Let’s just get one thing straight on Wednesday: you are going to have to pry Goldman’s Overweight commodities outlook from their cold, dead hands.
Yes, the global reflation narrative has fallen on hard times recently, and yes, things were looking decidedly tenuous in early to mid-March what with the bottom falling out from crude and correlations between copper/oil and HY spiking commensurate with the pain.
But generally speaking “patience is working [and] reflation requires time.” Or at least that’s what Goldman is out saying this morning.
Here’s a bullet point summary of the bank’s note followed by a few short excerpts and visuals.
- Besides agriculture, commodities are back to the same levels they were in February, bank says.
- Bank says markets likely to be supported by hard macroeconomic data, real physical demand for metals in China and U.S. oil inventory draws caused by OPEC production cuts
- Markets “need more patience”
- Goldman says its 2017 top trading recommendation to go long on the enhanced GSCI is up 7% “due to patience”
- “The strategic case for commodities remains as solid with cross-commodity and cross-asset correlations collapsing. We believe this is a direct result of the reduced uncertainty around long-term oil prices due to confidence in shale as the marginal source of supply”
1) Oil prices have rebounded back to their pre-March sell off levels. Take out the weather driven sell-off in agriculture, commodity markets are back to the same place they were in late February and are seemingly facing the same questions as they were then. Will the survey macroeconomic data turn into strong hard macroeconomic data; will the Chinese credit data turn into real physical demand for metals; and will the OPEC production cuts turn into solid US oil inventory draws? We believe the answer to all of these questions is yes and that the base case logic remains intact. We still believe that the market needs more patience. The macroeconomic data has been partially distorted by weather events in the US. In China, we still have no hard data yet for March to know whether the post-Chinese New Year rebound in activity has occurred, and the oil draws were not anticipated until second quarter. As a result, we maintain our overweight recommendation on commodities and our 3- and 12-month ahead forecasts of +5% and +4% respectively. Due to patience, our 2017 top trading recommendation, long the enhanced GSCI, is back to being up 7%
2) In addition, the strategic case for commodities remains as solid with cross-commodity and cross-asset correlations collapsing (see Exhibit 1). We believe this is a direct result of the reduced uncertainty around long-term oil prices due to confidence in shale as the marginal source of supply. With shale now the dominant new resource base, the only uncertainty on the supply side is how much will shale cost to extract, not what technology the marginal barrel of oil will come from.
3) We have long argued that demand drives commodity markets on a 1-to-2 year horizon while supply drives these markets on a 2-to-10 year horizon. With supply uncertainty mostly resolved across most markets, this reinforces confidence in long-term pricing, leaving demand as the primary focus for the market.
4) On the macroeconomic front there are three variables we are focused on to pace the transmission of survey data into hard data: industrial production, retail sales and labor participation. The global manufacturing data, which is the most important for commodities, has been very strong through March (see Exhibit 5).
5) In addition to ‘peak’ sentiment, the market also appears to have lost confidence in the Trump administration’s ability to implement policy. Currently, the only part of the Trump trade that the market still remains confident in is the impact from deregulation, as that can be implemented without congressional approval. Although the equity market has lost confidence in ‘good’ policy such as an infrastructure spending program, we are far more optimistic on potential infrastructure spending, though not our base case, as infrastructure can be self-funding through potential user fees that can back bond issuance.
6) Adding to the political uncertainty around the Trump administration – French elections, US missile strike on Syria and increased military tensions in North Korea – we believe the elevated gold price reflects a market that is caught in a tug-of-war between heightened geopolitical risks and a strong underlying global economy (despite a weak US payroll number last Friday). This tug-of-war has been reflected in the recent disconnect between real interest rates, that have been pricing an improving global economy, and gold that is reflecting the increased political uncertainty. Barring a US government debt ceiling crisis, which ultimately would affect the government’s ability to carry out tax reform later this year, we believe that the upside in gold from here is limited.
7) Unlike gold, copper remains in the same holding pattern as it did at the end of last year, waiting for evidence of stronger demand and physical tightness. Concerns over demand weakness have been supported, but not conclusively so, by 10-20% declines in steel and iron ore prices over the past month. But we believe this ferrous weakness can be explained by ferrous de-stocking after prices rallied to extremely high levels earlier this year, particularly as steel demand growth remains healthy (see Exhibits 8 and 9). Substantial upside risk to our current 3-month price target of $6200/t comes from the Chinese property market. Should property sales volumes in the cities not subject to a crackdown on speculative activity more than offset the slowdown in sales volumes in the 40 odd cities subject to restrictions, our 1H17 tactical bullish copper view could stretch through 2H17. With capital controls increasingly successful, the probability of this occurring is rising in our view, though not our base case. We await the March nationwide sales data.
A return to the pre-2003 environment goes to the core of our outlook for strong commodity returns this year, which is based upon backwardation and not price appreciation. In the 1990s, commodity returns were generated from carry not price appreciation. For example, in 1996, investing in oil generated 100% returns despite only a 30% rise in prices (see Exhibit 12). While we see prices almost unchanged from here, we expect 4% – 5% total returns, driven primarily by the positive carry. In addition, the stability in long-term oil prices is also what helps create the lack of correlation between oil and the dollar, which from 2003 to 2016 acted as a buffer to higher commodity prices to the rest of the world, as higher oil prices reinforced a weaker dollar. With that correlation substantially reduced the inflationary impact of higher commodity prices is also increased. In other words, it doesn’t take nearly as much of a move in commodity prices in the current environment to create commodity returns and much welcomed inflationary pressures outside of the US. Finally, the decline in correlation across commodity sectors is also driving the volatility of the broader basket of commodities in the S&P GSCI lower, which further increases, from a sharpe ratio perspective, the appeal of investing in commodities. This was particularly visible last month with further declines in 1-mo realized volatility despite the sharp sell-off in oil prices, and has brought commodity volatility closer to the current low equity volatility levels (see Exhibit 13).