Can commodities stage a comeback?

So last week the Dow hit a new record, the S&P 500 isn’t too far behind that, and while the Aussie market battles on and is still some 20% off its peak, it has rallied hard as well – 10% just this year.

All of a sudden the world doesn’t look like it’s ending and everyone is a little less fearful than they were. Having said that, there is a chorus of opinion that the stockmarket has departed from the fundamentals and consequently that equities have overshot – and they point to market pricing elsewhere as proof. So, for instance, bond yields are still at record lows and the fact is that commodities seem to have missed out on the party so far.

On the bonds side, I think that’s a disingenuous argument. Bond yields are low because central banks are monetising budget deficits. There is no market signal in that. Commodities, however, are one of the more intriguing aspects of the market. If you look at Chart 1 you can see that in fact equities and commodities have shown a clear divergence from mid last year, and a casual glance would indeed seem to suggest each market has a different assessment on the outlook.
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It’s not all bad, sure. Iron ore prices are up 6% – but then crude is flat, gold is 6% lower, copper and lead are down about 5% and coking coal prices remain deflated.  In fact the CBA commodity price series shown above (an index based on Australia’s top commodity exports by weight – iron ore, coal, gold, crude, wheat etc) is down some 20% over the year, while our ASX is 17% higher over the same period.

It would seem clear that the commodity market doesn’t seem to be buying into this ‘risk on’ moment – a clear challenge to the optimism of the equity bull-run.  When you throw in the fact that the equities are trading on low volumes – it would appear to give some credence to the view that all this optimism is on thin ice. 

Now some of these commodities have had very good fundamental reasons, specific to their market, for seeing price declines. Having said that though, others don’t, and the fact that commodity prices have failed to keep up with the equity bull-run points to a wider problem afflicting the market.  

But what might that problem be? I’ll admit when I go through a checklist of the main determinants, I’m not finding too much in the way of headwinds.

• So Chinese industrial production is on the up and US manufacturing indexes have accelerated.

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This is an important development as you would normally think that if the sharemarket is rising and growth indicators are rising then that would be good for commodities. Take a look at chart 3. It shows the US ISM and commodity prices (values are smoothed so it’s easier to read), which have generally followed each other over time – directionally – since 2009. Prior to that the relationship isn’t that great, but this is the risk-on, risk-off trading mentality that we’ve seen more recently. From 2011, commodities followed the ISM index down, but they have ignored the bounce back.

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• As for Quantitative Easing, there was a fear that it might end, and I discussed this in relation to gold recently. But Bernanke and his potential successor Janet Yellen (also a current voter at the Fed) have put any idea of this to rest.
• A stronger USD? Except that it’s weaker.
• Similarly, the Volatility Index (VIX) or ‘fear’ index is at its lowest since 2007 – which means risk appetite is up.
• Demand/supply imbalance?  Production for most commodities is up for sure, and it is forecast to continue to rise over the next year for most of the major commodity groups. But then again it’s the same for demand, and when I look at the major commodity groups I see no emerging imbalance developing.
• Which brings us to inventories.  As a general observation we are seeing no unusual developments here.  I mean recent press reports suggest copper inventories are at or will soon be at seven-year highs. But this is a bit misleading when you consider that, at best, global stocks are two -three weeks’ worth. The difference between a seven-year high or some low is about one-two weeks’ worth of supply. It’s the same with crude– about 30 days – and these are largely for strategic purposes anyway.  So maybe some inventories have lifted, but as a general rule we’re not seeing some broad-based excessive lift – a glut.
• Finally, and with the exception of perhaps some softs, there is no evidence of a big build-up in the short positions of traders. Square on copper (in other words shorts and longs neutralise each other), short wheat, although net long gold and crude.

With all that in mind I can’t really see a good reason why commodity prices and equities have parted ways or diverged. I think it’s clear that commodities aren’t signalling that equities are overbought – with all the support mentioned above it’s more likely the opposite. That is, that equities (and the rebound in economic data) signal a rebound in commodity prices is due. It’s taking its sweet time though, which makes me nervous there is something going on that the market isn’t aware of yet. It’s an odd anomaly to say the least. I mean roll-on/roll-off (RORO) may have eased but it isn’t dead - and what’s good for stocks is generally good for commodities.

For now the only thing I think we can say with any clarity is that commodities don’t signal the death knell for the equity bull-run. There is just too much support for them. It’s just that something is holding commodities back, and that something is usually confidence. Maybe that’s just it – a lagged sentiment response.

Either way, and for those who like to actively participate in the market, one way to play it might be to make a trade based on the idea of convergence. Inevitably the two markets will have to converge at some point, with either equities having to pull back or commodities pick up (so sell an equity futures index like the SPI and buy a commodity futures index).

In the absence of any physical supply or demand issues in the commodity space, convergence is what you’d expect, that we have not seen it yet is an anomaly. Long term I have no doubt commodities will push higher, shorter term I'd be applying the convergence trade.