Confirming that what Jeff Gundlach predicted last December, when the DoubleLine CEO said his favorite trade for 2018 is to be long commodities, has been spot on…
.. this morning Goldman’s head commodity strategist Jeff Currie writes that commodities are the best performing asset class of 2018, and echoes the bank’s recent enthusiasm on the asset class, saying “the strategic case for owning commodities has rarely been stronger.” The reasons for Currie’s enthusiasm, as we discussed previously, are straightforward:
Robust late-cycle growth is depleting global supply chains, creating increasing positive carry. As inflationary concerns push interest rates higher, cross-asset correlations with commodities decline, and the diversification benefits rise with higher rates. Rising geopolitical and trade policy risks only add to the inflationary mix in commodities.
And yet, perhaps in light of the recent sharp move higher in oil prices, Goldman admits that investors remain skeptical of commodity investments “even though Brent carry pays 15% pa and the supermajors are paying dividends north of 4%.” As Goldman lays out, concerns stem from:
- a decade of underperformance with E&Ps destroying 23 cents on a dollar invested,
- fear of buying the top of an ‘artificial’ rally from supply cuts, and
- the lack of a structural catalyst like China in the 2000s.
To boost investor morale, Currie lays out three bullish catalysts, first noting that the weak returns of the past decade are (likely) behind us:
1. The weak returns of the past decade are behind us. The global economy was operating below capacity in the ‘recession/recovery’ phase for over a decade and any early-cycle playbook warns of the poor returns in commodities when the global economy has slack in the system. Today it is operating near or above capacity.
2. The structural story is a lack of long-cycle investment. Short-cycle investments in sectors such as technology and even shale oil and gas have attracted capital over the past decade at the expense of long-cycle investments in oil and commodities. Going forward, short-cycle projects are not sufficient to balance demand and commodity prices need to incent long-cycle investment.
3. Prices are high because inventories are depleted. While supply cuts pulled forward market tightness, inventories are now low and demand levels significantly exceed supply levels.
This in turn leads to the most compelling observation by Goldman, namely that there is no precedent of supply from OPEC or any other producer overtaking demand this late in the business cycle to replenish inventories before a recession occurs.
In other words, the current dynamic may continue until such time as the negative feedback loops from surging oil prices send the world into a freefalling “cost-push” recession, a repeat of what happened in the summer of 2008, when $150 oil was one of the catalyst to unleash the financial crisis.
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And while a recession will clearly end the party, Goldman admits other risks are also present, chief among which is China, arguably the driving catalyst behind the 2015/2016 global recession. The recent Caterpillar warning only underscores these concerns. Here’s Goldman:
To be sure, this does not mean that commodities outperform in every quarter in this stage of the business cycle. For example, China metals demand was weak in Q1 owing to the late Lunar New Year and the uncertainties created by this year’s National People’s Congress in March. Inventories of steel, copper, and aluminum climbed sharply in the first quarter. Machinery sales were strong but mainly driven by replacement demand. Other indicators such as cement production and excavator hours point to weak construction activity. Through its strong trade linkages with other countries like Europe and Japan, it also contributed to the softness in global growth.
However, one important lesson we learned about China during the past year is that the overall growth target is still important to the government and policies are likely to remain flexible to counterbalance perceived risks domestically or from abroad. In fact, the PBOC recently announced an RRR cut to offset risks of trade tensions with the US. The politburo meeting in late April also signaled an easing bias while the country continues to pursue structural reforms. Higher frequency data have already shown demand picking up in China. Taken together, we think the Q1 weakness is temporary and continue to hold a constructive view on metals for the rest of 2018.
China aside, a bigger paradox in Goldman’s overall view is that, as Currie notes, the bank – like Gundlach – is pushing for a more aggressive ‘tilt’ just as growth is slowing, which “seems counterintuitive.”
Advocating for a more aggressive allocation just when economic growth is beginning to slow might sound somewhat counterintuitive. The reason for this is simple. Financial markets depend upon expectations and hence on expected growth rates in economic activity, which are showing signs of slowing.
In contrast to financial markets, however, commodities depend upon activity levels, not growth. So even if
growth slows, as long as demand levels are above supply levels – which creates market tightness – commodities can still generate positive returns. Some more details on this key thesis of a “scarcity premium”:
This observation is at the core of the late-cycle playbook for owning commodities and why commodities typically perform the best when other asset classes perform their worst, particularly in relation to inflation. When demand levels exceed the capacity to produce, i.e. a positive output gap, commodities inventories drawdown. The resulting inflationary pressure slows expected growth rates via higher interest rates, which hurts financial assets. In contrast, even if the growth rate of commodity demand slows, the high level of commodity demand continues to deplete supplies, which maintains the scarcity premium in commodity prices, i.e. spot prices trade a premium to forward prices.
The scarcity premium creates the positive carry in commodities as the investor buys forward at a discount. Think of oxygen: if it became scarce we would pay an enormous premium today for it as we don’t need it tomorrow if we don’t have it today. Financial markets cannot possess this characteristic which is why gold cannot go backwardated since it is not consumed like oxygen, energy or grains. But it is this scarcity premium that creates the late-cycle diversification benefits of commodities, particularly in relation to inflation.
In oil, the current scarcity premium is 14.7% pa, which means oil prices could drop by $10/bbl in and the investor still breaks even. It is important to point out that the scarcity premium is always larger the closer you are to physical spot prices, which means the investor would prefer to roll the front end of the curve 12 times as opposed to buying 12 months out. For example, the second month contract trades at a 1.1% discount to the spot versus the 12-month contract at a 9.2% discount, which means that rolling 1.1% 12 times creates a 14.7% return which is greater than a 9.2% return. This is the essence of scarcity.
The key to this scarcity premium in commodities is the high levels of demand usually associated with a late cycle economy. Underscoring that this commodity market is not artificially driven by supply cuts from China and OPEC/Russia is the increasing number of commodities developing a scarcity premium. Currently we calculate that 13 out of 24 commodities are in backwardation. As Exhibit 19 shows, as the business cycle deepens the number of commodity markets creating a scarcity premium has increased significantly as supply chains are depleted.
In conclusion, Goldman also reverts to another point it popularized last year, namely that while higher oil prices may sap consumer demand, they end up easing financial conditions, as “they lead to more global excess savings.”
And indeed, there is increasing evidence of an improving trend in the international dollar liquidity. BIS data shows that global banks’ cross-border claims and liabilities have been on the rise, indicating easier accessibility of dollar credit. Dollar credit to EM economies has rebounded particularly strongly in 2017. Higher frequency measures such as dollar liquidity of European banks, measured by their dollar claims on the US banks, has been on the rise as well. European banks are at the center of global trade finance/cross-border credit and their dollar claims on US located banks can be seen as liquid reserves which support their dollar balance sheets (Exhibit 22).
Meanwhile, as one would expect in a world of rising commodity prices, EM FX reserves have begun to build again as a result of higher commodity prices and improvement in net capital flows (see Exhibit 23).
As the events of late 2015 taught us, EM FX reserves are significant providers of dollar liquidity to the euro-dollar market, and European banks specifically, both by direct cash lending and indirect lending through the derivatives such as cross currency basis swaps as well as lending out of other dollar assets such as US treasuries. (just ignore the blow-out of the LIBOR OIS spread, which while showing some modest signs of normalizing is still a long way away from “normal.”)
Summarizing the above, the liquidity released due to rising commodity prices, sits at the center of the self-reinforcing loop between the 3Rs, a concept also popularized by Goldman one year ago, one in which higher commodity prices (reflation) and stronger demand growth in EM through credit expansion (releveraging), which reinforces global synchronous growth (reconvergence in growth): these are the 3R’s and they are central to Goldman’s bullish view by creating a positive feedback loop that supports higher commodity prices.
And while all of the above makes sense, even with the troubling implication that the surge in oil will only end with the next recession/depression, things would be much easier if the dollar wasn’t surging in parallel with oil, making any incremental gains for commodities that much more difficult, as the most important driver of easy financial conditions around the globe continues to tighten with every passing day in what may be an extremely painful short squeeze…