Commodities

Commodities, Supply-chains and Structural Changes in Demand
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Commodities, Supply-chains and Structural Changes in Demand

Macro Letter – No 139 – 18-06-2021

Commodities, Supply-chains and Structural Changes in Demand

  • Talk of a new commodity super-cycle may be premature
  • Once GDP growth returns to trend, commodity demand will moderate
  • Fiscal and monetary relief are key to maintaining growth and demand
  • Structural changes in energy demand will prove more persistent

As the spectre of inflation begins to haunt economists, many market commentators have started to focus on commodity prices in an attempt to predict the likely direction of the general price level for goods and services. This indexing of the most heterogeneous asset class has always struck me as destined to disappoint. Commodity prices change in response to, often, small variation in supply or demand and the price of some commodities varies enormously from one geographic location to another. Occasionally the majority of commodities rise in tandem but more frequently they dance to their own peculiar tunes.

Commodity analysts tend to focus on Energy and Industrial Metals foremost; Agricultural Commodities, which are more diverse by nature are often left as a footnote. Occasionally, however, a demand-side event occurs which causes nearly all sectors to rise. The Covid-19 event was just such a shock, disrupting global supply-chains and consumer demand patterns simultaneously.

The chart below shows the CRB Index since 1995: –

Source: CRB, Yardeni

This chart looks very different to the energy heavy GSCI Index, which is weighted on the basis of liquidity and by the respective world production quantities of its underlying components: –

Source: S&P GSCI, Trading Economics

The small rebound on the chart above is not that insignificant, however, it equates to a 55% rise since the lows on 2020. The fact that prices collapsed, as the pandemic broke, and subsequently soared, as vaccines allowed economies to reopen, is hardly surprising. Economic cycles wield a powerful influence over commodity prices; short-term, inelastic, supply, confronted by an unexpected jump in demand, invariably precipitates sharp price increases.

The lockdown which followed the initial outbreak of the virus, led to an abrupt change in consumer demand; hotels and travel were out, remote working was in. Whilst house prices were already supported by a sharp lowering of interest rates and debt forbearance measures, the price of lumber, for home improvements and property extensions, exploded: –

Source: Trading Economics

Similar patterns were evident in Steel and Copper, but also due to shortages and bottlenecks in the semiconductor supply-chain, which led a slowing of automobile production, in turn prompting a rise in the price of both for new and used cars.

The recent resurgence in commodity prices has encouraged suggestions that a new commodity super-cycle is underway, however, these are relatively rare events. The most recent cycle is generally thought to have begun with the rise of Chinese demand in the late 1990’s and ended abruptly with the financial crisis in 2008/2009. Since the crisis Chinese growth has moderated, although the rise of India may see another wave of rapid industrialisation at some point. The chart below, however, portrays a different narrative, suggesting that the 2008 peak was merely a corrective wave from the 1980 peak. The new super-cycle has just begun, it will peak some-time around 2045: –

Source: Janus Henderson, Stifel Report June 2020. Note: Shown as 10yr rolling compound growth rate with polynomial trend at tops and bottoms. Blue dotted line illustrates a forecast estimation. Warren & Pearson Commodity Index (1795-1912), WPI Commodities (1913-1925), equal-weighted (1/3rd ea.) PPI Energy, PPI Farm Products and PPI Metals (Ferrous and Non-Ferrous) ex-precious metals (1926-1956), Refinitiv Equal Weight (CCI) Index (1956-1994), and Refinitiv Core Commodity CRB Index (1994 to present).

Another short-term factor, which has exacerbated the rise in the price of key commodities over the past year, is the ongoing trade tensions between the US and China. Tariff increases have increased costs for importers and wholesalers, meanwhile the effect of the Great Financial Crisis has been evident for the past decade in the shortening of global supply-chains. Covid accelerated this de-globalisation, forcing many firms to seek out new sources of supply. The long-run effect of these adjustments will be stronger, deeper supply-chains, but the short-run cost must be paid for by the importer, the producer or the consumer.

A part of the new commodity super-cycle argument is based on more structural factors. The reduction of carbon emissions will entail the use of vast amounts of metals. Electrification calls for copper; silver will be needed for photovoltaic panels; electric vehicles require aluminium, nickel, graphite, cobalt and lithium, together with numerous rare-earth metals – of which China is fast becoming the monopoly supplier.

The last great structural shift in energy was from coal to oil. Colonel Drake’s discovery in Pennsylvania in 1859 and the Spindletop find in Texas in 1901 set the stage for the new oil economy, yet it took until 1919 for gasoline sales to exceed those of kerosene.

Although coal-gas was used for most of the 19th century and the first US natural gas pipeline was built in 1891, prior to the 1920s, the vast majority of natural gas produced as a by-product of oil extraction was simply flared away. Superior welding techniques during the interwar years marked a boom in natural gas adoption, but major pipelines were still under construction as late as the 1960’s.

The time-line from Colonel Drake striking pay-dirt in 1859 to mass natural gas adoption took more than a century. Technology and innovation move at a much faster pace today, yet the infrastructural investment needed to transform from carbon to renewable energy will take decades rather than years.

Meanwhile, there remain shorter-term reasons to doubt the arrival of a new commodity super-cycle so precipitously upon the last. Chinese GDP growth has fallen sharply from the double-digit rates of the last decade. Its working age population is shrinking, added to which the People’s Bank of China seem reluctant to allow credit expansion on the scale of previous cycles. Rebalancing towards domestic consumption continues to be official policy.

There is near-term evidence of energy supply constraints but over the longer-run oil and gas production, especially from the likes of the US frackers, can raise output rapidly in response to increases in the price of Crude. The chart below shows the fluctuations in the Baker Hughes US Oil Rig count over the past decade, no shortage of capacity is apparent here: –

Source: Baker Hughes, Trading Economics

Agricultural commodities tend to operate on even shorter supply cycles. If supply constraints send Wheat prices higher, farmers respond by switching away from Corn. Seasonal adjustments can be rapid.

The GSCI may have hit its lowest since the 1980’s last April and prices may have doubled since then, but it is still more than 75% below its June 2008 peak. Further upside may be seen as the global economy makes up for a year of lost economic growth, but as economic growth returns to normality demand for energy is likely to moderate just as fresh supply comes on stream.

The spending plans of the US administration may maintain demand in the US but China seems determined to nip its domestic credit bubble in the bud. In broad terms these factors counter-balance one another. According to the Federal Reserve, US GDP is forecast to range between 5% and 7.3% in 2021, falling to 2.5% to 4.4% in 2022 and 1.7% to 2.6% in 2023, meanwhile, according to the OECD, Chinese growth will moderate from 8.5% in 2021 to 5.8% in 2022.

Conclusion and Investment Opportunities

Back in January Goldman Sachs predicted a new commodity super-cycle. They see rising wages leading to faster, commodity price positive, home formation and more synchronised social policies, akin to those of 1960s ‘War on Poverty’ campaign. In other respects they believe this cycle has stronger parallels to the 1970s than the 2000s. Goldman expect industrial capex to run at 2000 levels whilst social rebuilding generates a 1970s style consumer boom.

S&P present some of these arguments in a useful infographic: –

Source: S&P Global

US unemployment has fallen from 11.1% to 5.8% during the last 12 months, even in the harder hit Euro Area it has declined from 8.7% to 8%, whilst Chinese data has followed a similar trajectory, falling from 6.1% to 5% since February 2020. Nonetheless, much of the global economy remains in some form of lockdown, with economic activity fuelled by fiscal spending. It remains difficult to envisage the conditions for a near-term sustainable economic boom. Remove global monetary and fiscal relief and commodity demand will evaporate.

As a general rule, in commodity and financial markets, what goes up price must eventually come back down. The price of US Stud Lumber (chart above) is well off its highs. Governments and their central bankers can attempt to remove the punch-bowl, but the markets are unlikely to take it well.

Inflation or Employment
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Inflation or Employment

In the Long Run - small colour logo

Macro Letter – No 95 – 20-04-2018

Inflation or Employment

  • Inflationary fears are growing and US rates continue to rise
  • Employment has become more flexible since the crisis of 2008/2009
  • Commodity prices have risen but from multi-year lows
  • During the next recession job losses will rapidly temper inflationary pressures

Given the official policy response to the Great Financial Recession – a mixture of central bank balance sheet expansion, lower for longer interest rates and a general lack of fiscal rectitude on the part of developed nation governments – I believe there are two factors which are key for stock markets over the next few years, inflation and employment. The fact that these also happen to be the two mandated targets of the Federal Reserve – full employment and price stability – is more than coincidental. My struggle is in attempting to decide whether demand-pull inflation can survive the impact of a rapid rise in unemployment come the next recession.

Inflation and the Central Bankers response is clearly the new narrative of the financial markets. In his latest essay, Ben Hunt of Salient Partners makes some fascinating observations – Epsilon Theory: The Narrative Giveth and The Narrative Taketh Away:-

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

…This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today. 

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

The author goes on to discuss the way that inflation and the war on trade has derailed the global synchronized growth narrative. Dr Hunt writes at length about narratives; those who have been reading my letters for a while will know I regularly quote from his excellent Epsilon Theory.

The narrative has not yet become flesh, to coin a phrase, but in the author’s opinion it will:-

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics. 

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

The two charts below employ natural language processing techniques. They show how the inflation narrative has rapidly increased during the last 12 months. I shall leave Dr Hunt to elucidate:-

… analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-one

Source: Quid.inc

What this chart shows is the clustering of content in 1,400 Bloomberg articles, which mention US inflation, between April 2016 and March 2017. The graduated colouring – blue earlier and red later in the year – enriches the analysis.

The next chart is for the period April 2017 to March 2018:-

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-two

Source: Quid.Inc

During this period there were 2,400 articles (a 75% increase) but, of more relevance is the dramatic increase in clustering.

What is clear from these charts is the rising importance of inflation as a potential driver of market direction. Yet there are contrary signals that suggest that economic and employment growth are already beginning to weaken. Can inflation continue to rise in the face of these headwinds. Writing in The Telegraph, Ambrose Evans-Pritchard has his doubts (this transcript is care of Mauldin Economics) – JP Morgan fears Fed “policy mistake” as US yield curve inverts:-

US jobs growth fizzled to stall-speed levels of 103,000 in March. The worldwide PMI gauge of manufacturing and services has dropped to a 14-month low. The average “Nowcast” tracker of global growth has slid suddenly to a quarterly rate of 3.2pc from 4.1pc as recently as early February.

Analysts at JP Morgan say the forward curve for the one-month Overnight Index Swap rate (OIS) – a market proxy for the Fed policy rate – has flattened and “inverted” two years ahead. This is a collective bet by big institutional investors and fund managers that interest rates may be falling by then.

…The OIS yield curve has inverted three times over the last two decades. In 1998 it proved to be a false alarm because the Greenspan Fed did a pirouette and flooded the system with liquidity. In 2000 it was a clear precursor of recession. In 2005 it signaled that the US housing boom was already starting to deflate.

…Growth of the “broad” M3 money supply in the US has slowed to a 2pc rate over the last three months (annualised)…pointing to a “growth recession” by early 2019. Narrow real M1 money has actually contracted slightly since November.

…RBC Capital Markets says this will drain M3 money by roughly $300bn a year…

…Three-month Libor rates – used to set the cost of borrowing on $9 trillion of US and global loans, and $200 trillion of derivatives – have surged 60 basis points since January.

…The signs of a slowdown are even clearer in Europe…Citigroup’s economic surprise index for the region has seen the worst four-month deterioration since 2008.  A reduction in the pace of QE from $80bn to $30bn a month has removed a key prop. The European Central Bank’s bond purchase programme expires altogether in September.

…The global money supply has been slowing since last September. The Baltic Dry Index measuring freight rates for dry goods peaked in mid-December and has since dropped 45pc.

Which brings us neatly to the commodity markets. Are real assets a safe place to hide in the coming inflationary (or perhaps stagflationary) environment? Will the lack of capital investment, resulting from the weakness in commodity prices following the financial crisis, feed through to cost-push inflation?

The trouble with commodities

Commodities are an excellent portfolio diversifier because they tend to be uncorrelated with stock, bonds or real estate. They have a weakness, however, since to invest in commodities one needs to accept that over the long run they have a negative real-expected return. Why? Because of man’s ingenuity. We improve our processes and invest in new technologies which reduce our production costs. We improve extraction techniques and enhance acreage yields. You cannot simply buy and hold commodities: they are trading assets.

Demand and supply of commodities globally is a complex challenge to measure; for grains, oilseeds and cotton the USDA World Agricultural Supply and Demand Estimates for March offers a fairly balanced picture:-

World 2017/18 wheat supplies increased this month by nearly 3.0 million tons as production is raised to a new record of 759.8 million

Global coarse grain production for 2017/18 is forecast 7.0 million tons lower than last month to 1,315.0 million

Global 2017/18 rice production is raised 1.2 million tons to a new record led by 0.3- million-ton increases each for Brazil, Burma, Pakistan, and the Philippines. Global rice exports are raised 0.8 million tons with a 0.3-million-ton increase for Thailand and 0.2- million-ton increases each for Burma, India, and Pakistan. Imports are raised 0.5 million tons for Indonesia and 0.3 million tons for Bangladesh. Global domestic use is reduced fractionally. With supplies increasing and total use decreasing, world ending stocks are raised 1.4 million tons to 144.4 million and are the second highest stocks on record.

Global oilseed production is lowered 5.7 million tons to 568.8 million, with a 6.1-million-ton reduction for soybean production and slightly higher projections for rapeseed, sunflower seed, copra, and palm kernel. Lower soybean production for Argentina, India, and Uruguay is partly offset by higher production for Brazil.

Cotton – Lower global beginning stocks this month result in lower projected 2017/18 ending stocks despite higher world production and lower consumption. World beginning stocks are 900,000 bales lower this month, largely attributable to historical revisions for Brazil and Australia. World production is about 250,000 bales higher as a larger Brazilian crop more than offsets a decline for Sudan. Consumption is about 400,000 bales lower as lower consumption in India, Indonesia, and some smaller countries more than offsets Vietnam’s increase. Ending stocks for 2017/18 are nearly 600,000 bales lower in total this month as reductions for Brazil, Sudan, the United States, and Australia more than offset an increase for Pakistan.

It is worth remembering that local market prices can be dramatically influenced by small changes in regional supply or demand and the vagaries of supply chain logistics. Added to which, for US grains there is heightened anxiety regarding tariffs: they are expected to be the main target of the Chinese retaliation.

Here is the price of US Wheat since 2007:-

Wheat since 2007

Source: Trading Economics

Crisis? What crisis? It is still near to multi-year lows, although above the nadir of the financial crisis in 2009.

The broader CRB Index shows a more pronounced recovery, it has been rising since the beginning of 2016:-

CRB Index since 2007 Core Commodity Indexes

Source: Reuters, Core Commodity Indexes

Neither of these charts suggest that price momentum is that robust.

Another (and, perhaps, more global) measure of economic activity is the Baltic Dry Freight Index. This chart shows a very different reaction to the synchronised increase in world economic growth:-

Baltic Dry Index - Quandl since 2007

Source: Quandl

In absolute terms the index has more than tripled in price from the 2016 low, nonetheless, it is still in the lower half of the range of the past decade.

Global economic growth may have encouraged a rebound in Copper, another industrial bellwether, but it appears to have lost some momentum of late:-

Copper Since 2007

Source: Trading Economics

Brent Crude Oil also appears to be benefitting from the increase in economic activity. It has doubled from its low of two years ago. The US rig count has increased in response but at 800 it remains at half the level of a few years ago:-

Brent Oil Since 2007

Source: Trading Economics

US Natural Gas, which might still manage an upward price spike on account of the unseasonably cold weather in the US, provides a less compelling argument:-

US Nat Gas Since 2007

Source: Trading Economics

Commodity markets are clearly off their multi-year lows, but the strength of momentum looks mixed and, in grains and oil seeds, global supply and demand look fairly balanced. Cost push inflation may be a factor in certain markets, but, without price-pull demand, inflation pressures are likely to be short-lived. Late cycle increases in commodity prices are quite common, however, so we may experience a short-run stagflationary squeeze on incomes.

Conclusions and investment opportunities

When ever I write about commodities in a collective way, I remind readers that each market is unique, pretending they are homogenous is often misleading. The recent rise in Cocoa, after a two-year downtrend resulting from an increase in global supply, is a classic example. The time it takes to grow a Cocoa plant governs the length of the cycle. Similarly, the lead time for producing a new ship is a major factor in determining the length of the freight rate cycle. Nonetheless, at the risk of contradicting myself, what may keep a bid under commodity markets is the low level of capital investment which has been a hall-mark of the long, listless recovery from the great financial recession. I believe an economic downturn is likely and job losses will occur rapidly in response.  

I entitled this letter ‘Inflation or Employment’, these are the factors which will dominate Central Bank policy. Currently commentators view inflation as the greater concern, as Dr Hunt’s research indicates, but I believe those Central Bankers who can (by which I mean the Federal Reserve) will attempt to insure they have raised interest rates to a level from which they can be cut, rather than having to rely on ever more unorthodox monetary policies.

Linear Talk – Macro Roundup for September 2017
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Linear Talk – Macro Roundup for September 2017

TRANSCRIPT

Linear Talk – Macro Roundup – 17th October 2017

Financial market liquidity returned after the thin trading which is typical of August. Stocks and crude oil were higher and the US$ made new lows. But a number of individual markets are noteworthy.

Stocks

The S&P 500 and the Nasdaq 100 both achieved record highs last month (2519 and 6013 respectively). In the case of the S&P this is the sixth straight month of higher closes, even as flow of funds data indicates a rotation into international equity markets.

The Eurostoxx 50 took comfort from the US move, closing the month at its high (3595) yet it remains below the level seen in May (3667) tempered, no doubt, by the strength of the Euro.

German Elections, showing a rise in support for the nationalist AfD and the prospect of an unconstitutional independence referendum in Catalonia, made little impression on European equity markets. The DAX also closed at its high (12,829) but, it too, failed to breach its record for the year of 12,952 witnessed in June.

Spain’s IBEX 35 was more susceptible to the political fracas in its north eastern region, but with other markets rising, it traded in a narrow range, closing at 10,382 on the eve of the referendum, having actually begun the month lower, at 10,329.

The Japanese Nikkei 225 remained well supported but still failed to breach resistance, making a high of 20,481 on the 18th. It has since taken out the old high. This move is supported by stronger economic data and revised growth forecasts from the IMF (released after month end).

Currencies

Currency markets have been dominated by the weakness of the US$ since January. Last month was no exception. The US$ Index made a new low for the year at 90.99 on the 8th but swiftly recovered, testing 93.80 on the 28th. Technically, this low breached the 50% correction of the move from the May 2014 low of 78.93 to the January 2017 high of 103.81. Further support should be found at 88.43 (61.8% retracement) but price action in EURUSD suggests that we may be about to see a reversal of trend.

EURUSD made a new high for the year at 1.2094 on the 8th, amid rumours of ECB intervention. By month end it had weakened, testing 1.1721 on 28th. This has created a technical ‘outside month’ – a higher high and lower low than the previous month. For this pattern to be negated EURUSD must trade back above 1.2094.

EURGBP also witnessed a sharp correction the initial Sterling weakness which was a feature of the summer months. From an opening high of 0.9235 Sterling steadily strengthened to close at 0.8819. Nonetheless, Sterling remains weaker against the Euro than in 2013, amid fears of a ‘No Deal’ on Brexit and continued expectations of an economic slowdown due to the political uncertainty of that exit.

Bonds

US 10yr Treasuries made a new low yield for the year at 2.02% on 8th. This is the lowest yield since the November 2016 election, however, expectations of another rate hike and the announcement of a planned balance sheet reduction schedule from the Federal Reserve, tempered the enthusiasm of the bond bulls. By month end, yields had risen 32bp to close at 2.34%.

In Germany 10yr Bund yields followed a similar trajectory to the US. Making a low of 0.29% on 8th only to increase to 0.52% by 28th. Increasing support for the AfD in the election, was largely ignored.

A trade which has been evident during 2017 has been the convergence of core and peripheral European bond yields. The larger markets such as Italy and Spain have mostly mirrored the price action of Bunds, their spreads widening moderately in the process. The yield on Portuguese and Greek bonds, by contrast has declined substantially, although there was a slight widening during September. Greek 10yr bonds, which yielded 8.05% at the end of January, closed the month at 5.67%. Over the same period 10yr Bunds have seen yields rise by 6bp.

UK 10yr Gilts also had an interesting month. From a low of 0.97% on 7th they reached 1.42% on 28th amid concerns about Brexit, the recent weakness in Sterling (which appears to have been temporarily reversed) and expectations that Bank of England Governor, Carney, will raise UK interest rates for the first time since June 2007. It is tempting to conceive that either the rise in Gilt yields or the recent rise in Sterling is wrong, these trends might both continue. Long Sterling and Short Gilts might be a trade worthy of consideration.

Commodities

Perhaps anticipating the IMF – World Economic Outlook – October update, in which they revised their world growth forecasts for 2017 and 2018 upwards, the price of Brent Crude rallied to a new high for the year on 26th – $59.49/bbl. Aside from expectations of an increase in demand, the effect of two hurricanes in the US and a strengthening of resolve on the part of OPEC to limit production, may be contribution factors.

Copper also hit a new high for the year, trading $3.16/lb on 4th. Technically, however, it made an outside month (higher high and lower low than August) a break above $3.16/lb will negate this bearish formation. I remain concerned that Chinese growth during 2017 has been front-loaded. Industrial metal markets may well consolidate, with a vengeance, before deciding whether increased demand is seasonal or structural.