- Market views on reflation, realignment and re-levering have driven a premature surge in commodity prices that we believe is not sustainable. Last year commodity prices were driven lower by deflation, divergence and deleveraging which were reinforcing through a negative feedback loop. Deflationary pressures from excess commodity supply reinforced divergence in US growth and a stronger US dollar which in turn exacerbated EM funding costs and the need for EMs to de-lever though lower investment and hence commodity demand. While we believe that these dynamics likely ran their course last year resulting in signs of rebalancing, the force of their reversal has created a new trend in market positioning that could run further. However, the longer they run, the more destabilizing they become to the nascent rebalancing they are trying to price.
- The reversal started last month with ‘green shoots’ of rebalancing. Deflation turned into reflation with evidence of long-awaited oil supply curtailments in both the US and other non-OPEC producers which supported energy prices. Divergence lost out to realignment with increased fears about US economic growth. This together with strength of EU manufacturing data over the same period and a pickup in China credit data in January led the market to question the idea that the US is fundamentally outperforming its peers. These worries are reflected in the recent weakness of the US dollar and strength in the gold price. And recent policy announcements in China combined with the pickup in Chinese credit raised the prospects of leverage-driven investment demand as a focus on de-leveraging faded.
- While these dynamics could run further, they simply are not sustainable in the current environment, in our view. Energy needs lower prices to maintain financial stress to finish the rebalancing process; otherwise, an oil price rally will prove self-defeating as it did last spring. The most recent macro data coming out of the US reinforces US growth divergence. Increases in core CPI, strong employment growth and a rebound in manufacturing, pushed the US MAP score – a metric for how much macro data surprises – up significantly to nearly positive for the first time in 2016. Most importantly, our US economics team continues to expect solid consumer spending growth of 2.5% to 3.0% in 2016. Finally, credit growth in China remains too high relative to GDP growth underscoring the need for de-leveraging.
- While we still believe oil will likely rebalance this year and create a deficit market by year end, ‘green shoots’ of a deficit alone are not sufficient for a new sustainable bull market. Only a real physical deficit can create a sustainable rally which is still months away should the behavioral shifts created by the low prices in January and February remain in place. Commodity markets are physical spot markets, not anticipatory financial markets that are driven by expectations. This is why an early rally in oil prices would prove self-defeating before a real deficit materializes as it would reverse the supply curtailments that are expected to rebalance the market in 2H16.
- The ‘green shoots’ for oil include US E&P’s guiding production lower (c.600 kb/d), supply disruptions in Iraq and Nigeria (c.750 kb/d), non-OPEC ex-US producers reporting significant potential reductions (c.400 kb/d) and strong US oil demand. While the Iraqi and Nigerian disruptions will likely prove temporary, they do help in the rebalancing process and have likely helped to tighten Brent timespreads. However, the other green shoots are both price sensitive and are still more relevant for expectations of rebalancing, than the rebalancing seen to date. The current oil market is still in a large surplus as witnessed by last week’s large US inventory build and the large global stock overhang. To keep the financial pressure on producers, we maintain our near-term view of a trendless oil market with substantial volatility between $40/bbl (under which creates financial stress) and $20/bbl (under which creates operational stress).
- We also maintain our bearish view on gold that has rallied along with the other commodities. Our short gold recommendation (which we opened with a 17% upside, in line with our $1000/toz 12-m forecast) is currently at a c.5% loss, with a stop loss at 7%. This gold rally was driven by a lack of conviction in divergence in US growth as a weak US dollar has been highly correlated with a higher gold price. We believe this realignment view of weak global growth is not supported by the US data, which will likely reinforce higher US yields, a stronger US dollar and the return of divergence, particularly should strong US consumer growth dissolve market fears regarding US growth. This in turn will likely put downward pressure on gold prices towards our near-term target of $1100/toz (current price is $1265/toz).
- Despite a continued deterioration in Chinese manufacturing data in the face of recent easing measures, copper and metal prices have also surged to fresh highs. Again we believe these rallies are also not supported by the broader financial environment in China. China is credit constrained and likely to use limited stimulus to promote consumption over investment through fiscal policy. The only real avenue for metals demand growth is through an improvement in property sales and prices that will eventually feed into higher construction activity, which the current data does not support and would be a difficult policy outcome to achieve by design.
- The Chinese government is publicly targeting a reduction in the inventory of residential structures to create higher housing prices and promote associated positive wealth effects, such as improved consumer confidence. As a result, the government is restricting new starts in cities with high inventory levels while stimulating sales through credit availability. As a result, China property new starts and completions are likely to remain weak in 2016 despite the recent policy measures. Accordingly, we are maintaining our near-term copper price target of $4500/mt (current price is $5000/mt).
- Iron ore rallied the most in the past week, breaching $60/t today. We believe this rally too will likely prove temporary and are maintaining our end-of-year target of $35/t . The rally in iron ore prices was the result of a surge in steel prices needed to widen mill margins in order to incentivize operators to pay the restart costs and rebuild operating inventories of raw materials as China enters this year’s peak construction season. However, the physical shortfall in steel supply can be filled easily and the subsequent deterioration in steel margins is likely to put iron ore prices under renewed pressure. In other words, the market fundamentals are unchanged and the current rally is only a brief lull before production cuts at high-cost mines are required to make room for low-cost producers.
- While deflation, divergence and de-leveraging are all likely to reassert themselves and reapply modest downward pressure on commodity prices in the near-term, we do believe that the negative feedback loop that they create has mostly played out in this cycle from a bearish price trend perspective, particularly in oil which is why we maintain a bullish end-of-year view in energy. However, it is important to remember that in the end this was a supply-driven bear market and will not trade like a demand-driven market. In a demand-driven market, once demand gets ahead of supply following an economic recovery, supply struggles to catch up as it was also likely slowed by the lower prices. In the current supply-driven market, demand hasn’t really changed, it takes lower prices to push and keep supply below demand to create a deficit. As a result, higher prices are much harder to sustain in a supply-driven market since supply is primed to return with higher prices. But this lesson will likely only be learned through false starts.
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Here's the very latest from Goldman Sachs, who are calling copper lower by 10% and gold to move back down to U$1,100/oz in the near-term, among other pearls.
Don't kill the messenger, people. This is capital markets, not Sparta.
Thanks due to A.Reader: