Expect Decoupling: Buy Agriculture And Short Industrial Metals

by: Nicholas Pardini

2011 started off well for the commodities markets and basic materials equities, but fears of a hard landing in China and a slowdown in Europe took caused them to slump the rest of the year and severely underperform. Correlations were also strong amongst the commodity sector as well as all of the commodities outside of gold declined for the year.

However, in 2012 I think this correlation will break. The problems in China with the collapse of the coastal China real estate bubble and declining exports are substantial enough to send China down to a hard landing. Wealthy elites in China who are unsatisfied with government interference in their business operations and the lack of civil liberties are moving away in droves to the US, Canada, and Australia. They are taking their assets with them out of the country with them which adds to deceleration of Chinese growth.

Since China is responsible for 40% of commodities demand for China, I expect commodities as a whole (assuming no massive QE3) to continue to struggle into 2012. However, I expect there to be divergence among different types of commodities. Industrial metals will continue to decline and underperform while agricultural products will outperform commodities indexes.

The reason for this disparity is the diverging effect of Chinese slowdown on industrial metals versus farm products. The decline in Chinese growth from 8-10% annually to below 5% adversely hurts industrial metals because at a slower growth rate, China's appetite for industrial metals deteriorates rapidly. Supply has increased rapidly just as demand for metals has been falling. 2011 was a record year for copper, silver, and iron ore production. As a result of excess supply, inventories of steel, iron ore, and copper are overflowing in commodity exchanges around the world ranging from China to New Orleans. This combination has and will continue to create downward pressure and bearish speculation among industrial metals.

Agricultural commodities on the other hand face much less elastic demand. Less housing in construction in China hurts copper demand, but it does not change the fact that people will not stop eating. Emerging economies may be facing slowdowns, but they are not contracting or halting to the point that consumers will be forced to change back to a grain based diet from their newly acquired meat based diets. Agricultural output has been rising, but not at the pace to keep up with long term population. High birth rates and access to modern medical technology in developing countries has created a Malthusian trap for large parts of Asia and Sub-Saharan Africa. This continuous growth in global population versus food supply is a strong support for food prices going into the near future. In addition to this, increased volatility in the futures market has made farmers hesitant to increase production in 2012. Overall, these trends place excellent support levels for agricultural commodities and will drive prices upward into 2012.

The best way for investors to capitalize on these trends in the commodities markets is via pair trades that go long on agriculture and short on industrial metals. The least risky way to do this is through ETFs. Go long on the Powershares Agriculture ETF (NYSEARCA:DBA) and short the Powershares Base Metals ETF (NYSEARCA:DBB). This pair trade can also be completed with individual stocks as well. Some combinations include going long Potash (POT) and short Rio Tinto (NYSE:RIO), long Seaboard (NYSEMKT:SEB) and short Aluminum Corporation of China (NYSE:ACH) or for a Brazilian twist go long Brazil's leading sugar producer Cozan (NYSE:CZZ) and go short on struggling iron ore producer Vale (NYSE:VALE).

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in DBB over the next 72 hours.