WHERE ARE THE COMMODITY MARKETS HEADED?

By Data Diary:

I’m as prone to selection bias as the next man – so keep that in mind while we try to discern where commodities are heading in the near term.

Market indicators

1) The USD is rallying – and the CRB has rolled over

With at least the juiciest dishes on the commodities smorgasbord priced in USD, the recent strength in the greenback will hurt commodities. Demand may have become more price inelastic than in earlier years, but with the CRB breaking its recent support expect further weakness to come.

2) China stockmarkets and the Baltic Dry Index are also soft

If the BDI is a reasonable indicator of bulk commodity demand, then it’s hinting at weakness.  Similarly, if China has lead the global recovery, the relative underperformance of its stock markets suggest that something is amiss.

Put these together and you get a near term picture suggesting lower commodity prices are on the way.

Economic indicators

1) Leading indicators – as we noted here, it looks suspiciously like the OECD CLI is marking out a turn.  This indicator has a reasonable track record in forecasting industrial production.

As Albert Edwards pointed out (analysed in “Leading indicators as buy/sell indicators for equities markets” here) – the lesson from the Japanese experience of the 90’s was to sell the rally when the stimulus was removed.  With the US and China both applying their own versions of the withdrawal method (though we note that Japan is still pumping away as furiously as ever) now is that time .

2) Purchasing Manager Surveys – Quite apart from the decline in China’s PMI (discussed here) – consider what these charts are saying:

As with many market signals in recent times, the bounce back in the steel price has been unusual as it has not yet been accompanied by supply constraints. In the context of a slowing in new orders growth (as might be expected if the OECD CLI were reading the pulse correctly) this inconsistently looks even weirder.   (See here for Markit’s steel report.)

The disconnect between price and supply is even stronger in the copper market.  You could reasonably argue that the market is anticipating shortages to come as the new orders are stronger in this metal with only the US looking like turning weaker.  Note however the new order to inventory ratio (not shown – go to Markit’s report here for further charts) is falling, suggesting speculative balances are on the rise.

Finally, aluminium too has seen its price run ahead of supply.  Same picture as copper for the new orders too and (would you believe it?) the new orders to inventory has also turned down suggesting at the very least a cap on prices to come. (Full Markit report here.)

Conclusion:

Short term – the odds are for a pullback in prices.  Whether this develops into something deeper depends to a large degree on how China’s demand is impacted by tightening in liquidity and more generally, how the US-China trade tensions are resolved. Even given a negative shock to China’s demand, the longer term picture remains favourable. This is not only because industrialisation will inevitably continue in China and India but the ultimate effect of money printing by the developed world will be debasement of paper relative to hard assets.

Buy the dip – and load up if there’s a deeper correction.