rate as an admittedly coarse proxy for the U.S., and the credit impulse consistent of changes in total social financing and local government debt for China, we can see that those two liquidity measures overlap fairly well—they “rhyme.”

Chart 1

Armed with the assumption that oil prices themselves are strongly related to liquidity since oil producers are paid mainly in U.S. dollars, we can deduce how those liquidity impulses worked their way through the financial system in an ebb and flow of deflation and reflation.

With a contraction in liquidity, demand for commodities tends to decline, and we see that the contraction in both time periods was meaningful enough to cause a pronounced drop in a whole range of commodities. Note that we are looking for similar patterns, not similar price levels; after all, the global economy has changed dramatically since the 1990s, but general economic relationships should still bear strong resemblance.

Chart 2

Receding liquidity shouldn’t only have an impact on commodity prices, but naturally on imports and export orders around the world. As a matter of fact, producer prices responded to the moves in orders and commodities just how we’d expect them to: a distinct correction, followed by a strong reflationary rebound once the liquidity impulse turned firmly positive.

Chart 3

Now, considering that a marked contraction in orders, production, and prices was followed by a clear-cut expansionary period, businesses reacted exactly like we believe they should once work starts pouring in after a dry spell, with skyrocketing optimism, plans to increase capital expenditures, and stronger hiring intentions. Here’s a Chart of the Moment we issued on U.S. business confidence earlier this year.

Chart 4 Chart 5

Not surprisingly, asset markets also behaved in a similar way. It becomes clear that emerging markets were bound to profit vastly from the inflationary impulse that was waiting to happen in the second half of 2016—and while we concede the timing of markets to rally to the Trump election—we’d have to point out that higher demand was already in the pipeline, ready to burst higher. Calling the recent rally a “Trump trade” might hence only be marginally correct.

Chart 6

Curiously, the ebb and flow of the reflationary impulse happened at a very similar point in the business cycle of the United States, with unemployment, wages and profit growth seeing comparable developments. Cause and effect of this observation are harder to assess.

Chart 7

Further, it would be a poor research practice to avoid pointing out differences in this analogy. Apart from markets that have changed in composition or size and are hence less prone to the same reactions, the biggest difference can be seen in financial stress indicators. Generally, interest rates are where demand for and supply of credit clears. However, if we can observe that the household sector is still reluctant to borrow despite unprecedented low interest rates, it might be an indication that consumers got burned so badly in the Great Financial Crisis that they are simply unwilling to borrow, no matter how low interest rates are. As a consequence, interest rates can at least partially lose their signaling function we’re so used to, which in turn, would cause spreads and financial stress indicators—which are in large part determined by interest rates and spreads—to behave differently this time around, and is exactly what can be observed.

Chart 8

This analogy begets the question: Do we believe the global economy is awaiting the same fate we saw play out in the early 2000s? As stated in the beginning, we’d advise anyone to not jump to any conclusions. We’re pointing out in our latest macro outlook that there is plenty of evidence of a much more favorable backdrop for the global economy. Correlations never persist. It is really the task of an investment manager to determine when and how those correlations might change, and also the prime reason why the study of financial markets is both challenging and extremely engaging at the same time!

Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.