A Summer in search of a bullish catalyst. Though still the best asset class in 2018, the risk aversion to commodities and EM this summer left the market in search of a catalyst to generate the final 5% in our 2018 returns forecast and our 12m expectations of 8% returns, This is particularly the case for metals which are down 14% YTD. Despite a trade war, EM concerns and a strong dollar, commodities are up 8.5% YTD, of which nearly 2% is due to carry.
Physical premia likely to drive the financial markets higher. The risk aversion this summer created significant EM destocking, particularly in China as consumers attempted to avoid a strong dollar and tariffs by liquidating inventories. This liquidation, however, has a physical premia for oil and metals- a sign of physical shortages. This is likely the catalyst the financial markets have been looking for.
Dollar unlikely to derail our bullish view on commodities. The dollar is strong because the US economy is stronger than expected, not because the Fed is overtightening. A strong global growth impulse from the world’s largest consumer can only be positive when viewed in aggregate. Further, we find only a small share of EM regions with concerning external dollar debt. The vast majority of dollar debt is tied to commodity producers who earn dollar revenues.
Moderating bullish gold view on EM selling. Our Fear & Wealth framework for gold looks very similar to the late 1990s: no DM fear due to tech boom and no EM wealth due to Asian crisis. EM concerns have created a sizeable fall in financial and physical holdings. Net specs are outright short now. The key is renewed EM demand which we believe is coming from physical signals as even Turkey’s CB has now stopped selling. We are revising our 12m forecasts to $1,325/toz from $1,450/toz.
The ‘great’ destocking continues. The 2016 recovery in demand brought with it a sharp rise in the cost to carry record-high stockpiles of all tradable goods built up from 2009 to 2015. Unprecedented destocking ensued that was not tied to risk aversion. We find relative funding costs play an important role in the speed and location of destocking, however, the broader global trend remains intact and continues to move markets further into backwardation.
- The ‘great’ destocking followed an unprecedented rise in inventory. Following the collapse in demand levels in 2008/09 and the subsequent sluggish global demand growth for the following 7 years, global inventories of all goods and commodities rose to unprecedented levels by the end of 2015. Such large stock piles were financed by an equally unprecdented decline in intterest rates. The resulting collaspe in prices in late 2015 resulted in rationalization of excess capacity via China and OPEC policy which helkped to jump start the destocking process. However, at the core of this destocking were demand levels finally reaching a point that stressed the ability for markets to deliver. And as growth accelerated during 2016 to early 2018 the resulting inflationary pressures forced the US-Fed to finally raise interest rates and as the cost of carry increased so did the speed of destocking.
2. Accelerated EM Destocking masks stronger fundamentals. Despite a trade war, EM concerns and a strong dollar, global demand growth for commodities remains robust. High-frequency data for August implies global oil demand up 1.8 mb/d, albeit partly from a weak August base from last year, and copper demand seems to be tracking at 2.8% yoy according to CRU. Accordingly, commodity inventories for both oil and metals continue to draw. The rate of draw, however, is faster in areas with higher relative funding costs. We find that a stronger dollar and trade war have increased local costs of carry relative to the US and accelerated the destocking in emerging markets, particularly in China. This, in turn, has created the temporary appearance of demand weakness in the developed markets as EM imports slowed. However, this is only a temporary phenomenon as there is a limit on how long EM can avoid buying key commodities, particularly food and fuel.
3. Physical markets likely to drive the financial markets higher. This perceived demand weakness has made investors hesitant to buy EM-related assets like base metals: however, as EM inventories deplete, physical buyers, don’t have this same luxury to wait for these EM concerns to subside and they are already returning to key markets like oil and copper. In oil, Chinese refiners returned at the beginning of this month after being absent for 3 months. This created a $9/bbl rally in flat price from mid-Aug, but more importantly, it brought back the backwardation in the Brent and Dubai forward curves. In copper, inventories have been depleted to the point that the Shanghai curve is backwardated and local physical premia for metal have started to rise, which suggests that physical Chinese metal consumers are likely to return to global markets soon. We [Goldman Sachs] believe such evidence of physical demand will be the catalyst to create financial demand for both commodities and EM assets.
4. Dollar unlikely to derail our [Goldman Sachs] bullish view on commodities. A key concern is whether a strong dollar will derail global demand growth in 2019. We [Goldman Sachs] believe not. The dollar is strong because the US economy is stronger than expected, not because the Fed is overtightening, A strong global growth impulse from the world’s largest consumer can only be positive when viewed in aggregate. After the catastrophic experience of the late 1990s when local currency devaluations created solvency crises due to too much US dollar denominated debt against local currency income, most regions have not made the same mistake. Note that most commodity producers don’t have this problem as the income is dollar-denominated, Only a few places like Turkey and Argentina made this mistake and the strength is the dollar has already exposed these weaknesses. In fact, we [Goldman Sachs] find that while EM’s share of commodity demand has increased significantly, EM’s share of US dollar debt has declined sharply.
5. Growth in the Big 4 has not slowed materially. As we [Goldman Sachs] have argued in the past, commodity demand is mostly dependent upon the ‘Big 4’ – US, EU, China, and India. Both hard and soft macroeconomic data do no show a material slowdown in Chinese growth. Most of the slowdown has been in the more fragile EM countries. Even in India, the hard data shows growth where the soft data has disappointed. Yes, the August Indian oil demand data disappointed, but that was due to a ban on the import of petcoke for use as fuel. Motor gasoline and diesel demand growth was fine. Looking forward, the Chinese have done a lot to stimulate growth by relaxing both deleveraging and environmental restrictions. On the credit side, July and August TSF picked up against the latest PBOC liquidity injection. And given that infrastructure spend was a big worry earlier this year, the latest NDRC announcement on infrastructure investment and increases in local government bond issuance are important.
6. The final unwind of the ‘great’ carry trade. The ability of China to use monetary policy to stimulate growth is limited. This past summer, US and Chinese rates kissed for the first time since 2009, and now rising US 2-year rates have started to put upward pressure on Chinese 2-year rates. However, the ability for Chinese rates to trade substantially below US rates is constrained by the lack of capital outflows that China will allow given the capital controls that are in place. Although China has controls around the flow of capital in and out of China, it does not have controls on the flow of commodities. As a result, commodities were used as a form of capital to arbitrage interest rate differentials, particularly from 2011 to 2014. This helped to facilitate the large build in Chinese commodity inventories thru late 2015. Today, however, the concerned interest rate differential between the US and China incentivizes moving metal out of China, reinforcing local destocking.
7.Commodity inventory is a form of dollar liquidity. Given commodities are traded in US dollars, commodity inventories can be viewed as a source of dollar liquidity. When dollar liquidity was ample with extremely low rates and QE, commodity inventory was unprecedentedly high. As interest rates have risen and dollar liquidity has declined with a stronger dollar, commodity inventories were liquidated to create dollar liquidity. This was particularly a motivating factor in China and emerging Asia this past summer. As funding costs increased this summer in emerging Asia, commodity inventories were liquidated to help ease pressure on margins, particularly petroleum refiners, but also metal fabricators.
8. Trade war uncertainty reinforces physical destocking. This week the trade war was escalated and markets shrugged it off with copper rallying. The reason is the market has already factored in an extended standoff between the US and China. While we believe that the ultimate solution will be to redirect trade routes where possible to avoid the tariffs and other inflationary pressures, the initial impact appears to be local destocking even in the US under the hopes of a quick resolution. Shipping data also show evidence of destocking of large, lumpy bulk commodities and durable goods, but continued consumption of non-durables. But as physical tightness continues to materialize, new supplies will be needed and new trade routes will need to be established at which point we [Goldman Sachs] believe that freight rates will likely rise sharply from currently depressed levels.
9. Financial destocking makes metals a value play and oil a carry play. The split between DM and EM is seen not only in the equity markets but also in the commodity markets with oil, a DM commodity, significantly outperforming metals, an EM commodity. Driving this wedge was massive financial liquidation of positions in both base and precious metals. While oil positioning was modestly liquidated it has since rebounded somewhat. This suggests that metal prices administration focused on capping oil prices ahead of the mid-term elections. Oil is, however, later cycle and inventories are lower with the backwardation and carry in oil likely to be far stronger. Nonetheless, oil has the strongest fundamental outlook going forward driven by strong US demand growth, sanctioned losses, and other supply disruptions and still constrained US shale production. While our [Goldman Sachs] near-term price target remains $80/bbl, the core of our view to being long oil is driven by the positive carry of 7% pa in Brent. This carry gives the opportunity to take advantage of any upside risk created by increased geopolitical risk which like the trade war are constantly escalating. Metals, on the other hand, are a value play as prices have come off significantly in line with rising market concerns regarding the EM outlook. This is reflecting through Comex copper positioning, which continues to inch lower, with net specs outright shorts at the start of September. We [Goldman Sachs] maintain our end-of-year copper target of $650/t.
10. Moderating bullish gold view on Em selling. Using our [Goldman Sachs] Fear & Wealth framework for gold, the environment today looks very similar to the late 1990s. From 1998 to 2000, a tech boom reduced DM fear and boosted US real rates while at the same time the Asian financial crisis wiped out EM wealth, pushing gold to $250/toz. While nowhere as extreme, the same forces have been at play this year in gold. The low DM fear and strong US real rates were part of our [Goldman Sachs] forecast which saw prices rising above $1400/toz in 2018, where we [Goldman Sachs] erred was on EM wealth. Softening EM growth and a strong dollar both simultaneously put downward pressure on USD-denominated household savings( the key wealth metric for determining EM gold demand). As such, we [Goldman Sachs] have seen a sizeable fall in gold ETF demand (primarily DM driven, which we [Goldman Sachs] estimate accounts for around $60/toz od the decline in gold prices since April) and physical gold demand (primarily EM driven, which accounts for around $80/toz of the decline). There are already signs that gold fundamentals are starting to change with the dollar weakening over the past week [September 21st], Chinese and Indian gold purchases rebounding, and Turkish CB holdings stabilizing. From here, we [Goldman sachs] continue to expect gradually higher gold prices on the back of renewed EM demand. However, against this, we are already seeing a later cycle US economy with higher interest rates increasing the contango (negative carry) in gold. On net, while we [Goldman Sachs] continue to see gradually higher price path for gold we now forecast gold at $1250/toz, $1300/toz and $1325/toz over the next 3,6 and 12 months (previously $1350/toz, $1375/toz and $1450/toz).