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…

Now, one of the truest truism’s in financial markets is the saying that not everyone can be right at the same time. The reason is that if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion. This is what is meant by the phrase ‘the market has priced it in’.

But just occasionally, this rule is broken – most usually because people have not acted on the strength of their convictions.

The question then is whether the universal pessimism is baked into market prices – and if so, does this prohibit consensus actually unfolding.

Let’s quickly summarise the state of play – it’s pretty easy to paint the bearish picture:

1) Global leading indicators suggest we are heading into a synchronised slowdown in economic growth with possibly a double-dip for emerging economies like Brazil and India, and reasonable odds that the US and Europe will follow. The jury remains out on China – with its property development sector likely to falter and local governments loans being hived off bank balance sheets the signs aren’t great, but it’s a command economy and can put the foot back on the accelerator in short order.

2) Australia is in a difficult position. On the one hand planned capital investment is historically huge and coal and iron ore exports remain very strong – but unless you work in the sector, or own the resource, the benefit of this plunder is questionable. The main way that the Australian economy benefits is through the tax take – and that money has already been spent. So the bulk of the Australian economy by headcount at least is struggling under the weight of excessive debt, high interest rates and rising consumer prices. This is why residential property is turning up its overhyped toes and why retail sales have dried up.

3) With equity markets having enjoyed the global re-rating of risk and now looking weak at the knees, no wonder fund managers are feeling a little queasy about the outlook.

So we get to the crux of the issue. Have portfolio managers acted on their sense of imminent doom? If we had access to some meaty data on portfolio flows, we could have a real stab at answering that (it’s something being worked on). So the simplest proxy to get a feel for the answer is by looking at relative sector performance:

What we are looking at here is the 50 day moving average for indices for Consumer Staples (XSJ), Materials (XMJ) and Financials (XXJ). If fund managers had been rotating out of risk and into defensive stocks then consumer staples would outperform – and perhaps at the margin this has been the case since the most recent wobbles began back in March. But it certainly doesn’t look like a fully fledged exit. (We’ll come back to the performance of the financials in another post.)

Another way to look at this possible sector rotation is in the following charts that look at relative performance in a longer term context:

Notably, the more defensive consumer staples sector has been outperforming both the small cap and discretionary sector since March. So this would seem to confirm the trend. But for mine if we were to really be seeing an exit from the risk trade it would show up in a flight from the resources sector – and to date, this is just not really happening.

Conclusion – while fund managers may be very pessimistic about the outlook, it does not look likely that these opinions have been ‘priced it in’. This’d be consistent with my colleague’s reply when asked, “Are portfolio managers underweight risk then?” …”I don’t think so.”

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/2010/08/20/chinese-growth-hormones-and-other-performance-enhancers/ http://www.datadiary.com.au/2010/08/20/chinese-growth-hormones-and-other-performance-enhancers/#comments Fri, 20 Aug 2010 01:34:42 +0000 Rohan Clarke http://www.datadiary.com.au/?p=3163 Australian equities have benefited from two major trends over the last couple of decades (casting aside the credit bubble on the grounds that it hurt).  They are 1) the growth in our compulsory superannuation investment pool and 2) the growth in China’s demand for all things resources.  It’s interesting then to compare and contrast the relative contributions of the finance and resources sector to our national wealth.

If there was any doubt about the importance of the umbilical cord between Australia and China, the following chart mapping the relative performance of some of the world’s stockmarkets bears this out:

Australia’s economy, that was being at risk of being left behind in the sandpit in 2000, has ridden the China bull all the way to the bank. We can see the importance of the resources sector in driving this performance in a comparison of the materials to the financial sector over the same period:

The sucking sound emanating from the financial sector is profoundly disturbing.  Remember that over the same period our pension savings pool rose from ~$500bn to ~$1,500bn, and our household debt climbed from $350bn to $1,250bn currently!

One more perspective on this – consider the following chart from the ASX (here) that gives a breakdown of market capitalisation by sector in 1989 and 1999:

In the midst of the Asian crisis, admittedly as a swathe of Australia’s mining sector was being repossessed and the average return on shareholders equity was just north of zero, the market capitalisation of the sector was ~$100bn in comparison to ~$200bn for the finance sector.  Fast forward to today, and the financial sector is around $425bn versus a resources sector closer to $400bn.

With the Australian economy at best stalling, hope our surrogate continues to take their vitamins.

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:

Most commodities are in contango more often than not, effectively costing investors the spread between the nearby future and the more distant future every time the position is rolled.

See in my day, commodities were in backwardation more often than not.  What happened?  It’s a result of the overpowering of physical markets by financial participants. And I’d argue that this investor dominated market structure increases the probability of extreme volatility in commodities prices.

Backwardation is common in a physically dominated commodities market

Once upon a time, the received wisdom from our commodity market elders was “don’t be caught short”.  The guiding principle was that while a commodity could ‘only go to zero’, there was no limit as to how high the price could run in a squeeze.  In a physically dominated market, the squeeze could kill you.  It was not uncommon for the forward curve of various base metals to be in backwardation (far prices less than nearby ones). Contango was generally associated with very low front-month prices (for example during the Asia crisis).

Now I’d like to show you some analysis of how forward curves have evolved over time, but the LME has put longer term historical data behind a paywall.  So let’s just take it as a working assumption and move on.  (Note too that all commodities have their own idiosyncrasies that can be expressed in their forward curves – for example, if memory serves me correctly, zinc was more likely to be in contango and displayed less volatility than its compadre nickel which was the opposite.)

What happens when non-physical participants take over

Let’s take this chart of the current copper forward curve, as provided by the LME (here), and extrapolate:

We can see the point that Neils makes – the curve slopes up and away from the cash price until we reach the nether regions beyond the 15 month contract – where presumably liquidity and financing interest tail off.  If investors are continually rolling the rock back up the hill (eg. buying 6 month copper – over time it becomes 3 month – roll back out to 6 months and repeat), then they are paying the steepness of the curve everytime. It has been one of the primary criticisms levelled against commodity trading vehicles like ETF’s.

This raises another concept that befuddled our gold desk colleagues back at the turn of the century.  In the base metal markets there was no such thing as an interest rate for borrowing base metals (the equivalent of a gold lease rate).  It could well be argued that the financialisation of these markets has changed this.  When investors buy ‘notional’ copper through a futures contract, they do so on the strength of the balance sheet that promises to pay them the cash equivalent of any profit when the position is closed.  The firm ‘selling’ copper has effectively created the metal by leveraging their balance sheet, and must be compensated for this.  The investor pays the ‘financing cost’ for the synthetic long position.

The long and the short

Neils’ article refers to various research that supports the idea that investors now dominate commodities markets.  This situation implies that the massive growth in financial leverage in commodities should lead to large ‘naked’ long and counter-balancing short positions (in the parlance of the times).  The buyers and sellers of synthetic copper are entering into transactions where there is no physical metal supporting the trade.

How the market is distributing the ‘shorts’ created by the growth in investment demand is not easy to get to the bottom of.  The CFTC has been looking into how ‘index’ investors have affected both the OTC and futures markets since they put out a ‘special call’ in 2008.  You can look at their reports (try here and here) – which provide some sense of the scale of the activity but little else.  It’s notable that the recommendations flowing out of the report – like separating the activities of swap dealers from the commercial traders where they are filed – have not been acted upon as yet.

You might argue that the financial firms that are creating this liquidity are doing so in the knowledge that there is a wealth of resources yet to be pulled from the ground.  And maybe there are.  But in my experience, mining houses are loath to hedge future metal production – even if it is simply to take advantage of the steepness of the curve.  Also there is a big difference between an ingot in the warehouse and ore yet to be mined.  At its simplest this trend should be understood for what it is – the firms that have sold notional commodities have created liquidity out of leverage.  And as is the case with leverage in all its forms, this is likely to magnify the impact of price changes when sentiment turns.

It’s all predicated on the China industrialisation story

It’s been said that the success of marketing commodities as a separate, non-correlated asset class has led to the current situation.  It could equally be added that the notion of the ‘industrialisation of the East’ has inflamed the trade.

I’m not arguing against the principle that China (and other emerging markets) have increased aggregate demand for commodities. That much is clear.  What I’m suggesting is that creation of a whole investor class that is punting on the same trade, such that the volume of this punt swamps the physical demand, creates an unbalanced market.  The motivations of both the shorts and the longs are not the same as producers and consumers of the physical stuff.  The price of the terminal market is no longer predicated on actual physical flows but on perceptions of how these flows might change.

This doesn’t mean that the risk is only to the downside.  While the weak hands look to be those that have bought the China growth model, equally those that are effectively short the commodities markets do not have unlimited capital. If commodities were to spiral upward in price (let’s imagine hyperinflation caused by a supply disruption), these shorts may find it increasingly harder for commodity punters to take their balance sheet risk.  It is not out of the realms of probability that a massive short squeeze could force the financiers of the commodity trade to stop out of their shorts.

Conclusion

Either which way – I’d argue that the leverage that has taken over the commodity markets means that they exposed in a way that has not existed before.  As ever, the risk is that leverage will continue to grow until it implodes under its own weight – which given the recent gyrations in risk markets, seems like a material probability. For mine, the risks to the China growth story are crowding upon events – I wouldn’t want to be long commodity producers should the China miracle lose its lustre.

The strange thing is that the same economic result could be achieved through revamping the existing royalty system. I’m beginning to suspect that this is the Commonwealth government’s end-game.

The story so far

Yesterday we had a quick look at how the RSPT would apply to an existing mining operation.  The conclusions were:

• It is complicated to implement – so much more so than a royalty on sales.  It will create a whole industry around ‘optimising’ the actual RSPT paid.
• Using ‘undepreciated tangible tangible capital expenditure’ as the effective price that the government ‘pays’ for its ’40% equity stake’ leads to highly inconsistent results.  This cost base will vary depending on how old the mine is etc and has little relationship with a ’40% stake’ – even if that stake is intended to be calculated off the cost base and not the prevailing market value.  The net result is that the impact of the RSPT is likely to be very different across individual mines.
• Investing in Australian mining companies is suddenly a whole lot less attractive – the government has taken the sword to the upside, while the price discovery process to determine the perceived fair value for existing assets has some way to run.

The RSPT and new mines

Today going to have a look at a hypothetical new mine.  Let’s assume that you’ve got a copper deposit that will require $100m in capex to start mining and has a projected 10 yr life over which the initial investment will fully depreciate. How are you going to fund it?

1) A banking syndicate puts up $40m – that will fully amortise over the mine life.  Broadly plausible.

2) You issue $20m in subordinated debt – paying a coupon of say ~3% (equivalent to the dividend yield on mining stocks) that is also indexed to the price of copper.  For simplicity assume that it matures at the end of the mine life – paid out of a reserve that is built up over the term.

3) You raise $40m in equity.

Without trying to over-engineer the example, the point I’m trying to make is that the risk/return in the capital structure has been skewed by the RSPT.

Think about it – the government has guaranteed tax credits to 40% of the capital cost of the project (ie. $40m).  These tax credits are ultimately redeemable against the government’s balance sheet.  Equity investors are effectively investing in a government bond – with some upside to earnings.

The hybrid equity investors on the other hand, have the protection of this $40m first loss piece – fantastic.  And, taking into account the need to structure within debt and equity rules, can effectively share in commodity price appreciation. The earnings on which the miner pays the RSPT are reduced when commodity prices are high.

Ultimately, it’s the same issue that pokes its head up with existing mines – the ‘undepreciated tangible capital expenditure’ is not the same thing as the equity invested.

Finally

I’ve spent a couple of days on this RSPT simply because mining is so important to our equity markets.  In the end, the RSPT comes across as a half baked tax.  If the government is wedded to the idea of extracting additional tax from the mining industry when times are good, then it would be a whole lot simpler to revamp the royalty system – centralise the administration and implement a scaled royalty rate that tracks higher (or lower) depending upon the prevailing commodity price.  But again this may have been the government’s goal all along.

The index was up 15.1% for April in A$ terms – partially reflecting the contract wins that the miners had in iron ore (up 100% YOY), thermal coal (up 36-40%) and coking coal (up 55-100%).

These increases have been baked into stock prices for some time.  If anything the prices of Australia’s resource stocks had been easing into the weekend before the government slapped them on both cheeks as can be seen in the performance of XMJ – the ASX materials sector index – to the end of April:

Notably, while momentum has been fading in our leading index since the start of the year, it is yet to turn down.

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