- An overview of commodity trends and related currency impacts.
- Yen-related currency turbulence in emerging markets has upended resource economies.
- With QE winding down, the end of global "easy money" has also impacted commodities pricing.
The events in Ukraine - a nation on no one's radar a few months ago - underscore the unpredictability of, but also the opportunities from, investing in physical assets. The incursion into Crimea and encirclement of Ukraine military bases by Russian troops sent commodity prices to six-month highs. Ukraine, according to USDA, is the world's fifth-largest wheat exporter and third-largest corn exporter. Ukraine was previously forecast to export 10 million tonnes of wheat this year, but the military crisis could disrupt transportation. Russia is estimated to sit on one-quarter of the world's natural gas reserves. Russian natural gas is shipped to customers in Europe via pipelines through Ukraine.
During the year-end 2013 stock rally, investors who thought stocks were getting overpriced stayed along for the ride because they had nowhere else to go - certainly not to the bond market amid rising rates. Commodities were already in a rising trend this year before geo-political events spurred surges in energy and agricultural commodities.
Both economic and fiscal factors have been lending support to commodities, which are still well below their 2011 highs and represent an attractive asset class. We could see institutional money accelerate into commodities. Institutional asset reallocation into commodities could represent as much of a challenge to stocks as this supposed "Black Swan" event.
Real Assets within a balanced portfolio
The Argus Asset Allocation Strategy for balanced portfolios recommends 65% equity, 25% fixed income, 5% cash, and 5% alternative investments (real assets/commodities). Alternative assets include physical assets, such as gold, oil, industrial and agricultural commodities, as well as currencies and non-REIT real estate. Within our recommend 5% exposure to real assets/commodities, we suggest 100-200 bps exposure in real estate and 300-400 bps exposure in commodities, currencies, & non-equity energy.
First-time commodity investors should be aware of the dangers of replicating exposure. Ownership of hard assets can overlap and potentially replicate positions and exposures within equity asset classes. Energy currently represents 10.0% of S&P 500 weighting, in a diminishing trend; Materials has a 3.5% weighting, in a rising trend. For investors with market-mimicking equity asset allocations, overweighting/underweighting of real assets can amplify/decrease commodity-related risk.
Currencies & Commodities: Accelerating Turbulence
Normally the dollar-commodities relationship is quite straightforward. Raw and semi-finished commodities are priced in dollars. Dollar strength historically inversely correlates to commodity prices. This relationship can be superseded in periods of extreme commodity demand, called "super-cycles." For longer-term investors, real demand is the key determinant of returns as time and foreign-exchange movements cause currency impacts to dwindle.
However, we have seen unusual foreign exchange volatility for the past 18 months. Under "Abenomics," Japan implemented a hyper-QE phase to deliberately tank the yen and improve trade attractiveness relative to China, Korea, and other Asian economies. The U.S. launch of open-ended QE3 extended dollar weakness, further eroding emerging economy competitiveness - and, eventually, emerging economy currencies.
"Soft" money nations - those like the U.S. dependent on money-printing stimulus programs such as QE - have seen long-term declines in their trade-weighted currency. The U.S. dollar index fell from a peak of 148 in 1995 to 112 in 2002 and is at 79 currently; the cycle low under 70 was reached in 2011-12.
Argus has historically favored "hard money" currencies, meaning nations no reliant on excessive quantitative easing. These include Swedish krona, Swiss franc, South Korean won, and the Aussie and Canadian dollars. Europe-based, non-resource hard money currencies are holding up. In this turbulent currency period, however, resource-reliant currencies have weakened along with underlying commodities demand.
Strengthening in China's currency alongside weakening yen has hurt Chinese economic activity and impacted China's appetite for raw goods imports. Since 2008, the yuan has appreciated against the dollar a cumulative 35%-plus. Very recently, the yuan has weakened slightly. Yuan weakness may be tonic for China's lately wavering growth prospects and in turn for commodities demand. The euro has been looking stronger, although the Ukrainian crisis, if extended, could test euro strength.
Argus believes a sustainable phase in emerging market currencies could be reached in coming months. For emerging economies to stabilize, recent relative stability in the yen must persist; and it would be helpful for the yuan to reach near-term stability as well. Beyond stability, actual growth in emerging market economic activity is reliant on strengthening in Chinese economic activity.
Despite economic outperformance relative to nearly every other region the U.S. dollar has weakened since mid-2013 particularly vs. UK sterling and euro. As yen stabilizes, we expect the U.S. dollar to stabilize but not rally. Continued weak/stable dollar would be positive for commodity pricing
Commodities: rising across 2000-11, down across 2011-13
Commodities have ridden a roller coaster in recent years. Commodity "super-cycles" ending in 1917, 1951, and 1973 coincided with heavy materials demand from wartime. Argus believes commodities were in a possible "super-cycle" that began in 2000; this super-cycle was associated not with war, but with China. We believe this cycle peaked and possibly ended in 2011-12.
For consistency in tracking changes in commodity pricing demand, we tracked the Commodity Research Bureau (CRB) Bureau of Labor Statistic (BLS), a daily spot index of 22 basic commodities sensitive to changing demand across the breadth of the economy. The super-cycle and China drove CRB BLS spot index from a reading of 220 in April 2000, to peak price of 576 in April 2011, an advance of more than 160%.
The CRB BLS spot index fell hard to 489 by December 2011, and then drifted down over the next two year. Altogether, the CRB BLS fell 21% from its spring 2011 peak to 454 by December 2013.
What broke the decade-long uptrend in the CRB BLS spot index? There were both economic and monetary/fiscal factors, in our view. We believe the sharp fall from spring 2011 into year-end was first catalyzed by the European sovereign debt crisis. The steady drift down from year-end 2011 to year-end 2013, in our view, coincided with China's economic deceleration, hurting resource-reliant and resource-hungry economies. Eroding Chinese demand impacted neighboring trading partners and in turn hurt natural resources demand.
While these negative economy-sensitive trends in the commodity market were years in the making, fiscal and monetary events unfolded faster. Across early to mid-2013, asset markets underwent culture shock, as cheers for perpetual QE gave way to fears about tapering. We have seen that implementation of tapering signals not only the end of QE but also the end of easy money and the cyclical rise in interest rates. These trends have roiled all emerging economies dependent on cheap capital.
Commodities: Recovery taking shape?
In 2014, we have seen encouraging signs not only in CRB BLS spot but also in sub-categories. [For this analysis, we have excluded March 2014 commodity-price movements, which have been heavily impacted and potentially distorted by the Ukrainian crisis.]
As of the close of February 2014, CRB BLS was at 475, or up about 6% year to date. A range of sector-specific CRB spot indexes were also rising. The CRB metals, which declined 11% from 945 in February 2013 to 840 in June 2013, has risen approximately 12.5% since mid-2013. The CRB Foodstuffs index was up 9.8% year to date as of close of February, pulling it . level with October 2013; recall that all agricultural commodities indexes plunged across summer and fall 2013 in response to the bumper U.S. harvest. The CRB Raw Industrials Index was approximately flat year to date as of end of February, though up 2% from the end of January.
Our more positive commodities outlook has both an economic component and a fiscal/monetary component.
From an economic perspective, we see mixed but generally positive signs across all major regions. Europe appears to be inching toward growth. The IMF's eurozone GDP forecast is 1.2% for 2014 and 1.7% for 2015. Among the major European nations, France remains the "soft spot." Germany, the UK, and Scandinavia are strongest, but even key Southern European nations show improvement.
In Asia, approximate 25% devaluation of the yen has had the desired effect of improving Japan's trade activity. We believe the yen will not go meaningfully lower. In China, the modest downturn in Yuan after multi-year strengthening could be positive at an important time for that nation. Since Xi Jinping assumed Communist party leadership (11/12) and the presidency (3/13), China's leadership has been more concerned with stabilizing the banking system and reducing speculative excesses in real estate than in rekindling economic activity. With the worst excesses presumably corrected, China's leadership can focus on restoring growth. China import/export activity has been accelerating, although PMIs remain wobbly. We expect economic re-acceleration in China to lead to ongoing recovery in industrial commodity prices.
The United States remains the most significant factor in the global economy. But apparently, we have to stop shivering before we can resume growing. After several soft economic reports in 2014 to date, investors on 3/3/14 were treated to above-consensus readings on personal income & spending, the ISM manufacturing index, and construction spending. Those bullish indicators were drowned out by growls from the Russian bear on the worst day (to date) of the Ukrainian crisis. Still, we believe they provide a better indicator of the underlying strength in the economy that should become visible once all the snow and ice melts.
The U.S. Federal Reserve's tapering program signals the wind-down of quantitative easing, but also the end of easy money worldwide and a cyclical trend toward higher interest rates. As rates rise amid accelerating economic activity, we expect inflation to accelerate modestly. Inflation has been held back by a dearth of wage inflation. But as we creep toward full employment in the U.S., even wages are starting to move higher.
Inflation has historically benefited hard assets such as oil, metals, and agricultural commodities. These "wealth in the ground" assets should increase in value as prices for finished goods move higher.
A final consideration is the long-term trend in the dollar. Argus Chief Investment Strategist Peter Canelo points out that while concern about deficit spending has gone away, our $15 trillion national debt has not. With the U.S. still spending about $1.33 for every dollar of tax receipts, Peter believes the dollar can go much lower over time. Given that historical reverse correlation, a weak dollar would benefit commodity prices for the long term.
Argus Specific Commodity Asset Forecasts:
Within a long-term rising trend, gold experienced a spectacular run from spring 2009 to its summer 2011 peak. Moderate declines across 2011-2012 gave way to gold's 28% crash in 2013. Then as now, gold was hurt by weak consumer trends in Indian, China, and other emerging economies. The "Gold Bug" thesis, meanwhile, has weakened as recovery dissipates gloom & doom from great recession, and tapering eliminates prospects for unending QE.
Even before the spike in Ukraine, gold prices experienced an 8.5% recovery in the year to date. nonetheless, we expect gold prices to decline in 2014 due to short-term dollar strength, global GDP growth, and interest rate increases from tapering. These negatives could be potentially offset by net central-bank buying, strengthening consumer demand China and India, a reversal in global GDP growth outlook, and/or a true "Black Swan" event.
Industrial Commodities & Metals
Although CRB METL is up 12.5% since mid-2013, the index was flat YTD as of the end of February 2014. Copper spot is down 2.5% YTD; iron ore spot is down 6%; and LME aluminum spot down is about flat. We are encouraged by trends in Europe, and we believe the U.S. recovery remains on track.
But for metal spot prices to gain in 2014, China must move beyond shoring up its banking system to restoring growth incentives in the broad economy.
Despite being the world's largest industrial economy, the United States finds itself in the rare role of being the global "bread basket." After 2012's great drought sent grain prices higher, the U.S. bumper crop in 2013 tanked agricultural commodity prices. CRB Foodstuffs and CRB Livestock both crashed by double-digits in final quarter of 2013 to cap weak full-year.
The change of seasons has changed the trend. CRB Foodstuffs is up 9.8% YTD in 2014; and CRB Livestock is up 8.2% year to date. We are not meteorologists, but we can listen to a weather forecast. Our understanding is that the global conditions creating record cold in the Northeast and Midwest could persist at least though mid-year. Altogether, we anticipate a more normal growing season in the U.S. in 2014. Ongoing demand growth from the fast-growing emerging economy consumer should keep agricultural commodities prices heading north in 2014.
In the immediate aftermath of Russia's incursion into Ukraine, prices for Brent, WTI and Henry Hub natural gas all shot higher. The sharp seasonal decline in gas futures prices from a week ago has now reversed There could be longer-tailed impacts as well. Should the U.S. and other nations implement sanctions actual or pending deals to develop Russian energy assets could be postponed or cancelled.
Our energy price forecasts for 2014 assume a $2 drop vs. 2013, to $96 per barrel; a $4 decline in Brent, to $105; and a $0.26 increase in Henry Hub natural gas, to just under $4.00. Putting aside the most recent geo-political events, which are impossible to predict, we may need to tweak our estimates upward after unusually harsh winter in the U.S.
In the intermediate-term, strained pipeline resources are likely to keep Henry Hub natural gas prices high. Utilities have responded to the gas-price spike by switching to coal. But the long-term trend is ongoing retirement of coal-fired utility plants, which is favorable for gas (particularly if pipelines remain constrained). For crude oil, global GDP acceleration would be positive for pricing in the short term. For energy overall, our long-term thesis is that the trend toward increasing supply (shale) and decreasing demand (energy efficiency) will result in declining prices.