Wednesday, July 22nd, 2015

Circular Logic

Our theme this week is the weakness of global commodity prices. Copper has fallen 13% year to date and is down 46% from its 2011 peak. Iron ore for delivery to China has fallen 26% year to date and is 74% down from its peak, also in 2011. There is no exchange-traded base metal contract which is showing a profit in 2015. The story in precious metals is the same, with gold down 46% from its high and looking poised to break below $1000. When Brent crude fell from $114 to $46/bbl in less than six months, some investors hoped that there would be an equally powerful rally as soon as the Saudis managed to restore pricing discipline. Six months later the rally has petered out with a high of $67/bbl and the price is threatening to drop below $50 again. So, what does it all mean?

We think global consumption forecasts, particularly relating to China are just too high. For some commodities (e.g. iron ore and aluminium) part of the blame for falling prices rests with some aggressive increases in supply. For others, like copper, the data on apparent consumption may have been distorted by hoarding and its use as collateral for hard currency borrowing. Before the slowdown in Chinese GDP growth these forecasts looked optimistic; now they are starting to look just fanciful. This has obvious implications for the growth forecasts for other emerging markets and their terms of trade with developed markets, including their exchange rates.

Commodity prices are also be responding to the approach of the first US rate rise in over seven years. The link between interest rates and gold prices is well understood, but the diversification of institutional portfolios into commodities has increased sensitivity of the whole asset class to the rest of financial markets, above all the recent strength of the US dollar. Dollar strength is a major contributor to the decline in commodity prices and also powerful evidence that this trend is expected to continue.

The US equity market as a whole is not directly affected by falling commodity prices, but it is affected by their fellow travellers. Further dollar strength adds to the translation pressure on overseas earnings while the weakness of growth in China and emerging markets impacts volume forecasts. This has been a recurring theme for the last two results seasons, and leaves the consensus of 12% growth for 2016 and 2017 looking vulnerable. This would not be the first time that consensus estimates were too high, but the combination of incrementally rising rates and falling forecasts is not propitious.

Adjusting the portfolio to this paradigm is not difficult. Our sector models in all regions and all asset classes (equity, investment grade credit and high yield) continue to recommend an aggressive underweight in Energy and Basic Materials. Few of our clients disagree with this idea, but we find that many are nervous about the level of benchmark risk implied by our stance. Likewise many clients still have exposures to emerging markets which are not consistent with their worst case scenarios for commodity prices, let alone ours. The same goes for developed markets like Australia and Canada.

Some investors just regard this as circular logic, (rising dollar validates falling commodity prices which validates global growth fears, which validates a rising dollar). The trouble is that the logic was every bit as circular in 2010 and 2011 – only the other way around.

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