Opinion: The commodity conundrum — why are prices so weak?
The usual explanations don’t hold up
While it is accepted wisdom that energy is the most important commodity complex, representing more than 80% of the dollar volume of trading in commodity markets, there are dozens of important raw materials and soft commodities that also serve as important barometers of the global economy.
Two of the major commodity indexes — the CRB Commodity Index and the S&P GSCI Commodity Index SPGSCI, -0.41% — seem to be performing a rather uncomfortable rollover after what seems to be a completed weak rebound off a climactic low in January 2016. The “rollover” effect is clearly illustrated at the right end of this chart.
This weakness in commodity prices comes in a seasonally strong time for commodity indexes, since oil and energy commodities comprise the majority of the S&P GSCI Commodity index and March begins the seasonally strong part of the year for the energy complex. Instead, the S&P GSCI Index has entered what looks to be a volatility squeeze, or a tight sideways trading range. Given how aggressively oil has sold off of late, it would not be surprising for that trading range to fail.
By comparison, the CRB Index caps oil and related commodities at 33%. (See table.) Note that natural gas, which is often a byproduct of oil drilling, is broken out in a different category and capped at 6%. The CRB Index is more balanced than the S&P GSCI Commodity index and is much weaker. It is clear that the CRB Commodity index is lower and is “rolling over” more.
All this is fine and dandy but the most important question is “Why”?: Why is the CRB Index rolling over and the S&P GSCI Index flatlining the way it is? I can say with a high degree of certainty that the crash in the commodity markets that commenced in mid-2014 — a 50% decline in 18 months — was driven by the slowdown in the Chinese economy. This is because China is the No. 1 or No. 2 global consumer of most commodities in these indexes. If the Chinese economy is slowing, there is a clear multiplier effect where demand for such commodities will fall much faster than the magnitude of GDP slowdown.
How then does one rectify weak or flat commodity indexes with Chinese economic data, which has shown improvement over the past year? This doesn’t rhyme in my book. Chinese Manufacturing and Services PMI both declined at last count, but they have both shown improvement since mid-2016. (See chart.) Commodity markets are forward looking, and it very well may be that the turn lower in Chinese PMI Indexes after a year of improvement may be the start of a weakening trend that has already shown itself in commodity indexes. Those are the demand considerations.
If the Chinese economy experiences a hard landing, the chances of which are much higher than consensus estimates, I think we are looking at a second leg lower for the major commodity indexes, similar to 1997-1998. The only difference is that Chinese GDP at $11.065 trillion is much bigger than the combined GDP of all countries involved in the Asian crisis by a factor of two to three times. The present consensus forecast is that the Chinese economy will see accelerating GDP growth in the next couple of years and that the Chinese economy will top $12 trillion in GDP.
I think those accelerating GDP growth forecasts are pure baloney. (See chart.) I would watch for an acceleration of capital outflows out of China and the action of the U.S. dollar-Chinese yuan exchange rate, which is now being gently devalued by the People’s Bank of China. Those two would be pretty good indicators of the evolution of the Chinese credit bubble unraveling, which may drive commodity prices in the intermediate term.
The Down Under effect
While Chinese authorities can doctor their own economic data, they cannot doctor the price of globally traded commodities, and it would be very hard for them to doctor the exchange rate of the Australian or Canadian dollars, which are major developed market currencies driven by commodity prices.
It is not surprising to see a strong correlation between the commodity indexes vs. the Australian dollar as commodities are the main Australian exports. (See chart.) But in this case, we have a double-whammy effect, as China is the major export destination with 30.8% of exports going there — along with 22.6% of Australian imports coming from China. While this is not as close as the world’s most intense trade relationship (between Canada and the U.S., where 76.7% of Canadian exports go to the U.S. and 53.2% of imports come from the U.S.), the trade relationship between Australia and China has evolved much faster as the Chinese economy has grown 11-fold since the turn of the century. All that tells me that if the Chinese economy sneezes, Australia is likely to catch a cold. Which suggests to me that the present weakening of the Australian dollar should be closely monitored.
Iron ore, which is Australia’s main export, had an exceptionally weak month of April. (See chart.) I do not believe this is a fluke. There are two drivers of the price of commodities — supply and demand. There was no meaningful increase in the supply of iron ore in a month. That leaves demand to be the issue. The No. 1 consumer of iron ore is China. I know the U.S. is threatening legal action on the Chinese dumping of steel on the U.S. market, but I do not believe this is the driver here. It is more likely the Chinese economy.
Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates. The opinions expressed are his own.