I’ve said it before and I’ll say it again: You are going to have to pry Goldman’s bullish commodities thesis from their cold, dead hands.
Just to recap, commodities are having a rough go of it lately and it’s not difficult to explain why. Here are some sore spots:
- Crude is collapsing
- There are persistent concerns about demand in an environment where the incoming data continues to suggest that 2017’s “synchronous global growth” narrative has morphed into a story about a “synchronized global slowdown”
- The threat of further escalations in the trade war only exacerbates concerns about the global economy
Given all of that, it’s no surprise that the Bloomberg Commodity index has fallen for six of the last seven weeks to its lowest levels since summer of 2017.
30-day vol. has of course exploded to the upside.
Well, if you’re a “it’s always darkest before the dawn” type, Goldman’s latest note on beleaguered raw materials is for you, because far from throwing in the towel, the bank is doubling down – and then some.
“Given the size of dislocations in commodity pricing relative to fundamentals with oil now having joined metals in pricing below cost support, we believe commodities offer an extremely attractive entry point for longs in oil, gold and base”, the bank writes, before suggesting that the near-term catalyst is likely to be the G20.
More than a few folks have suggested that in addition to the hotly-anticipated meeting between Trump and Xi, the G20 will also effectively determine the trajectory for crude given that both Vladimir Putin and Crown Prince Mohammed bin Salman will be in attendance (hopefully, Prince Mohammed will leave his bone saw in Riyadh).
“Many of the political uncertainties weighing on commodity markets have a significant chance of being addressed in Buenos Aires”, Goldman contends, adding that “this includes some improvement on the China/US relationship (metals and soybeans) and like in the 2016 G20 meetings, some greater clarity on a potential OPEC cut (oil).”
The bank goes on to marvel at the simultaneous underperformance across nearly all assets in 2018. To wit, from the note:
Never have markets seen every asset class down for the year outside of a global recession or economic crisis. Usually when equities and bonds underperform outside of a recession it is due to concerns about the impact of rising rates on future growth as it is today, not current growth. Because commodities are spot assets and price current growth, they typically act as a diversifying asset with oil and commodity prices spiking until macroeconomic concerns turns into an outright recession, which diminishes commodity demand. However, we are seeing no such demand weakness.
So, what accounts for this? For Goldman, the answer is “the lack of discretionary risk capital devoted to commodity markets” or, more to the point, the preponderance of robots, algos and other non-carbon based life forms in markets.
Part of the issue for discretionary, fundamental-based investors is the unpredictability of U.S. foreign policy. Goldman argues that because the Trump administration has “more tools at its disposal to influence commodity markets than financial markets”, raw materials are increasingly subject to the whims of the man in the Oval Office.
“Commodity markets have been disproportionately impacted by a US foreign policy that has shifted towards active engagement” the bank pseudo-laments, before listing “sanctions, the SPR for oil, Section 232 for metals and the CCC for agriculture” as weapons in Trump’s armory.
When you “combine an indeterminate trade war, vague Iranian sanctions and suggestions from the US administration for oil prices below $54/bbl against a US costs basis of $55/bbl, it becomes difficult to take fundamentally driven trading positions let alone write about them,” a frustrated Goldman says.
And then there’s the machines – damn the machines!
“Without discretionary traders, systematic traders become a far larger share of the market and are having an outsized influence on commodity prices”, the bank frets before reminding you about the dynamics that ultimately accelerated the losses in crude.
Recall that in addition to the bearish fundamentals, momentum chasers pushed WTI through key strikes tied to producer hedges, forcing dealers who were (and still are) short those puts to sell more and more oil in order to stay hedged themselves.
Here’s the problem, as delineated at length by Goldman:
The key is that these systematic traders are based on rules that respond to price patterns or perceived risk premia, which become more important than spot fundamentals or even anticipatory views on such fundamentals. Historically, they have been focused on momentum and volatility selling strategies to create alpha. In the current environment, the short volatility strategies are being unwound, creating a spike in volatility, while the momentum strategies drive the market lower in oil. With no discretionary money to take the other side, market liquidity is drying up, which reinforces the momentum to the downside, causing commodities to decline more than equities, making them appear to price a more dire demand outlook.
And listen, if you don’t believe that the abundance of systematic investors and the dearth of humans is destroying price discovery, then Goldman thinks it’s time you take a hard look at the history of onion volatility (“not the Onion”).
“Just look at onion futures after the US government banned active investors in the 1960s, volatility exploded”, the bank flatly notes, on the way to reminding you that “when markets overshoot fundamentals, discretionary traders either buy or sell to push prices back in line with fundamentals and dampen volatility.”
The bottom line from where Goldman is sitting is that this isn’t a sustainable state of affairs over the longer term. It’s creating misallocated capital, distorting markets, destroying the role of fundamentals in pricing and, perhaps most importantly, it’s making Goldman’s commodities bull thesis look increasingly wrong-footed.
So, how will this extremely untenable situation resolve itself? Like this, according to an exasperated Goldman:
Either discretionary money will come into the markets should US/Chinese policymakers create market confidence in the coming weeks or the physical markets will ultimately correct the paper markets sometime during 2019. In any case, both solutions point to higher commodity prices and an opportunity for discretionary investors to take advantage of severely dislocated markets.