Commodity Markets Poised For Relief Rally

by: Daniel Moser

The commodity markets have become more volatile and more highly correlated with the risk on/risk off market regime that has done nothing but cause trouble and confusion for most investors over at least the past year. From time to time commodities have shown some solid resilience and at other times commodities have been taken out back for a solid beating. One of the key fundamental drivers behind the occasional strength in commodities has been demand from China. Some people argue that China is increasingly becoming a house of cards. While the China bears do make a lot of valid points, I find it very challenging to conclude that all of the growth in China is a total facade ripe for a catastrophe at any moment. Nontheless base metals have not been a particularly compelling trade in 2011 because Chinese demand, the primary driver of commodities, has been entirely relient on credit conditions in China - which up until very late have been tighter and tighter month after month.

In a recent article authored by Leslie Hook in the FT, she noted, "After a year of credit tightening and efforts to cool the property sector, Beijing’s restrictive policies are starting to have a visible impact on the real economy. Nowhere is that more clear than in raw materials such as steel, copper, and cement which are linked to construction and the cooling housing market." Tightening credit conditions in China, coupled with less than desirable non-Asian basic materials demand growth, have created a condition in which commodities are a direct function of two variables...Chinese monetary policy (a.k.a. credit conditions) and risk on/risk off related to macro risks that aren't likely to vanish anytime soon. The monetary policy in China may be on the reversal as of late which could potentially lead to improving basic material demand in the coming months.

An article by Simon Rabinovitch in the FT discussed signs of changing monetary conditions in China. According to the article, "China’s money market rates have fallen sharply amid signs that the government is beginning to ease its tight monetary policy around the edges to keep growth on track. Premier Wen Jiabao vowed last week to "fine tune" policies, which many analysts said heralded a shift towards a moderate loosening of the monetary straitjacket imposed on the economy over the past year to control inflation." While talk is cheap, and China does a lot of it, there are signs that they are making good on their words. The article argues that, "an indication that the government was delivering on its promise came on Wednesday with a nearly 70 basis point drop in the seven-day repo rate, the steepest decline in three weeks in the country’s most important gauge of interbank liquidity. Moving in tandem, the one-year interest rate swap plumbed a six-month low at 3.37 per cent."

The article goes on to say that the "countries biggest banks have ramped up their lending at the end of October after the central government called on them to provide more credit support for small and medium-sized enterprises, according to a report in the official China Securities Journal on Wednesday." The article cited an economic forecast from Mizuho Securites arguing that they believe "loosening will proceed faster than expected".

As with anything market related, there are always risks. The article does provide some overall context that the Chinese central bank will want some degree of confidence that inflation will remain under control before it begins a full-out easing of monetary policy. So it is a bit early to assert that monetary policy in China is undergoing an official shift to easing. But the evidence is starting to build.

In a seperate research note from Barclays Capital there may be some incremental support for base metals cropping up outside of Asia. They argue the following:

With the release of October’s PMIs, our leading indicators for base metals demand bounced back above 50 for the first time since May, suggesting a pick-up in y/y demand growth is in sight for early next year across the base metals complex. The rebound was mainly centred in the US, where the “order book” (new orders and backlog of orders for manufacturing goods) jumped from 45.6 to 50, its largest monthly increase in ten months. Furthermore, our forward-looking measure of “expected purchasing” of manufacturing goods increased from 39.9 to 50.9, its largest boost since April 2009, due to a combination of falling inventories (from 52 to 46.7) and rising orders.

Barclays does go on to highlight that demand out of China appears to be relatively weak in comparison to recent past. But this makes perfect sense given the increasingly restrictive monetary policy and credit conditions that have only tentatively just begun a reversal.

On a long-term basis: until the macroeconomic risks within Europe are solved or there is at the very least a clear path forward that everyone has accepted and can believe in, basic materials are too volatile and correlated with the risk on/risk off market regime to warrant an overweighted position in an investor's portfolio.

On a short-term basis: there are some notable fundamental changes in China that have me believing that basic materials are poised for some stronger times ahead over the next 2-6 months at least. I think pairs trades between SPY and a basket of basic materials companies such as VALE, Freeport-McMoRan (NYSE:FCX), Southern Copper (NYSE:SCCO), Rio Tinto (NYSE:RIO), Terra Nitrogen (NYSE:TNH), Cliffs Natural Resources (NYSE:CLF), Mosaic Company (NYSE:MOS), etc. or simply XLB might be just the ticket to some upside in the coming months. I would also consider any options strategy, with a limited downside payoff profile, on any basic materials names you consider best of breed.

Disclosure: I am long TNH, and short positions in SPY