Commodity prices are currently both high and volatile relative to the past few decades, consistent with the physical supply and demand fundamentals that underpin these markets. However, the increase in prices and volatility is not unprecedented, having occurred during other large global supply and demand shocks throughout the past century. There is a lack of convincing evidence (at least to date) that financial markets have had a materially adverse effect on commodity markets over time periods of relevance to the economy. It is possible that speculators have had some effect on commodity price volatility, but their contribution would appear to be relatively small – particularly when compared with the contribution from fundamental factors – and short term in nature.

If we line up the central banks with the papers they have published, we get some interesting correlations (apologies for the simplistic paraphrasing):

Federal Reserve – commodity prices are driven by physical demand from emerging economies; not our monetary policy

Bank of Japan – commodity prices are higher than physical demand alone implies; we should know, we are a commodity importer

Australia – commodity prices are driven by ever increasing demand from emerging economies; we should know, they are our best customers

Hmm.

Speaking of correlations in the commodities markets, RBC published an interesting chart recently (via FT) that compares real copper prices to inventories:

All those grey circles in the upper left quadrant are telling us that the last decade has been very different to previous ones – prices have remained stubbornly high against relatively stable supply. The big question is why?

Clearly, demand from China for industrial resources has grown very strongly, just as it has risen for agricultural products and energy across the developing economies. This supports the argument that the growing demand in absolute volume terms requires a higher level of inventories on a weeks-of-consumption basis. There is no doubt then that higher demand from China et al has pushed up prices relative to the experience of the prior two decades.

But to downplay the impact of investors that have plowed relentlessly into the supercycle commodity story, as the RBA has done, is plain irresponsible. It is self-evident, to me at least, that the weight of investor money in the sector means that this capital flow is capable of being the marginal price setter. With commodity investors making up some 40% to 50% of futures markets turnover, can they really be anything else?

We’ve discussed this before (in May last year here and with some charts from James Montier here). The evidence is plentiful – from the volumes being traded in futures markets to the distortions being created in the forward curves.

If nothing else, the growing presence of investors increases the potential for extreme movements in commodities prices. It is well to remember in this context that commodities as an investment in their own right do not pay a dividend. Investors rely solely on higher prices to generate returns – or at the very least, stable prices to get their money back.

Still when you look at this chart from the RBA’s analysis, one gets the sense that the supercycle proponents are comfortable with the risks for some time yet. To be fair, it’s a pretty compelling picture…

…most notable was the massive change in China’s imports of iron ore between January and February which collapsed from 68 Mt to 48 Mt and when this was combined with the 10 Mt fall in the country’s coal imports also in February the resulting 30 Mt drop exceeds anything that was seen even at the time of the freight market collapse in 2009.

With the supply side not doing the shipping industry any favours, its no wonder that the Baltic Dry Index is still plumbing the depths:

Preliminary estimates for March indicate that the index rose by 0.6 per cent (on a monthly average basis) in SDR terms, after rising by 1.4 per cent in February (revised). The largest contributors to the rise in March were increases in the price of crude oil and the estimated price of coking coal, while gold prices also rose notably. Most rural and base metals prices in the index fell in the month. In Australian dollar terms, the index rose by 1.6 per cent in March.

By my records the RBA’s A$ all-comers index was recorded in its last report as 101.9 for February – as against the current 101.6 reading in March. That would be a 0.3% fall not a 1.6% rise wouldn’t it?

It looks like the discrepancy arises as ‘preliminary estimates for iron ore, coking coal and thermal coal export prices are being used for recent months, based on market information.’ As these items are material to the calculation of the index, revisions in these estimates can give rise to ‘adjustments’ in previous reported levels. If March is higher than February, it seems it has as much to do with February being lower as March being higher.

All this implies that the RBA, based on intelligence from exporters, has ratcheted down its expectations for iron ore and coal price rises for the March quarter from just a month ago. Pity the RBA didn’t explain what is happening here.

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Still, there is no denying the strength of commodity prices and the Australian dollar – it’s as if the Japanese crisis gave the reflation trade a much needed fillip. Per the RBA’s latest numbers for March:

Note that base metals lagged gold in this latest shunt higher. Whether this is indicative of a growing belief that inflation is destined to take hold of the global throat is, at least to my mind, counter-intuitive given that we are heading into the tail of QE2. It seems more reasonable to expect rising uncertainty about continued loose money – with debates about interest rate rises in Europe, credit tightening in China and the impending pulling of the Fed’s bid.

Still if it’s the spectre of inflation haunting markets, think we can expect gold to continue to outperform its poorer cousins in the industrial metals complex – ultimately we revisit the relative lows of 2010 – much the same way that gold continued to thrash copper in the late 70′s and early 80′s.

Finally, the idea that this latest thrust higher is anything but monetary in origin is just fanciful. Granted the world economy has regained some of its poise, but the leading indicators are still turning over and suggest that the marginal user of commodities is fighting inflation by contracting credit (see latest global PMI data here). For valuations of metals and mining companies to be justified, we need the expansion to continue.  We need Chinese equities to signal a return to the good times. Now one might argue that the recent outperformance of EEM versus the S&P500 is signalling exactly this.

Heck, it isn’t convincing me. I’m happy to stick with the playbook – we’ll remain defensively positioned into the end of the stimulus. It’s a time tested strategy (see here for our test of the Albert Edwards playbook).

The prices of Australia’s basket of commodity exports climbed higher against all comers.

Preliminary estimates for February indicate that the index rose by 2.2 per cent (on a monthly average basis) in SDR terms, after rising by 5.3 per cent in January (revised). The largest contributors to the rise in February were increases in the estimated prices of iron ore and coal, reflecting some further adjustment towards the higher contract prices in the March quarter. Increases in the prices of crude oil and wheat also contributed to the rise, while beef & veal prices fell. In Australian dollar terms, the index rose by 1.9 per cent in February.

And we can expect more of the same according to ABARE – their forecasts for Australia’s top 10 exports for this year and next (here):

That is a pretty bouyant outlook for our commodities exporters, however you paint it – all those Chinese farmers moving into brand new apartments have to get a fridge, dishwasher and playstation from somewhere.

So how much are equity prices reflecting these types of expectations? Well, running through valuations for some of Australia’s major miners, it looks like both volume and price assumptions of this ilk are baked into prices. Consider BHP ostensibly trading at ~10.5 times 2011 forecast earnings and 9.0 times 2012. Looks reasonable – on the assumption that China demand growth continues apace – and therefore commodity prices at least hold around todays levels.

We can see the tight correlation between spot commodity prices and those of the commodity producers in the following chart that maps the RBA’s US$ base metal price index against the Australian materials index (XMJ). We’ve included the non-rural index to highlight the point – resource equities are a risk market that take their lead from the more visible and tradeable metals markets:

It is because resource equities have kept pace with spot price appreciation that the risk/reward is skewed against owning them.  For equities to move higher from here, commodity prices need to climb further – something that is becoming progressively harder and harder to sustain.

Which gets me to the thought that has been nagging away – will higher commodity prices create their own demand destruction? It’s an extension of Morgan Stanley’s point on oil prices (via Pragmatic Capitalism here). Not only are higher energy prices likely to undermine the economics of many a zinc, aluminium and copper refiner, the higher raw material prices are doubling up the total cost for the end user. Perhaps this is why Chinese equities have been underperforming commodity equities for some time now?

For a reality check on how Chinese demand might evolve in a tighter credit environment read this article from AsiaOne news “Chinese steel prices slip again as demand falters” (here). The following quote would have Minsky rolling his eyes in despair:

“The interest rate hike hasn’t been so awful for traders as long as the commodity prices are high, but the really painful thing is the credit crunch – steel traders cannot borrow money,”.

The US has been leading the way – from the JP Morgan Global PMI Report report (here)

The US PMI rose to an eighty-month high in January, while its counterpart in the Eurozone hit a nine-month peak. The UK PMI rose to its highest level since (UK) data were first collected in 1992. Meanwhile, the China and India PMIs crept higher from December’s three-month lows and an expansion was signaled in Japan, albeit only slight, for the first time since last August.

Only Australia and Greece were on the contracting side of the ledger. On the face of it, this ‘fundamental’ demand should throw a supportive bid behind commodities – and may help explain why the major miners have caught an updraft over the last couple of days. (Chart from Investment Postcards from Cape Town here)

Yet it’s reasonable to ask whether it is only fundamentals driving commodity prices.  While it might well be argued that base metals have at least paid some attention to the ebbs and flows in industrial production, the relative strength in gold suggests that there may be more to the story.

Similarly, supply constraints cannot explain the entirety of the recent rise in foodstuffs:

Bernanke (at the National Press Club here) claims that higher commodity prices are the result of emerging world demand and supply constraints. This is true – at least in part.  Certainly, weather patterns over recent times have not been conducive to agricultural production nor for the supply of some industrial commodities. And yes, emerging world demand has been strong since early 2009.

But this is too simplistic an explanation as it ignores the role of government and speculation in driving commodities prices.

Without exception, ‘fundamental’ demand has been strong due to government stimulus efforts. Most particulary, the rise in emerging world demand was intimately tied to the launch of China’s huge monetary stimulus in 2009. This trend has reached its end.  China is tightening money – and other emerging economies have been applying their own capital constraint measures. The fall in the Baltic Dry Index may be partly inspired by oversupply, but fading ‘fundamental’ demand is also at play. It is no coincidence that Chinese equities have also caught a cold.

The reversal of stimulus policies reflects a need to slow price rises.  For example, food prices are said to comprise 35% to 40% of disposable income in China, and are higher in other emerging economies. Higher food prices will inevitably squeeze demand, and more ominously, lead to unrest. It’s notable that at the same time Bernanke was making his speech, UNCTAD was hosting a conference on Global Commodities with the explicit aim of “calling for attention to climbing, volatile prices” (here).

The point is that there is a limit to the price that emerging markets can pay for commodities – and the evidence suggests we are close to that point.

So if China is tightening money, we might reasonably expect commodity prices to start easing – in anticipation of declining demand from emerging economies. Yet copper tops US$10,000/t, Brent breaks US$100/bbl and cotton makes new record highs. This raises a question as to who is buying – and increasingly over the last decade, the answer has been investors.

Investment demand for commodities is something that we have looked at before (here and here and here) so we won’t labour the point. Suffice to say, the current run-up in the prices of some commodities has all the hallmarks of classic price distortion away from fundamental demand (aka ‘bubble’ behaviour).  As seasoned traders will oft be heard to say – the prices have gone parabolic – meaning that speculative fervor has taken over. With the herd increasingly headed in the same direction, it will take progressively less and less to tip the balance in the other direction.

Conclusion – Just like the grotesque in Dorian Gray’s closet, high commodity prices are the non-to-hidden price we must pay for a forever young global economy. With QE2 itself passing into its twilight age, the risk/reward of being long commodities doesn’t look too flash – with diminishing upside and plenty of room on the downside. Emerging markets are already signalling weakness and the commodity currencies are showing all the signs of exhaustion. While we may not have called for the last rites just yet, the priest is in the parlour.

Disclosure – no position in base metals, long energy and agricultural equities, and nibbling at gold again.

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Postcript

• The Short Side of Long has a neat summary of current commodity markets in its “End of Month Commodity Report”
• Zero Hedge published a Standard Chartered report on “The threats of inflation” (here)
• and Nomura’s September 2010 report “The coming surge in food prices” (here) has a top 25 countries vulnerable to rising food prices

On the one hand, we have the (glacially slow to market) OECD leading indicators that have been signalling a slowdown in China for some time now (see here – next update due 13Dec10).  Albert Edwards notes (via Alphaville here) that with these indicators in contraction territory, the augurs are not good for commodity prices.

Once again, China’s leading indicator is pointing towards a very significant slowdown in economic growth ahead. The last time the Chinese OECD leading indicator was this weak, commodity prices had just reached their euphoric mid-2008 peak, having spent the first half of the year resolutely ignoring the clear signals that the economy was about to slow sharply. Commodity and EM bulls ignore the weak Chinese leading indicator at their peril.

Then we have those market oriented indicators that are generally thought to be anticipatory in nature.  They are sending a mixed bag of messages. Notably the Baltic Dry Index, the Shanghai Composite and A$ Base Metal index were all down for the month, though still above their lows for the year.

Rolling these into a single index, we can see that their performance has been diverging from that of the ASX200 materials index for some time. It’s unlikely that this divergence can be sustained indefinitely – either share prices of our commodity exporters fall or one or another of metal prices, the Chinese stock market and/or the Baltic Dry index turn higher.

So to perhaps the most forward looking of the lot, the PMI’s and in particular Jonathan Wilmott’s extrapolation of current trends (again via Alphaville here).

Our version of Chinese industrial production (a reworking of officially published data) has grown more than 2 per cent m/m each month for the past three months – the fastest growth since the immediate post-Lehman recovery. That suggests pretty firmly that China’s post-stimulus slowdown is over and the economy is firmly back on a solid growth track, something which fits the observations of our commodity analysts during a recent field trip.

Wilmott has a pretty good record on this front, so it’d be wise to pay heed. And perhaps his point is valid, as when we look at the rate of change in the OECD CLI for China we can see that the contraction is slowing.  This is very different to the situation that prevailed in June 2008 where the worst was yet to come.

On the basis of this evidence, we could probably agree with the assertion that the post-stimulus slowdown is at least close to its end.

While I’m in the camp that sees a day of reckoning for China’s investment lead growth model, looks like it won’t be this side of Christmas.

]]> http://www.datadiary.com.au/2010/12/02/chinese-leading-indicators-past-present-and-future/feed/ 0 http://www.datadiary.com.au/2010/11/04/trade-flows-following-currency-movements/ http://www.datadiary.com.au/2010/11/04/trade-flows-following-currency-movements/#comments Thu, 04 Nov 2010 11:40:13 +0000 Rohan Clarke http://www.datadiary.com.au/?p=3788 Follow-up on an earlier post (here) where we suggested that recent moves in currencies were impacting trade flows, Markit (here) reports that world trade was up in October lead by exports from developed economies – and in particular the US.

Note that new export orders for Australia, Brazil and Russia were all down for the month.  While China and India were the laggards in export growth. The USD and EUR leading the way.

To see the AUD currency effect from a different perspective, here is the latest RBA Commodity price index. Note the climb in the AUD continues to outpace commodity prices:

The point is that currencies matter. Consider for example the latest RBA commodity price index (original release here):

Commodity prices continued their surge higher in September – at least in US$ terms. In A$ terms, the index was actually lower month-on-month. The gap between the performance of the two has opened to a chasm that is rarely seen, or been sustained (at least for our dataset which does not go beyond 1982 and therefore does not include the commodity induced inflation of the 1970′s).

All this of course is a result of easy money – the impact of which can also been seen in the relative performance of the carry trade over the commodity trade (via AUDYEN and AUDUSD).

Prior to the Jackson Hole symposium, the carry trade was at an ebb and the commodity sensitive AUDUSD had begun to outperform. But once Bernanke reopened the sluice the rules changed. Even EURYEN has turned up – as the BOJ announced its own debasement strategy and China stepped up its support of the European periphary.

As the closest thing to a floating exchange rate, the AUD offers a rare pedigree in a world of big-arsed mutts. It makes the rationale for investing in it pretty simple. Good yield, rising commodity prices, reasonable government debt position. If you don’t like our housing market, you can always join a hedge fund or two and short our banks.

Still all good things must come to an end – not sure we are there yet, but our composite indicator for the materials sector is still not confirming the recent index strength. (It’s a composite of the Baltic Dry Index as a proxy for volume, the A$ denominated RBA Base metals index as a proxy for price and the Shanghai equities index for demand.  XMJ is the ticker for the ASX200 Materials index.)

And from the RBA:

Over the past year, the index has risen 53 per cent in SDR terms. Much of this rise has been due to increases in iron ore, coking coal and thermal coal export prices, although all components of the index increased over this period. With the appreciation of the exchange rate over the year, the index rose by 38 per cent in Australian dollar terms.

The miracle growth in China’s economy has treated Australia well.  Of course, while the prices for Australia’s export commodities are back to their highs by the RBA’s reckoning, our equity market remains well below its peak:

The fact is – risk appetite is just not what it once was. Without the bottomless credit-creation cup, the leveraged risk taker has vanished. Risk premiums have risen pretty much across the board.  Assuming all else were constant, this in itself could go a long way to explaining why the All Ordinaries remains ~33% off its peak.

But all else ain’t constant. Credit was all pervasive prior to the GFC. The end of the developed world’s thirst for leveraged consumption has also strangled the West’s nuts-and-bolts economies. Structurally higher levels of unemployment, declining house prices, and recurrent concerns about the strength of government finances continue to undermine the developed world’s economic growth.  Under the new world order, uncertainty lauds it over those willing to push out the risk curve.

History would suggest that once started, the impulse to deleverage is difficult to stop.  A balance sheet recession requires the debt to be overcome. This will take time.

Which perhaps is the key point – leverage will continue to fall – at the very least in relative terms (relative to incomes, GDP, however you think about it).

In this less-liquid environment, the macro trade dominates. We get a couple of optimistically spun data points, the risk markets rally. Funds flow out of perceived safe havens and up the risk curve.  A bad data grab will send the flows into reverse.  Sentiment, and the stop loss mentality that comes with it, drives short term market direction.

In this context, China has been swimming hard against the tide.  The fact that it has maintained ~10% GDP growth rates is a testament to its willingness to borrow against future demand for its goods – most hopefully from the emerging Chinese consumer, less so from the Western world. Capital investment has been a key pillar of this growth strategy – and hence Australia’s resources have been in hot demand.

The question is then how long can China continue to hold out against the currents?  There are some pretty deep pockets betting that it will succumb sooner rather than later. Still, as the longevity of the credit boom showed, unsustainable circumstances can be sustained for an unreasonably long time.  Till then the Australian trade balance will shine.

The fact that it continued to climb is partly a function of its composition (see here for a breakdown – note gold makes up a handy 9.5%) and partly the way it is calculated (eg. the effect of recent increases in iron ore contract prices are spread over time – notwithstanding Chinese spot iron ore prices were down on the month).  In this context, it’s notable that gold has continued to outperform base metals:

And that at least for our dataset, the base metals to gold ratio is once again approaching historical lows.

I’ll admit to being a little nervous about gold’s prospects to push on from here.  The logic of owning gold over the longer term horizon is sound – there is a certain inevitability to the destruction of the paper money idol.  But in the immediate future, it’s harder to see the catalyst for another surge higher (other than the technical one – it’s a cup and handle thing).  A stop seeking shot to the downside would do me the world of good – maybe it’s wishful thinking…

Anyway for our purposes we focus on the RBA’s US$ base metal index. We combine this with the Baltic Dry Index (as a proxy for volume) and the Shanghai stock market (as a proxy for Australia’s biggest customer) to get a benchmark for the ASX200 Material Sector.  This indicator has rolled over and is threatening to break its recent lows: