June 17, 2013

Reasons for the commodities’ revival: real rates and asset class rotation - Part 2

Commentary by Senior Market Strategist Robert Balan

«When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up. »

Ray Dalio

Last week, we started to point out factors that will contribute to the commodity revival in the second part of the year. We mentioned the negative sentiment on commodities, the US dollar and China. This week, other factors will be explored in detail such as lower real interest rates and the asset leadership rotation sequence.

There are reasons to believe that several structural sector rotations are about to take place, which will help boost commodities ahead of the pack. The first rotation event involves real interest rates which should soon peak, possibly as early as post-FOMC meeting in June 18-19 during which we expect the Fed to regain control over its wayward communication strategy over the QE tapering process. Commodities have suffered greatly after a rise of real interest rates in the past few months as a consequence of better US growth prospects -- pushing up nominal rates at a time when inflation and inflation expectations remain low due to the structural lag of inflation rates relative to growth. We are getting some support for this view in the recent decline in nominal rates -- the 10yr US Treasury yield may have peaked at 2.30% earlier in the week (spot on our intermediate target) and may fall to 1.90% - 1.80% during Q3 2013.

The fall in real rates should be further exaggerated by what we expect to be an unexpected rise in inflation over the next few months, as the impact of the commodity prices increases during H1 2012 finally shows up in the inflation data. Falling nominal rates and rising core inflation data should bring real interest rates lower, which should benefit the energy and metal (base and precious) sectors over the short-term at least.

The other sector rotation event which is slowly taking place is the structural rotation of asset classes in response to the changes in the phases of the credit/growth (business) cycle. We have a stylized view of the business cycle in the form of a two-humped cycle (caused by the different destinations of credit at the start of a recovery phase). However, the responses of the various asset classes remain generally the same over the two half-cycles that comprise the full cycle construct. At the late part of cycle's down phase, bonds outperform as growth and inflation decline. At the bottom of the next half-cycle (which we set at mid-2012) it was the equities turn to outperform and have been doing so in the past few months (see the chart of the week).

But two weeks ago, we may have seen the beginning of another shift in outperformance -- as the sequential changes imply, it is commodities turn to lead the pack. If this is the case, (and we will soon see if our hypothesis gets the timing right), equities and commodities should rise together until the peak of the half-cycle, which we believe will occur in Q4 this year. But commodities will likely outperform at the late part of the plateau, while equities start to decline. This is the sequence which we saw in late 2007, at the start of the Great Recession. As a matter of interest, we also point out that the same sequence was seen in 2001, after the top of the Technology Bubble. We may see that same commodities outperformance late in the current cycle sometime at year-end or by Q1 2014.

Commodities and Economic Highlights
Commentary by Robert Balan, Alessandro Gelli, Marion Megel and Alban De Rougé

Lower transparency in the oil market could increase volatility

In April 2013, non-OECD countries consumed more oil than OECD countries for the first time, according to the US Energy Information Administration. The rising share of non-OECD oil demand over global oil demand is making the oil market less transparent. OECD countries have dominated the oil market for years. But its share of global oil demand fell from 64% in 1999 to 51% in 2012. OECD countries and especially its largest member, the USA have contributed to make the oil market more transparent by publishing oil data at a high frequency. However, the significance of those reports are declining. The share of US oil demand over global oil demand also fell from 26% in 1999 to 21% in 2012.

On the other hand, non-OECD countries, which are becoming more important players in the oil market, do not provide as much and as reliable data on the oil market than OECD countries. For example, China, the world’s second largest oil consumer, does not publish oil demand data. Market participants use implied demand (imports + production ± change in inventories) to estimate Chinese oil consumption. Several major agencies are trying to reduce the growing opaqueness of the oil market by combining their data into one large database: the Joint Organisations Data Initiative (JODI).

Nonetheless, data are missing or are incomplete for large oil players such as Russia. The lack of data or unreliable estimations from non-OECD countries are hence likely to gradually have a larger impact on the oil market, due to the growing share of non-OECD oil consumption. Lower transparency could trigger higher volatility in oil prices.

Oil supply disruptions are mitigating weaker demand expectations

The oil market is well supported between supply concerns outside North America and lower demand growth expectations. Supply disruptions have emerged in several places. In Libya, the national oil company said that production fell in May 2013 by almost one third to less than 1 million b/d due to protests. Dispute between armed groups for the control of oilfields could also had an impact on crude oil output. The unstable political situation increase uncertainty about Libyan crude oil exports. They are hence likely to remain volatile.

Not far from Libya, crude oil exports from South Sudan, which were recently restarted at around 200’000 b/d, are likely to be stopped due to Sudan’s decision to halt the major oil pipeline that transports South Sudanese crude oil. In Yemen, the main oil export pipeline with a capacity of 110’000 b/d was attacked last Friday, reducing crude oil exports. The oil infrastructure in Yemen has been frequently attacked since 2011 due to growing political tensions. Moreover, the maintenance season has started at North Sea’s oilfields, reducing crude oil supply and increasing the risk of unplanned outages. Two weeks ago, crude oil output was halted at the 200’000 b/d Buzzard oilfield in the North Sea due to technical issues.

Production from Saudi Arabia rose in May 2013, due to stronger domestic demand and higher foreign demand from Asian countries that need to replace Iranian crude oil supply. Since 2011, Iranian crude oil production fell by more than 1.0 million b/d due to the sanctions that prevented exports. This is the equivalent of the size of Libyan crude oil production last year. These supply issues could have a larger impact on the oil market in the coming weeks due to stronger seasonal demand, pushing oil prices higher.

Copper supply is looking increasingly vulnerable

The copper physical market is showing additional signs of tightness. The production losses from Kennecott’s Bingham Canyon in the US (following the massive landslide in April 2013), and from Grasberg in Indonesia (following a tunnel collapse that killed 28 workers), continue to have a profound impact on the mine supply of the red metal. Grasberg is indeed the world’s second largest copper mine and Bingham Canyon usually supplies 20% of the US needs. Production risks are also rising in Chile, where mining labour contracts will be renegotiated this year, which happens to be also an election year in the world’s largest copper producing country.

In addition to the mine production losses, market participants have also reported a scrap supply squeeze, which usually accounts for a little less than a third of copper global usage (including direct scrap). The combined effects of: (1) a slowdown in industrial activities in Europe (the largest producer or scrap copper) and (2) the fall in copper prices encouraging scrap dealers to sit on stocks, have severely reduced supply. Several trading houses estimate that scrap global availability could tumble by 10% to 20% this year, representing a loss of 350,000-700,000 tonnes of supply, equivalent to the closure of a top producing mine. Consequently, while scrap is usually traded at a discount to refined metal prices, the high-grade scrap has moved in May to a premium in China and in the US. The shortage of scrap has already prompted three of China’s largest smelters to shut down some operations for a combined capacity of 400,000 tonnes annually, including Jiangxi Copper, Jinchuan, and Yunnan Copper.

Following the mine production losses and the scrap shortage, premiums have climbed further in the US, Europe and Asia. In Shanghai, the grade A copper cathode is now priced $150/tonne over the market fixing, more than doubling from the start of the year. In Europe, premiums for that same cathode have also nearly doubled from just $59/tonne at the end of February 2013 to $117/tonne last week. In the US, premiums for high grade cathodes have soared to $198/tonne, up from just $121/tonne in April 2013.

Corn prices are supported by an important supply risk premium

Last week, the US Department of Agriculture (USDA) decreased the corn yield by 1.5 bushels per acre (b/a) to 156.5 b/a, due to the late planting this year. This revision contributed to reduce the US corn production estimation to “only” 14 billion bushels. This would nonetheless be a record harvest if realised. Ending corn inventories could hence reach 1.9 billion bushels, 2.5 times higher than last year.

The USDA is thus pointing to lower corn prices. So why are corn prices remaining at a high level? Corn prices indeed remained 3% above prices reached in the first part of 2012 and are significantly higher than prices in 2009 and 2010 (+70%). The major reason is again concerns on the corn crop. Indeed, the USDA’s forecast on corn crop has important downside potential. The late planting could reduce further the corn yield. According to agronomic research, a yield penalty is observed when planting occurs after mid-May. Moreover, 43% of the corn crop has been planted during the same week. This will create a situation where a large portion of the crop is going through the riskiest stage, pollination, at the same time, elevating the risk of more widespread damage occurring if a major hot or dry spell hits the Corn Belt during that timeframe.

Thus, the market remains cautious on the US corn crop. Last year, the worst drought in more than 50 years took the market by surprise, which anticipated a record crop like this year and failed to materialise. The 2012 drought contributed to an increase in corn prices of 29% in only 9 days. The supply risk premium on the corn crop could hence prevent corn prices to decline until the pollination is done at the end of July.

Chart of the week: Asset class leadership rotation

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