06-01-2018

Commodities’ Modest 2018 Growth Will Be Offset by Risk

The Bloomberg Spot Commodities Index has risen for 14 straight days to its highest since 2014. But don’t expect the euphoria to last: 2018 will be a year of just modest growth.

Although each commodity has its own idiosyncratic characteristics and market, there are major macroeconomic factors influencing global prices.

China: As the largest consumer and producer of most global commodities, from steel to soybeans, China is set to continue on its path of growth and infrastructure development. Downside risks include rising leverage of the non-financial sector and uncertainty about housing prices. In December, the World Bank raised its forecast for China’s 2017 economic growth, supported by personal consumption and foreign trade, to 6.8 percent from 6.7 percent. But the government’s campaign to reduce the financial sector has forced up borrowing costs, heightening concerns that gross domestic product growth could slow in 2018.

On the upside, it’s in China’s best interest to keep the price of export commodities high (these include rare-earth and industrial metals, coal, and grains). The country also wants to give a boost to commodities such as soybeans and corn, which are trading at depressed levels due to a global glut. China wants to increasingly call the shots when it comes to commodity prices in its effort to become a price-maker. To enable a large role in price discovery, commodity exchanges such as the Shanghai Futures Exchange and the Dalian Commodity Exchange are seeing increasing volumes from their efforts to increase the nation’s market share of exchange-traded commodities.

The dollar: Global commodities are typically traded in dollars, making the currency a major influence on prices. The dollar is negatively correlated to commodities, meaning a weak greenback boosts commodity prices. Throughout 2017, the dollar weakened against major currencies, while commodity prices benefited. More recently, with the signing of the U.S. tax bill, the dollar bounced from its annual lows. The Trump administration’s emphasis on growth generation, coupled with low inflation in the euro zone and Japan, means potentially moderate strength in the dollar and thus some pressure on global commodity prices.

Interest rates: Low rates are good for commodities. They allow businesses to expand and consume raw materials, and they encourage home building and auto sales, supporting energy, industrial metals, lumber and rubber. U.S. interest rates are at historically low levels, even though the Federal Reserve’s raised them three times in 2017 to reach its target of a 1.25 percent to 1.50 percent federal funds rate. Yet factoring in inflation at 1.5 percent makes the fed funds rate effectively 0 percent. So even though rates may be raised twice, and possibly four times, in 2018, expectations are already baked into forward curves, and such small moves, from a global perspective, should be manageable. Furthermore, the appointment of Jerome Powell to replace Janet Yellen as Fed chair will have minimal effects as they are, for the most part, like-minded in their approach to monetary policy. Global inflation, particularly in developed nations, is low and not a threat.

U.S. policy: If President Donald Trump follows through with his infrastructure plan, including a controversial border wall, commodity prices — particularly steel, copper, zinc and lumber — should soar. But little of this plan has come to fruition after his first year as president. Given how long it took to pass the tax bill, any rapid outcome on the infrastructure package is wishful thinking. Trump may be able to come through on his promises, though for now sheer hope continues to support commodity prices.

In advance of the Trump trade tariffs expected to take effect in 2018, many overseas producers have rushed to ship cargo to the U.S., particularly steel. This means shipments will slow down until inventory is consumed, pressuring prices early in 2018.

The tax bill is largely bullish for commodity prices as it lowers the corporate tax to 21 percent from 35 percent and allows for a deduction of capital equipment. In a perfect commodities world, these savings would go toward capital spending. But that won’t happen. Savings may go toward cutting prices or to shareholders via dividends and stock buybacks, or to employees through higher wages or additional funding for pension liabilities. As for individuals, the average household is expected to save about $1,000 in taxes but will likely pay off loans in light of rising rates.

Trump’s desire to drill for more energy could create a supply glut, pushing down prices of oil, gas and refined products. Although the measures will harm the environment, the easing of Environmental Protection Agency regulations and the passage of legislation opening Alaska’s Arctic National Wildlife Refuge for drilling are initially good for energy equities, but not for oil and gas prices. There is only so much OPEC can cut before its actions become detrimental to its member nations.

Adding to a potential glut is the global drive for sustainability, recycling and resourcefulness through advanced technologies, such as electric cars, batteries, solar panels and biofuels. The world is increasingly eager for greater commodity efficiency, and while the U.S. did not sign the Paris climate accord, most American business chose to adhere to its standards anyway.

Geopolitical risk and mother nature: There’s plenty on the geopolitical front to keep supply-focused investors on edge: escalation of war in the Middle East and Africa, threats of a North Korean nuclear attack, terrorist groups and Special Counsel Robert Mueller’s investigation of the Trump campaign’s Russian ties. In addition, 2017 was a banner year for natural disasters. There’s an $81 billion package of relief for hurricane and wildfire victims in the U.S. as well to address the destruction from the Mexico earthquake. Fear of more to come from global warming or otherwise is supportive of commodities.

The upsides to commodity prices for 2018 look modestly consistent and rational, while the headwinds and their strength are far less predictable and more dangerous. A small gold hedge is advisable in a blended portfolio of consistently monitored commodity positions.

Source: Bloomberg

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