You Can Have Goldman’s Bullish Commodities Thesis – When You Pry It From Their Cold, Dead Hands

Commodities, as a group, had a rough go of it in June.

Specifically, the Bloomberg commodities index had its worst month in nearly two years:

Part of the problem here is the threat of demand destruction emanating from trade tensions.

“As well as the direct hit to steel and aluminum, tariffs on end markets such as electronics, machinery and autos risk weakening demand for the commodities that feed them,” Morgan Stanley wrote last month.

The Bloomberg agriculture subindex fell to a record low this week, days ahead of the Friday deadline after which U.S. tariffs on Chinese goods and Beijing’s reciprocal duties will take effect.

Between the trade war concerns and Donald Trump’s ongoing efforts to badger Saudi Arabia into engineering a deep and sustained drop in crude prices (and yes, the administration’s hardline stance on Iran works at cross purposes with the push for lower prices at the pump, but that’s a “stable genius” for you), you’d be forgiven for questioning whether it might be a good idea to take profits at this point, given that commodities are still one of the better performing asset classes in a year where performance has been hard to come by.

Well, if you’re Goldman, you’re not ready to give up on your OW commodities reco – not by a long shot. In fact, you will have to pry that reco from their cold dead hands.

GOLDMAN MAINTAINS OVERWEIGHT RATING FOR COMMODITIES

just FYI: you are going to have to pry this reco from their cold, dead hands. pic.twitter.com/QIH8h6TP47

— Heisenberg Report (@heisenbergrpt) July 5, 2018

Do note the hilarious time stamp on that: it was out just hours after Trump took to Twitter to demand lower oil prices for the hundredth time in the last three months.

Goldman has of course been pounding the table on commodities for months. Back in February, for instance, they laid out the case for why they’re “the most bullish in a decade” on raw materials.

Well, in their piece out Wednesday evening, the bank takes you through the myriad reasons they’re staying bullish, starting with an effort to explain why things got derailed last month.

Basically, they cite two phases of economic weakness, the first in Europe (well publicized and analyzed to death ahead of the June ECB meeting) and the second in EM. They illustrate this in a variety of ways, but here’s a simple chart using the euro and the yuan:

Goldman believes the DM-ex-US weakness is largely behind us and as far as EM, they note the following:

The second phase of metal weakness and dollar strength was created by weak EM macro data — particularly in China, which showed weaker-than-expected money and credit, IP, investment and retail sales data in May. While some of the data softness is related to measurement issues, the broad-based weakness suggests that tightening of financial regulations and restraints on local government debt may have started to impact the real economy. Note that this was ultimately a policy decision, and the government has already been stepping up policy loosening and administrative tools to support credit and growth.

So we’re banking on looser policy in China, which would presumably be dollar positive to the extent it reinforces policy divergence, and that, in turn, should be bearish for commodities, but Goldman is glad you brought that up. They go on to say that the “trio” of higher rates, rising commodity prices and a stronger dollar isn’t ultimately sustainable.

Obviously, we’ve been over the stronger dollar/higher rates/higher commodity prices argument dozens of times in these pages over the last several months and I’ll spare you that discussion here. Suffice to say Goldman’s commodities team thinks “something has to give” and they agree with their own FX strategists that “the dollar will likely weaken from here.”

On the oil front, it’s all about supply risks. I cited this passage earlier, but I’ll use it again here:

The oil market has rebalanced over the past year on the combination of strong demand growth and large OPEC production cuts. We forecast that the market will remain in deficit in 2H18 despite higher production by core OPEC producers, with rising supply threats elsewhere potentially threatening a sharp further rise in prices and global economic growth. Actual and likely production losses are adding up: (1) production is most at risk in Iran, with the US administration targeting a significant drop in exports that could threaten more than 1 mb/d by year-end, (2) Venezuela production continues to decline at a pace of c. 170 kb/d per quarter, (3) Libya production has also been disrupted following violence in the east of the country leaving exports suspended from Eastern ports, with flows currently down by 600 kb/d, and (4) Canadian production will likely be down by 360 kb/d through July because of an outage at the Syncrude Canada plant. On aggregate, this far exceeds the 1 mb/d proposed increase in OPEC+ production, with these issues able to quickly exceed our estimate of short-term available spare capacity of c. 2 mb/d.

Don’t tell that to Donald Trump.

Speaking of Trump, Goldman goes on to take a lengthy look at what’s actually being taxed in the trade spat (the administration would really appreciate it if you didn’t call it a “war”, ok?) with China. Basically, the bank’s contention is that this is clearly more about politics than economics. To wit:

The logical goods to impose tariffs on would be ones where the targeted imports represent a small share of total imports (giving the importer more options to source supplies) but a large share of the targeted nation’s exports (reducing their options in finding a new consumer). However, a close examination of the goods targeted by both China and the US suggests that the choices were far more driven by politics than economics (see Exhibits 16 to 19). The US chose to implement tariffs on goods closely tied to China’s Made in China 2025 plan for further industrial development. However, a simple reading of the data shows that the US is more dependent on imports of these goods from China, than China is on exporting these goods to the US. The Chinese chose soybeans, and while this initially appears to satisfy the conditions of a rational target for a tariff (the US exports more soybeans to China than anywhere else), it is actually China’s most economically vulnerable import as there is no ‘spare capacity’ in global trade which can be rerouted towards China to compensate. However, again this is a good that is politically relevant, given the importance of the farm belt in US politics. In summary, China targeted commodities in the US like oil and soybeans while the US targeted high-end technology goods that are more metals-intensive, but with little impact on domestic Chinese metals demand.

The upshot there is that Goldman doesn’t generally see the first round of tariffs being particularly impactful on the surface, but they do acknowledge that the hit to sentiment/confidence could be material.

Where they do see the potential for significant demand destruction is in the proposed auto tariffs. That threat (that the U.S. would cite “national security” on the way to slapping duties on $275 billion in car imports), has been the subject of vociferous debate over the past month and although Goldman doesn’t think the tariffs are likely to be implemented, they do offer the following cautionary analysis:

Assuming the tariffs go though and other countries retaliate with similar tariffs, we find that the total impact for metals could be substantial in the short run. We find that, based on historical price elasticity of demand for US autos, in the short run there could be a loss of demand of 0.7% for zinc, 0.8% for aluminum and 0.4% for copper as consumers defer their purchases in response to higher prices.

In any event, the bottom line from this entire note (which runs to 14 pages), is this:

We maintain Overweight commodities, with a 12-month expected return of 10%, and view the current weakness as a buying opportunity. The pillars of our view remain: 1) strong late-cycle commodity demand that depends on demand levels rising and not slowing growth rates 2) supply disruptions in key oil and metal markets which are exacerbated by recent sanctions 3) depleting inventories which create increasing positive carry in nearly all energy and metal markets.

So take that for whatever it’s worth, or isn’t worth, and do remember that to the extent any of it is predicated on Trump being a rational actor, that assumption is never a safe one.