Commodities at a Crossroads

Our CEO, Jack Rivkin, recently revisited his thus far prescient view of economic issues facing “The Rest of the Americas.” There are several key drivers one should pay attention to when evaluating the Americas, most of which ultimately lead to the commodity markets.

From the Fed’s decision on interest rates (which is highly data dependent), currencies, the dependence of Chinese demand for commodity exports out of Canada and Latin American countries, and nearly ubiquitous political disharmony, commodities are at an inflection point. Here is why:

 

US Economic Data and the Fed
April retail sales were up 1.3%. Job creation is improving and wages are starting to improve as well. Economic data is getting better, but it’s not necessarily good enough for the Fed to take action. What are the possible scenarios and impacts on commodities?

  • Good Data: If we continue to see decent economic data, it could spur the Fed to raise interest rates at the upcoming meeting in June. An increase in the Fed Funds rate generally leads to strength in the US dollar (USD) relative to other currencies. Conventional wisdom stipulates that a strong USD is typically a negative for commodity markets; the two are negatively correlated since commodities are priced in USD. If the USD strengthens, commodities tend to suffer because it will take more dollars to buy the commodities. While that’s been true the majority of the time, it’s not always the case as one can see below:

Fig1of3_Charts_USD+CommoditiesCorrelation_051916

  • Great Data: That said, if the data out of the US is very positive—one could view this as a growth theme. In this case, the Fed will almost definitely raise rates in June; the USD will rise; but if the US is consuming more, spending more, and on an improved economic growth trajectory, that could spur increased demand, which could actually push commodity prices higher.
  • Bad Data: The last scenario is if the US data gets worse. We don’t think this is all that likely, but low inflation could make the Fed blink. Where we may see bad data is globally. With global markets more intertwined than ever, it would be bold for the Fed to ignore any further and significant global weakness. Moreover, the big Brexit vote shortly after the June Fed meeting could give Yellen pause, ultimately postponing a hike until July.

 

China
According to both the World Economic Forum and the Wall Street Journal (WSJ), in 2015, China consumed “roughly an eighth of the world’s oil, a quarter of its gold, almost a third of its cotton and up to a half of all the major base metals.” In addition, as Jack pointed out in his Perspectives piece, China also produces about half the major base metals. One cannot discuss commodities without discussing China.

Fig2of3_WorldEconForumGraphic_low-res

All eyes are on Chinese growth to continue fueling this impressive demand. Chinese growth is less than it was in prior years but their growth target remains between 6.5%-7.5%. While momentum has slowed, 6.5%-7.5% is not insignificant. To give some obvious context, the U.S. economy grew 0.5% on an annualized basis for the first quarter of 2016.

As Chinese demand for and production of commodities vacillates and its growth moderates, we could see more idiosyncratic Chinese market movements. For example, during September of 2015, China’s National Administration provided new standards for the use of aluminum cables. Aluminum is significantly cheaper than copper and China is rich in aluminum resources—substituting aluminum for copper allows for lower costs and less importing. Prior to September of last year, copper and aluminum prices moved fairly closely together. Since this time, however, we’ve seen more dispersion, periods in which aluminum rallied and copper declined. Thus demand may be increasing right now for base metals, but one may continue to see more substitution versus base metals moving in concert.

The remainder of 2016 should be interesting. If China backs off stimulus or increases local production, it could spell trouble for commodities given their significant share of commodity consumption. We tend to agree with the team from Gavekal Research, who recently stated the following:

 

 

“Since GDP growth in 1Q16 remained above the 6.5% target, it seems likely
that policymakers will now focus more on averting a major bubble and
dialing back leverage, than adding fresh stimulus. This is not to say that
the central bank will cause another interbank liquidity crunch, but it will instead
focus on keeping rates low and stable. Hence, do not expect more easing
policies in the next 3-6 months; after accelerating for the last year credit growth
is likely to stabilize at the current level.”

Gavekal Research, Chen Long, The Daily—“No More Easing Likely,” May 15, 2016;
http://research.gavekal.com/author/chen-long

 

If this is true, we may not see more stimulus from the Chinese central bank. Yet, a complete economic slowdown followed by stunted commodity demand seems unlikely.

Political Unrest
With the exception of Trudeau’s white knight status in Canada, much of the rest of the Americas’ leadership remains on shaky ground. Democracy in its raw form is coming to the USA, Rouseff is on her way out of Brazil, while Mauricio Macri is still sorting out the pieces in Argentina—and he’ll be doing that for a long time. Any perceived weakness in leadership could be viewed by investors as a sign of a weak economy. This too matters because as faith in these governments declines, so may their currency as we witnessed several times last year. For example, one of Brazil’s largest exports is coffee. A weak Brazilian real led to lower coffee prices. In fleeting moments of real strength, coffee rallied alongside.

Fig3of3_Charts_Brazil Real+CoffeePrices_051916

For countries that rely heavily on commodities for exports, a weak currency is not necessarily a positive. Therefore the impact of political unrest on commodities could make for a bumpy ride, at least in the short-term.

Commodities Now?

One may ask, is this a good time to get into commodities? The reality is, it depends on what sector, what commodity, and when. The question also assumes that investors only have the option to go long commodities. Imagine if you could have been short crude oil over the last two years? Our preference is to invest in strategies that can go long and short, such as trend following managed futures strategies. These strategies are systematic in nature with the goal of following price trends. If gold continues to rally, trend following systems will likely add more and more long gold exposure. In fact, most managers we follow are positioned long after gold’s rally this year. If the trend abates, these systems will typically reduce exposure and if the trend reverses strongly, these systems will follow the price trend in the other direction. Investing in systematic trend following strategies allows for long and short investing while taking out the discretionary judgement of trying to time these often volatile markets.

Commodities are indeed at a crossroads with some dispersion likely. Much of what can move individual commodity markets for the remainder of 2016 remains to be seen, as various other cross currents make it difficult to predict. In other words, even if we get Fed clarity, China and other variables could remain uncertain. Investors may want to look for trend following managed futures strategies that have the ability to follow commodity markets directionally once the fog clears.

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