One of the most interesting aspects of the financial markets is the interaction between different asset classes and the intricate web of connections that can build up between them.
Some of these relationships are pretty obvious, for example that between the FTSE 100 Index and Sterling exchange rates.
The FTSE 100 constituent companies earn 70% plus of their revenues from overseas, or in other words they are largely exporters.
The weaker pound we’ve experienced over the last 11 months, since the EU referendum, has made the goods and services provided by these exporters cheaper to foreign buyers – many of whose currencies will have appreciated against Sterling in this period.
The FTSE 100 has risen by an impressive 1290 points since May 2016, with the majority of those gains coming after the referendum result.
The US dollar, for its part, has often been an influence on commodity prices.
Historically, a stronger dollar was seen as being negative for commodity prices and commodity producers, simply because these basic raw materials are themselves priced in US dollars.
A stronger dollar made commodity prices dearer to foreign currency buyers.
Whilst this basic relationship remains in place and always will (whilst commodities are priced in dollars, anyway), it’s less influential than it was even a few years ago.
It’s not just currencies that can affect prices in different asset classes of course… individual commodities can do something similar.
Here’s how copper can influence the markets…
Take, for example, Copper – one of the most widely used and traded industrial metals. As we noted recently, copper can act as barometer of demand and global growth.
That’s because it’s intrinsically linked to many manufacturing processes, for example in construction, for plumbing and wiring, and in electrical equipment, such as motors and heat exchangers.
Copper prices and expectations about levels of copper demand can, and do, influence stock markets.
Our own FTSE 100 index is a case in point…
The mining sector currently accounts for around 6% of the UK’s blue chip index, but has been a much bigger component in the recent past.
The chart below shows us the Copper price in blue, plotted against the FTSE 100 index drawn in green.
Click image to enlarge.
As you can see, the two are closely correlated from 2003, all the way the way through to mid-2015, at which point they start to decouple.
The reason for that decoupling can be seen clearly in this chart below, which plots copper against the FTSE 350 mining sector index.
Click image to enlarge.
Quite simply, the value of the UK mining sector (this time drawn in blue) declines rapidly from mid-2014, following the copper price (in green) lower as it does so.
That contraction reduced the influence of the mining sector within the FTSE, and therefore copper’s influence over the UK equity index was similarly diminished.
To the right hand side of the chart you can see the rebound in both copper and the mining sector, as global economic recovery hopes built up in 2016.
But as we have noted elsewhere, this so-called “reflation trade” has lost much of its momentum in 2017.
Is gold the player it once was?
Gold has often been seen as a hedge against inflation and a store of value away from paper currencies, whose worth can be undermined by negative returns, which occur when interest rates paid on cash deposit are below the rate of inflation.
This is something we’ve started to experience here in the UK, as the 12% fall in the value of sterling has helped push up UK inflation to around 2.3%, whilst base rates are at a lowly +0.25%.
Savers can find better interest rates for their cash but not always for large sums, and this could become a serious issue going forward for those that are looking for income.
One of the main arguments against holding gold has been that it doesn’t produce an income, though that barrier has been knocked down in an era of negative interest rates.
Given the above, we could be forgiven for thinking that gold would be a reverse indicator for the financial system.
If it were, then the price of gold would move in the opposite direction to the price of, say, UK banking shares.
But rather intriguingly, and perhaps counter intuitively, this has not been the case for much of the past seven years, as the chart below shows:
Click image to enlarge.
Over the shorter term, the positive correlation between the two items is being tested, with gold up +6.0% year-to- date and the UK banks up a more pedestrian +2.8%.
Gold has lost ground over the last week however, as the banks have gained – so perhaps we will meet in the middle, as it were, in the near future.
Some of gold’s thunder as a portable store of value has been stolen by so-called “crypto currencies”, such as Bitcoin.
Though these are not yet established in the mainstream and, given their history and design, perhaps they never will be; they are likely to exert a growing influence over those looking for alternative investments.
To some extent gold has also been overshadowed in terms of its relationship with inflation.
Firstly because, for much of the last seven years there has been little or no inflation in major developed western economies, despite an orgy of money printing.
And secondly, as the markets consider the possibility of a return to normal monetary policy, investors are looking at Oil prices for clues and cues about future inflation levels, rather than to gold.
I think that’s largely because gold has few significant industrial uses outside of jewellery manufacturing.
Investors today are looking for the green shoots of economic recovery and demand-led inflation, which gold’s price does not provide.
None of these relationships are cast in stone of course, and they will vary alongside investor sentiment, but as they are all part of the investment lexicon we should be aware of them in action.
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