Global commodities under pressure

Posted by Walter

With the dollar's renewed strength and slower global demand, commodities are under pressure again.

Source: barchart

The situation in Brazil is not helping as the weak Brazilian real encourages producers to dump commodities at lower prices (in dollar terms). And Brazil is one of the largest commodity exporters in the world (from corn to iron ore). Here is the Continuous Commodity Index (broad commodity index).

Source: barchart

While the dollar rally and the weakness across the energy patch are pressuring commodities, other drivers exists as well. One specific commodity to watch closely is lumber. Here's May-2015 lumber futures contract. Is it an indication of slower US housing demand on higher rates ahead? Is the Canadian housing market in trouble?

Source: barchart

And then we have the raw materials prices in China: steel rebar (used in construction) and iron ore (May-2015 contract). The rebar weakness tells us not to expect a housing recovery recovery in China this spring.

Source: barchart

And China's recent growth downgrade is sending iron ore futures to multi-year lows (see story).

Source: barchart

While the focus has been on crude oil, a number of non-energy commodities are also in trouble.

Source: CRB

With the Fed's expected rate hike in 2015 and further dollar strength widely expected, the global deflationary environment is pressuring commodities across the board.


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Is China's anti-corruption campaign responsible for global commodities sell-off?

Commodities came under severe pressure yesterday, in part driven by some negative news out of China, the world's largest single consumer of natural resources.

CRB Commodity Index (Bloomberg)

The nation's GDP growth rate came in below expectations.

Source: Econoday

Anecdotal evidence suggests that some large hedge funds were forced to unwind commodity holdings across the board. This latest move has been extraordinarily painful for investors, who are left scratching their heads in trying to understand the fundamentals. Many point to China's lackluster industrial production as the cause for this weaker than expected growth. But there is a new theory emerging to explain China's negative surprise. Some analysts believe that the latest anti-corruption campaign is having a chilling effect on the nation's economy.

Worried about being accused of spending excesses, local officials have cut down on extravagant parties and gifts used to entice (and essentially bribe) central government bureaucrats. Restaurants and luxury goods have been hit especially hard.

Global Post: - Since the end of last year, Xi has spearheaded a drive to curb officials' notoriously lavish dinners and high-end gift-giving. At a Party meeting in December, he called for new regulations that require cadres to cut back on liquor, flowers and extravagant banquets. Some provinces even banned the use of red carpets to greet visiting officials.
...
"Abalone, baby birds, sharks, big prawns, sea cucumbers and geoduck clams are just some of the creatures who can breathe easier, for a bit at least," says Bill Bishop, a commentator in Beijing and author of the influential Sinocism newsletter. "But [food and beverage] businesses should expect more pain."

Can a slowdown in these sectors really have a significant effect on China's overall growth? Some economists are convinced that the impact is quite real and is indeed responsible for slower growth.

Bloomberg: - “The anti-corruption action by Xi is creating unprecedented phenomena, including an absolute fall in high-end restaurant sales,” said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, who previously worked for the European Central Bank. “It’s certainly a big factor dragging down short-term growth.”

And that in turn could be a big part of the story behind the latest sell-off in commodities.

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From our sponsor:

China's economic improvement is becoming visible in global markets

An unexpected rise in China's trade surplus announced today had a material impact on global markets. The increase in trade activity shows that China's economy may be picking up steam faster than originally anticipated (see discussion).

Source: Tradingeconomics

Exports rose 14% on a YoY basis against 4.5% consensus.

Source: Econoday

Global markets responded with the "risk-on" trade. The dollar sold off while commodities rallied.

CRB Commodity Index (source: barchart.com)

One of the broader developments in recent weeks in response to the China growth story has been the rally in US transport shares. DJ Transports index has materially outperformed DJI since mid-December.

Cognito: - China is the world’s second largest and most rapidly growing major economy. It is also the world’s largest exporter. As a result, a bottom and potential turn in China’s international shipments can be reasonably viewed as a sign of a bottom and potential turn in worldwide trade. Many of the twenty companies comprising the Dow Jones Transportation Average are engaged in the international shipment of goods. Hence their sales and earnings would benefit from an increase in global trade. Global transportation bellwether Federal Express/FDX is a prime example. Perhaps not coincidentally, FDX is attempting to emerge from a substantial reverse head-and-shoulders consolidation spanning more than two years!

This is not unique to the US, with Australian transport shares rallying as well. An improvement in the transport sector is good news for global growth because it tends to lead economic expansion.

DJ Transport vs. DJ Industrials (source: Yahoo/Finance)

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From our sponsor:

The anticipation of aggressive monetary expansion by the Fed woke up inflation expectations

Friday's poor employment report has given us a good window into how financial markets react to prospects of a monetary expansion. The weakness in the US labor conditions has significantly increased the probability that the FOMC will lean toward an outright asset purchase program. Friday's market reaction to this possible move by the Fed is shown in the table below.

Typically weak labor markets are an indication of decreased demand and should not result in price increases in industrial commodities or energy. Yet Friday's moves in copper and oil are clearly the result of QE expectations (see this discussion). Some analysts continue to argue that Friday's gasoline price increase is due to the Hurricane Isaac hampering the refining capacity in Louisiana. That is a difficult argument to make in the face of the CRB commodity index as a whole rising 90bp for the day.

In a classic response to a potential monetary expansion, the dollar had a sharp decline of nearly a percent (see this discussion). And as expected treasuries rallied after the jobs report increased the probability of the Fed's incremental buying. But later in the day a more troubling trend was established. The treasury curve steepened, with the 30y bond and other longer dated treasuries steadily selling off for the rest of the day.

Source: Bloomberg

Steepening Treasury Curve

Treasury yield changes Friday, 9/7/2012 (Source: Bloomberg)

Why did the treasury curve steepen in spite of clear expectations of the Fed's new securities buying program? The answer has to do with market participants beginning to price in materially higher longer term inflation. While shorter term inflation expectations remain relatively benign (though rising), the 10-year expectation for example (derived from inflation linked treasury prices) rose to 2.37% on Friday (chart below). The same expectations of elevated inflation in the future also drove up the price of gold.

10y inflation expectation intraday (10y "breakeven"; Bloomberg)

Rising long term inflation expectations intraday had pushed real yields for longer dated treasuries deeper into negative territory (see this post), forcing a selloff in the 30y bond, even as the shorter dated treasuries were up on the day. In fact the 10-year inflation expectation (and gold price) has been on the rise (chart below) since the market began anticipating additional easing from the Fed and the ECB.

10y inflation expectation (10y "breakeven"; Bloomberg)

An aggressive monetary easing program at this juncture could be a dangerous move for the FOMC. Structural changes in the US labor market since the Great Recession make the Fed's quest to materially bring down the unemployment rate rather fruitless (see discussion). And as an "unintended consequence", the central bank could boost inflation expectations - particularly the headline number that includes food and energy. With the US consumer sentiment already shaken (see this discussion), it wouldn't take much for spending to begin declining. Gasoline and food prices may not be a major part of the overall consumer spending in the US, but rapid increases can play an important psychological role in inhibiting spending, thus negating the very reason for the expansionary policy.

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Monetary expansion, the US dollar, and commodity prices

Economists continue to insist that there is no connection between the Fed's monetary expansion programs and increases in commodity prices, particularly agricultural products globally (discussed here). Here is a typical comment:

If it is commonly believed that the FOMC can cause a worldwide food shortage then we are truly in a dark age of macro. The FOMC has no ability to raise the price of commodities relative to national income, and I can't even imagine the rationale that monetary expansion could somehow increased prices internationally (that is, denominated in foreign currencies). The only way they could raise food prices in real terms is if they could spur increased food consumption domestically, which would be much more likely if they strengthened the dollar than if they weakened it. The FOMC can cause a lot of trouble, but this is just not on the list of problems they can cause, and certainly not via monetary expansion.

Unfortunately macroeconomic theory here diverges from market experience. Monetary expansion in the recent past corresponded with significant dollar weakness. The chart below shows the dollar weakening during both QE1 and QE2. "Twist" on the other hand did not involve monetary expansion and only focused on reducing the average duration of treasuries.

Source: BNP Paribas

Dollar weakness to any commodity trader is a signal to buy - which is not necessarily linked to demand fundamentals. Those who don't believe this should only take a look at the following chart comparing the dollar (DXY) with the CRB commodity index.

Source: Bloomberg

What's important to point out here is that the commodity price movements have been much larger than the dollar movements. In fact on a percentage basis the CRB range in the graph above is almost double the dollar range. That means even for currencies that are not in any way tied to the dollar (although a number of emerging market currencies are), when the dollar weakens, commodity prices move higher even if denominated in these other currencies. Commodity price increases due to dollar weakness therefore propagate globally even in nations whose currencies are not linked to the dollar. This empirical relationship drives global commodity markets even if supply/demand fundamentals don't warrant such adjustments. But when one faces tight and uncertain supply conditions to begin with (as we have now for agricultural commodities), dollar weakness will force an even larger commodities swings to the upside.

In 2011 the CIA was chastised for not being able to see the Arab Spring coming. Where did all that pro-democracy fervor come from all of a sudden? Why wasn't the CIA able to see key signs of the movement earlier? The answer has less to do with zeal for democracy and more to do with not being able to buy food. As food prices spiked across the Arab world, so did the protests.

Source: Bloomberg

Certainly in the long run macroeconomic fundamentals should play out. But we don't live in "the long run". Global markets take seconds to reprice, usually far overshooting/distorting the "fundamentals". And, as the Arab Spring showed, people don't wait for these fundamentals to settle to their expected levels.

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Implied US real long-term rates moving deeper into negative territory

The chart below compares the 10-year zero coupon US treasury yield with the 10-year zero coupon inflation swap rate. The difference is the implied 10-year zero coupon real rate (h/t Greg Trotter who will be writing a guest post on the topic) - which is becoming increasingly negative. We are not in a stagflation environment yet, but this indicator is certainly starting to point in that direction.

10-year zero coupon US treasury yield (orange) and the 10-year zero coupon inflation swap rate (white)

Just to put things on perspective, the CRB Commodity Index broke through 300 today and is now up 14% from the lows. As inflation expectations pick up (due to increasing rents and rising commodity prices), this push into the negative real rate territory is only going to get worse.

CRB Commodity Index

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The longer term trend in commodities will be driven by China, not central banks

Commodities seem to have found a support level after a massive selloff recently. The CRB index recently broke through the previous support, correcting back to the levels of the early days of QE2. Have we now stabilized?

CRB Commodity Index

This stabilization in the past few days seems to be driven by stories of a potential coordinated central bank action that will supposedly provide liquidity after the Greek election this weekend. Given the global slowdown, central banks seem to be the only source of support for risk assets, as global addiction to stimulus continues.

Reuters: - European Central Bank President Mario Draghi said on Friday the bank was ready to support euro zone banks, should it be required, while Bank of Japan Governor Masaaki Shirakawa said central banks can offer liquidity to calm markets in case the weekend Greek elections heighten tension.

But we've seen this movie before. A new action from central banks, even a coordinated one, is not expected to last long. As soon as stimulus stops, risk assets (such as commodities) begin to correct (unless another stimulus action is anticipated). Ultimately any lasting strength in the commodities markets will have to come from emerging markets growth - particularly from China. The chart below from the ISI Group shows how strong the relationship between China's corporate sales and global commodity valuations has been.

Source: ISI Group

If China experiences a "hard landing", it would be hard to imagine that the ECB, the Fed, and the BoJ can really do anything to prop up risk assets. And although analysts are not yet predicting such a sharp slowdown, even the expectations from within China have not been great:

Reuters: - China's annual economic growth could drop below 7 percent in the second quarter, an influential government adviser said in published remarks on Wednesday, the most pessimistic forecast of any government or private-sector economist.

Sub-7 percent growth would reflect the pace of the economy during the global financial crisis. China reported economic growth of just 6.6 percent in the first quarter of 2009.

Ultimately to understand the longer term trend in the commodity markets, one needs to pay far more attention to China than to central banks.

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With commodities at recent lows, inflation expectations have declined

The CRB commodities index broke through the apparent support level discussed earlier. Commodities continue to be pressured by the global slowdown and Eurozone driven market stress. Recent dollar strength also added momentum to the selloff.

CRB Commodities Index

With the correction in the commodities markets, US dollar inflation expectations are down sharply.  The 2x2 (two-year forward) TIPS implied inflation measure went from some 2.25% in March to under 1.5% now. As long as Europe continues to flare up and commodities are under pressure, inflation expectations should stay subdued.

2x2 TIPS implied forward inflation expectation

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The CRB index as a stress indicator

The CRB commodity index has been a good relative indicator of global risk appetite. During stressed conditions the expectations for global growth declines, forcing commodities lower. Oil prices for example respond to the upside during periods of economic growth. But they also move up due to regional tensions such as those associated with Iran. The CRB index on the other hand tends to respond mostly to growth expectations only.

The index peaked in the first half of 2011, driven by QE2. In the past 9 months the index has found a support level at about 293. This is the third time during the period that we've approached this level, and it looks as though we are again going to bounce up. But it tells us that this period of financial stress driven by Europe and the US slowdown is similar to what we experienced in September and December of last year. This will be one of the key indicators to watch for early signs of financial stress conditions going forward.

CRB commodity index

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Commodities don't provide "diversification" in a crisis

Investopedia is a great reference tool, particularly for those new to finance. But once in a while it provides advice that may not be entirely accurate. In an article entitled "Commodities: The Portfolio Hedge" Investopedia tells you why commodities help "diversify" your portfolio.

Investopedia: Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds....

Source: Investopedia

Yes it is true that the average correlation between equities and commodities from 1970 to 2003 has been negative. But if we've learned anything from the financial crisis, it is that correlations are not static and tend to spike in a deleveraging environment (whether you are dealing with mortgages, equities, corporate bonds, etc.). The chart below shows the correlation between the CRB Commodity Index (or equivalent basket of commodities) and US equities going back to1915 - almost a century of historical data.

Correlation between the CRB Commodity Index (or equivalent basket of
commodities) and US equities (historical correlation of monthly
changes, three-year window, source: Credit Suisse)

In a crisis a commodity basket may not be very effective in providing the diversification one would expect from historical correlations (reaching 80% in the recent crisis as commodities sold off with equities). The same thing happened in 1929. There is nothing wrong with having commodities in a portfolio of assets. One simply needs to be aware of the reasons the asset class is part of it. And the key motive to be long a broad basket of commodities is to protect against inflation, not to try "diversifying" the portfolio.


Update: Good comment from Kostas Kalevras:

There's basically a whole story about how Gorton et al 2004, induced institutional investors such as pension funds to invest in commodities futures as a hedge againt other asset classes. This investment was made through index funds and creates a perpetual long position on the underlying commodity futures. The liquidity injection was so large (of the order of $300bn by 2008) that it pushed oil and commodity futures to a contango situation playing a role in price increases as well as price volatility (due to the funds leaving partially after Lehman).

The process has been documented by various commentators, including the Fed:

• http://research.stlouisfed.org/wp/2011/2011-027.pdf
• http://stopgamblingonhunger.com/wp-content/uploads/2012/03/Better-Mkts-poslimits-comments-summary.pdf
• http://ideas.repec.org/p/lev/levppb/ppb_96.html

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From QE2 to Arab Spring - a Lesson for the ECB

As the ECB may potentially be forced into a round of "Quantitative Easing" (EUQE), dangers that span beyond Europe may loom. Known as the Arab Spring, the movement is often thought to be a "spontaneous" burst of pro-democracy fervor in the Arab world. But North African and Middle Eastern states have lived under dictatorships and tyrannical rulers for generations. These rulers were able to maintain their grip on power until, well, QE2 happened. Even though US inflation was fairly muted (although there is some debate about that), the US successfully exported dollar inflation into the rest of the world. Unlike in the US where food is around 14% of a typical family expenses, in many poor countries it constitutes a major portion of their earnings. Pushed to the limit with rapidly rising food prices, the Middle East and North Africa exploded.

Here is a quote from a research paper from the World Bank published earlier this year:

Global food prices remain high, partly due to increasing fuel prices, and the World Bank’s Food Price Index is around its 2008 peak. Since June 2010, an additional 44 million people fell below the $1.25 poverty line as a result of higher food prices. Simulations show that a further 10% increase in the Food Price Index could lead to 10 million people falling into poverty, and a 30% increase could increase poverty by 34 million people. Low-income and lower-middle-income countries are experiencing on average 5% points higher food price inflation compared to better-off countries. A special focus on the Middle East and North Africa region in this issue shows double-digit food price inflation in Iran, Egypt and Syria, with more moderate levels in other parts of the region...

Even China started showing signs of unrest due to rising food prices. The chart below shows the CRB commodity index' rapid rise as QE2 took effect, sparking major unrest in country after country.

So before the ECB (or the Fed) embarks on another round of QE, claiming that "core" inflation remains tame, they should consider the "unintended consequences" such as increased global suffering and unrest. The biggest impact of Arab Spring on the global economy was the revolution in Libya that caused global oil prices to spike.  Next time around it may be countries such as Pakistan and Iran, with much greater risks to global stability.

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