WCU: Commodities lower on demand fears

Ole Hansen

Head of Commodity Strategy

Commodities experienced another bruising week with the Bloomberg commodity index seeing all its gains for the year wiped out. This in response to the ongoing China-US trade war and the realisation that the Turkish crisis may turn out to be the canary in the coalmine for emerging markets challenged by high levels of dollar debt, a stronger USD, and rising costs of funding. 

Given the importance of EM growth on demand for many key commodities, the market sold off on the rising risk that an economic slowdown could have some negative implications for demand growth into 2019. This combined with additional signs that China (the world’s biggest consumer of commodities) is slowing sent tremors through the markets  

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Source: Bloomberg, Saxo Bank

Gold and precious metals in general found no respite from the recent selling with gold touching a 19-month low while silver headed for a record run of weekly declines after trading down for a tenth consecutive week. 

Grains led by soybeans recovered from the depressed levels that followed a recent update from the US government. In it they raised production and stock estimates for corn and soybeans while seeing a smaller than expected impact on global wheat stocks following a troubled growing season in Europe, Australia and CIS. The resumption of trade talks between US and China in late August also helped improve sentiment. 

Industrial metals suffered the most with copper, often seen as a gauge of the global economy’s health given its diverse usage profile, falling by more than 20% from the four-year high reached just a few months ago back in June. Copper was also troubled by news that a potential supply disruption from the world’s largest mine in Chile that had been looming for weeks showed signs of being averted. 

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HG Copper (source: Saxo Bank)

Gold remains under pressure from the stronger dollar and EM weakness, something that was highlighted when the collapse in the Turkish lira triggered across the board gains for the dollar while sending gold through support at $1,205/oz. The market is currently transfixed by the negative impact on those EM economies maintaining large external debt in dollars at a time where both the dollar and funding costs are rising.  

Instead of providing support to gold, these geopolitical problems have instead helped send the metal even lower. Longer-term investors trading exchange-traded funds backed by gold have cut around 115 tons from their total holdings and given the current price level below $1,200/oz, an additional 200 tons could be underwater compared to purchase levels (source: StanChart via Bloomberg). 

The combination of US stocks and core bond markets seeing demand has reduced the need for alternative investments such as gold. On that basis it would require a change in the direction of the dollar, not least against the Chinese yuan with whom gold has seen a very high correlation during the past few months. Other drivers could be a major sell-off across key stock markets or potentially a change in the outlook for the US economy and the need for continued interest rate hikes. 

On August 24, Federal Reserve chair Jerome Powell will speak at the Fed’s annual Jackson Hole conference. The narrative is arguably that global markets will remain in a fragile state until the Fed backs off its quantitative tightening and rate hiking regime, with the risk of a real crisis linked to EMs' overindulgence in borrowing USD since the global financial crisis. 

Should Powell unexpectedly blink and signal a slowdown in the tightening process, the dollar could get sold and potentially send gold on a path to recovery.

In such a scenario the recovery would likely gather pace on the back of the fact that hedge funds have been continued sellers for a while now. In the week to August 7, gold’s net-short reached a new record of 63,000 lots as funds continued to add length to the gross-short while cutting gross-longs. 

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Source: Saxo Bank

Due to its link to industrial metals and (at times of trouble) lower liquidity than gold, silver witnessed another week of losses, a record tenth in a row… and with that, the ratio to gold once again rose above 80. This is a level above which it has found relative support on numerous occasions since the financial crisis in 2008. 

Crude oil survived a mid-week challenge following a bearish weekly stock report from the US Energy Information Administration. Rising crude stocks and production helped send WTI crude oil, already reeling from the potential risk of an EM slowdown, lower before finding support at the 200-day moving average. Brent crude oil broke the July low but just like WTI managed to find support ahead of its 200-day moving average before finishing the week at relative safety above $71/b. 

In order to understand why crude oil has been left more exposed to an EM slowdown than before, we need to look at demand growth. According to the IEA via Bloomberg, some 50% of global demand growth in 1999 was driven by non-OECD countries. Today this percentage has risen to 87% with China and India being the biggest by far and it highlights the current risk to demand from key consumers as their currencies continue to weaken against the dollar. 

The forward curve in Brent crude is now signalling oversupplied markets all the way to February with the market at this stage not counting on a significant impact of the expected drop in supplies from Iran once US sanctions begins to bite. We believe this assumption is wrong and while an EM slowdown carries a big risk of longer-term slowdown in demand growth, the short-term supply outlook still looks challenging and should attract some attention eventually. 

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WTI crude oil (source: Saxo Bank)

For now, the focus remains on the dollar and developments in EM currencies. While hedge funds have been cutting long positions to 732 million barrels, the lowest since last October (data covering the week to August 7), they remain unprepared for a potential drop below key support. 

The combined gross-short in Brent and WTI at 71 million barrels is close to the lowest seen during the past five years.

US produced soybeans remain caught in the crosshairs of the US-China trade war. Soybeans, which are used to make cooking oil and animal feed, account for about 60% of the US’ $20 billion of agricultural exports to China. The announcement back in June that China would apply its own, retaliatory tariff on soybean imports helped trigger a 22% slump. 

Having seen it recover a bit more than one-third, it was then knocked sharply lower on August 10 when US Department of Agriculture projected that the combination of a record crop and Chinese tariffs could take stock levels to a record 785 million bushels by next summer. 

During the past week soybeans managed to recover some ground in response to news that low-level talks between the US and China would resume in late August. 

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CBOT Soybeans, November 2018 (source: Saxo Bank)

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