Goldman isn’t sure how many times they’re going to have to tell you to be patient on commodities, but they do know that as long as you persist in being skeptical, they’ll persist in sending you reminders.
A couple of weeks ago, we noted that you’ll have to pry Goldman’s Overweight commodities thesis from their cold dead hands. See, “patience is working” and “reflation requires time,” so if you’ll just give it a goddamn minute, things will work out just fine.
In reiterating that view earlier this month, the bank said the following (this was Bloomberg’s bullet point summary of the note excerpted in the post linked above):
- 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”
Well on Tuesday morning, Goldman is back out addressing what the bank calls some “common push-back to our bullish commodities view.” Here’s what they have to say…
The past two months have seen two commodity sell-offs – and fundamentals are not to blame
Back in late November 2016, we initiated a trading recommendation to go long commodities (through the S&P GSCI Enhanced 139 index) – our first long recommendation in over five years. While we saw some early gains on this trade (+9% by year-end), a one-week period in early March 2017 saw the trade lose more than 5 percentage points of these gains. By mid-April these losses had been mostly reversed and the trade was once again up more than 7%. However, over last week (April 17 – 21) we once again saw a 5pp one-week decline, and the trade is now back to almost flat from inception. While the sell-off timing has varied between each commodity, oil, metals, gold and coal and iron ore have all seen periods of sharp sell-off over the last two months.
As Damien Courvalin has argued for the oil sell-offs, technicals, rather than fundamentals, have been the key driver. As such, we have continued to argue that all that is needed is patience, to allow the markets to reach their new equilibrium and the logic underlying our base-case, bullish commodities view remains intact.
The most common push-back to our bullish commodities view we have heard, and our responses to them, are:
1.Will the strong survey data ever turn into robust ‘hard’ macroeconomic data? Yes. Indeed, we believe this is already happening.
The macroeconomic survey data have been very strong across the board since at least the start of 2017; however, with ‘hard’ data (such as industrial production) lagging, concerns about the underlying growth story and worries that we have reached ‘peak sentiment’ have increased.
In commodities, we are not nearly as concerned about this as in, for example, the equity markets. There are two reasons behind this. First, global manufacturing data have been stronger recently, and are now starting to close the gap with the survey data. Second, the pricing of physical assets depends upon activity levels not on growth rates. While financial markets are anticipatory assets which depend on growth rates, commodities markets are spot assets which depend on the level of activity. This is because the level of demand must exceed the level of supply in order to reduce inventories and push spot prices higher. Even if growth rates were now to slow, demand levels are starting to get high enough to exceed supply and begin creating inventory draws.
2.Will the previous wave of strong Chinese credit data turn into real activity (in particular, strong physical demand for metals)? Yes. And again, we see this already happening.
Last week we received confirmation, in the form of 1Q GDP and March activity data surprising to the upside, of a robust post-Chinese New Year rebound in activity. This mechanically pushed our economists’ 2017 full-year real GDP growth forecast to 6.8%yoy (from 6.6% previously).
In the commodities space, what we find particularly interesting is the continued solid pace of property sector data and house price appreciation. While potential downside risks in the Chinese housing market have been a focus for the market, we see a major upside risk to metals demand coming from Chinese property. Increased capital controls, and a lack of markets vast enough to absorb China’s savings, have seen property sales in lower-tier cities (subject to less of a crackdown on speculation) accelerate more than enough to offset the slowdown in sales in tier 1 & 2 cities. Strong property sales, and the associated consumer appliance demand, accounted for as much as 40% of copper demand in 2016 and this is a key factor underpinning our tactically bullish view on China’s ‘old economy’ in 2017H1.
3. Are policy-makers already putting the brakes on growth? No. Overall financial conditions remain supportive for growth and commodity demand.
With the Fed already some way into a hiking cycle, and Chinese policymakers raising interbank rates and cracking down on off-balance-sheet lending (including wealth management products), concerns have been raised over tightening credit conditions slowing growth.
In the US, our economists estimate that broad financial conditions, which are more illustrative of the underlying conditions for growth than short-term interest rates, have actually eased over 2017. Stronger equities, narrower credit spreads and a softening USD (vs. trading partners) all contributed to this easing.
In China, while recent tightening in the interbank market is a potential downside risk to growth, we do not expect it to result in growth dislocations. Further, we have not seen any significant tightening in mortgage rates, or broader interest rates that would substantially affect corporate or household investment (the more relevant credit metrics for metals demand). The ongoing crackdown on off-balance-sheet activity does, however, pose a downside risk to our view, particularly if it results in a greater-than-expected credit slowdown in 2017Q2.
4. How will the uncertainty over DM politics (US budget & trade, French elections) and geopolitical risks (Syria, North Korea) impact commodity markets? We see geopolitical risks supporting gold prices, counter-balancing stronger growth and higher rates.
Gold has historically been the commodity most exposed to geopolitical risks (it acts as both a safe haven, and a hedge against debasement risk). The recent period of heightened uncertainty has been no exception to this trend, with gold up more than 10%YTD.
Following the results of the first round of the French presidential election on Sunday, which saw Mr. Macron and Ms. Le Pen advance to the next round, gold has sold off by $17/oz. As Max Layton has argued, we continue to expect prices to move lower, towards our $1,200/toz forecast. The key catalysts we see for this move will be markets repricing to reflect higher US rates, a faster Fed balance sheet normalization, increased expectations of US tax reform (cuts), and stronger growth (as the hard data catch up to the surveys). However, we also note that prices could remain volatile as significant political uncertainties remain, including the prospect of a US government shutdown (more likely if the current budget debate extends into May) and increased military tensions in North Korea. Ultimately, we remain agnostic on gold over a 12-month horizon. While we see stronger growth, exactly how the Fed responds to this environment (i.e., the path of real interest rates), as well as how geopolitical risks will evolve, remain uncertain.
5.Will the OPEC production cuts turn into solid oil inventory draws? Yes. We believe it is just a matter of time.
Since before the OPEC cut, we have argued: (1) that OPEC’s incentives have been to normalize OECD inventories through a short-term, tactical cut; (2) that oil draws were not expected to materialize until 2017Q2, with the US being the last place to see inventories draw. We continue to believe in this analysis, and have subsequently argued that the oil market is indeed making progress on rebalancing, despite the record highs in US crude inventories over 2017Q1. We continue to expect sharp inventory draws in 2017Q2, and see March weekly US oil data as supportive of this view, with a seasonally-adjusted deficit (thanks to strong weather-adjusted oil demand growth), and imports from the Middle East finally declining with the lagged effects of the late 2016 supply push now ending.
Signs of increased certainty – the strategic case for commodities is already reasserting itself
While the recent sell-offs may raise some doubts that we are heading back into a regime of high commodity volatility, with little diversification benefits, the numbers do not bear this out. Both cross-commodity and cross-asset (commodities vs. equities, bonds or FX) correlations remain comparable with those seen in the 1990s/early-2000s (see Exhibit 1).
We believe this is a direct result of reduced uncertainty around long-term prices, due to increased confidence in resource bases. In the past, oil supply uncertainty was a question of which technology would be used to create the marginal barrel. Now, the only remaining uncertainty is the exact cost of shale extraction, giving a much narrower range of long-term price forecasts (see Exhibit 2). This certainty around long-term prices also greatly increases the likelihood that sovereign oil producers will hit their budget targets, reducing the need to save or borrow US Dollars. Less excess savings or borrowings put less oil-correlated price pressures on the Dollar, US rates and Dollar-denominated credit, reducing cross-commodity and cross-asset correlations.
As long-term supply certainty stabilizes long-term prices, demand is left as the primary focus for the market. As already noted, once the level of demand begins to exceed the level of supply, we start to see sustained periods of backwardation (positive carry) emerging. As a result, we maintain our overweight recommendation on commodities, with a 12-month-ahead forecast for the enhanced S&P GSCI at +9%, with roll yield (backwardation) accounting for around half of this return.