Wednesday, August 26, 2009

Commodities and related markets to fall first?

Equities continuing to roar ahead while government bonds are trading supported has a goldilocks taste to it. As mentioned on Monday (see Rates Strategy Update: Sticking to longs), I think that equities rally on the back of the improving growth outlook whereas bonds trade supported amid a lack of inflation pressures. On the other side, the development of commodities on average remains relatively muted with several important commodities seemingly going nowhere over the past weeks (for example oil and gold). While I still continue to look for the equities rally to falter, it could well be that commodities and related (emerging) equity markets will lead the way.

Earlier this year it was the emerging markets world (most notably China) which led the risky asset rally and in conjunction with ultra-low central bank policy rates and the quantitative/credit easing measures were fuelling the fear of rapidly rising inflation rates, especially via a liquidity-induced commodities rally. If anything, long commodities seemed to become a consensus trade. Furthermore within equities money was flowing towards the emerging markets world. However, as the chart below shows, commodities have significantly lagged the upswing in equities. I have set the S&P500, the DJ EStoxx and the CRB-Index at 100 for March 6 (the day of the equity low). Since then, the S&P and the EStoxx have traded almost exactly in line with the same performance. However, the CRB Index has trailed the substantial equity performance by a significant margin. Furthermore, especially over the past month, there is a discrepancy with commodities trading sideways to lower and equities rallying further.

Commodities lag equities
Source: Bloomberg

Bringing government bonds into the picture as the chart below does via 10y Bund yields suggests that bond yields are currently moving more in line with commodities than with equities and as a result show the same discrepancy in terms of performance.

Bonds trade in line with commodities and less with equities
Source: Bloomberg

The lacklustre performance of commodities supports my notion that bonds have been moving higher/yields lower on the back of easing inflation fears. But why is it that commodities fail to rally in line with equities? Furthermore, is the performance of commodities a sign of things to come for equities (i.e. a lack of end demand as a precursor for renewed growth weakness) or another positive for equities (as it eases inflation worries and helps to keep rates low for longer)?
For one, I think a key reason why commodities seem to be going nowhere these days can be found in China. China seems to have gone on a commodities re-stocking spree (see for example The China Syndrome by MacroMan) and has injected a massive dose of credit into its economy earlier this year. However, both seem to have come to an end as the announcement of a stricter lending environment by Chinese officials suggests. This was also mirrored by the Shanghai equity index which is down some 15% since the start of this month. The end of the commodities restocking cycle would also explain the easing in the Baltic Dry Index which already topped in early June but is down another 25% this month:
Source: Bloomberg
Clearly, easing commodity prices are a positive for net commodity-consuming economies such as the US or the Eurozone and constitute a positive terms of trade shock via lower imported inflation. Furthermore, as it eases still persisting inflation worries it allows central banks to keep ultra-low policy rates for longer. Thereby, this would come a long way in explaining the recent co-movement of government bond prices and equities (both up).
Furthermore, I remain of the opinion that there is more downside for commodities in general amid relatively less demand and because any re-stocking can not go on forever (first, it is costly to hold physical commodities and second, there are no infinite storage capacities). Given that a lot of speculative money seems to have flown into commodites and related equity markets, it might well be that performance disappointment sets in which would lead to downward prices on such assets. In turn, I maintain my negative view for the commodities complex and the bullish outlook for government bonds.
From the data I have available, I cannot judge yet whether the developments in commodities is a sign of a broader weakness in end demand or just due to the end of the re-stocking cycle and less speculative flows. If purely the latter, then the positive impact on developed market equities might be sustained, however, if more from the former, then we should see the US and Europe be dragged lower as well via renewed weakness in exports. So far, my view remains that the equity rally will falter soon amid renewed growth disappointment.

1 comment:

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