The market pullback in August was short-lived. Global equity markets registered sharp reversals, leading both the S&P500 and MSCI World indexes to all-time highs. Following a four-month losing streak, the TSX strengthened 2.5% during the reporting period. The gains were greased by a 10.4% surge in the price of oil. The commodity was spurred by the combination of improving supply/demand fundamentals and expectations that OPEC will extend production cuts. Efforts to eliminate the supply glut were initiated in November 2016 and were expected to last six months. However, the cuts were stretched in May until March 2018 and now there are hints that the controls will continue through 2018. Large inventory drawdowns are suggesting that the production cuts are becoming more effective. However, OPEC isn’t exclusively responsible for draining stockpiles. EIA estimates that refining operations will be reduced by 20% in September due to Hurricane Harvey’s impact on US refining. Longer term, political momentum for reducing fossil fuels in favour of renewable energy sources will slow the demand for oil. As such, it will become increasingly difficult for OPEC to balance the trade-off between manipulating current prices with the long-term goal of monetizing an asset that will have reduced utility on a go-forward basis.
The US 10-year Treasury yield continues to fluctuate, reversing August’s downward move by rising 6.1 bps to 2.23% at 22-Sep-17. Last month, we questioned if the price of Gold could hold above the $1,300 threshold, as it proved unsustainable on three occasions since Nov-16. September marked the fourth setback as the price slipped to $1,295 as governmental unrest became less worrisome.
The 10-year Treasury yield and gold prices will be influenced by a few key narratives. The Federal Reserve confirmed their intention to commence the gradual unwinding of Quantitative Easing. Beginning in October, the Fed will cease the extension of bond repurchases. They also surprised markets by indicating the possibility of raising rates again in December in addition to the three predictable hikes in 2018. Markets have not priced in the full suite of rate hikes but the possibility remains that investors are entering a quantitative tightening cycle that poses a great unknown to markets.
The other factor that is beginning to show signs of life is inflation. Though a weak US dollar surely has a large impact, emerging market demand for core commodities could create support for a sustained upward trend in inflation measures. Therefore, central banks need to be alert as a sudden rise could force more aggressive monetary initiatives. Authorities are keen to maintain a well-telegraphed tightening cycle to avoid a second “taper tantrum”. Recall that investors panicked in 2013 when the Fed disclosed that bond purchases would be discontinued. The ensuing sell off triggered more than $1.5 Trillion in Treasury Bond losses and stocks took a beating.
Gold and real-return bonds can be a strong hedge against inflation shocks. However, if investors begin to lose confidence in the ability of central banks to effectively communicate and implement tactics, unpredictable asset price movements will be the consequence.