Head of Commodity Strategy
The commodity sector recorded a third consecutive monthly loss in August as trade wars and emerging market turmoil more than offset a return to profit across the energy sector. This came as the focus switched to the uncertain outlook for demand with US sanctions against Iran starting to bite. Many of the developments, both up and down, can directly be linked back to decisions taken by the US administration and Federal Reserve in recent months.
A strong US economy has raised the prospects for further tightening by the Fed which in turn has increased the pressure on EM economies struggling with high levels of external dollar debt. Above all, however, we have the ongoing trade war between China and US which President Trump has signaled could be stepped up a gear in early September as he considers slapping tariffs on an additional $200 billion of Chinese imports. As a result, the market has increasingly been worried about the outlook for global growth and with that, demand for key commodities into 2019.
This is of particular concern for China, a dominant source of demand for industrial metals; in response to US tariffs, Beijing has allowed its currency to weaken thereby adding some additional downside pressure on metals, both precious and industrial, to which a high correlation has been observed in recent months.
In the grain market, the troubled harvest season outside the US this summer, which helped support a strong rally in July, was reversed during August on the emergence of a bumper crop in the US. This combined with Chinese tariffs on US soybeans helped drive the grains sector down by more than 7% in August.
With a few exceptions most of the August gains were seen across the energy sector. Crude oil recovered from the July to mid-August sell-off that was driven by the ‘trade war leading to lower future growth’ narrative. But as signs emerged of Iranian supply already being reduced due to upcoming US sanctions the focus switched back to this imminent loss of supply.
We maintain the view that the upside should provide the least amount of resistance in the short term. Tightening supply has seen time spreads move firmly back into backwardation as shown below with the 12-month spread between the December-18 and December-19 futures contracts. This development is likely to attract renewed demand from long-only funds while the threats by Iran to disrupt the flow of oil through the Strait of Hormuz could increase the geopolitical risk premium.
Since reaching a record high of nearly 1.1 billion barrels back in March, hedge funds have since cut their combined net-long in Brent and WTI crude oil futures by 40% to an 11-month low. During this time, however, it is interesting to note how limited the selling to go short interest has been. Even between July and August, when Brent crude oil dropped by almost $10/barrel, the gross-short (red line in chart above) was kept almost unchanged and close to the lowest seen during the past five years.
This tells a story of a market that remains underlying bullish albeit with reduced conviction compared to earlier this year. The short-term outlook points to higher prices but eventually demand concerns will re-emerge, not least if the current EM weakness and trade war continue to reduce future growth expectations.
Having broken back above $75/b, Brent crude oil is aiming to test the upper band of resistance between $78.50 and $80/b.
Gold is trading back above $1,200/oz as it continues to recover from its mid-August nadir. The recovery, however, has not been strong enough to prevent the yellow metal from recording a fifth consecutive month of losses. The weakness this year has been driven by the stronger dollar, rising US short-term rates, and no signs yet of inflation. Adding to this we have the lack of diversification demand due to the record run in the US stock market.
The market will now increasingly be looking for signs of if and when hedge funds begin to abandon their record net-short position in COMEX gold futures. During the six-week period up until August 21, they accumulated a record short of 79,000 lots, some 3.3 times bigger than the previous record from December 2015. A continued recovery could eventually trigger an accelerated rally from said funds but for now and as it has been for the past couple of months, the main source of inspiration remains the dollar, and this is true for both bulls and bears.
Once, as we believe, a recovery gets under way it is worth keeping an eye on both silver and platinum. Silver has reached a level of relative cheapness to gold that has only been seen on a few occasions during the past 20 years. Last time the gold-silver ratio traded above 82 (ounces of silver to one ounce of gold) in February 2016, the recovery that followed took the ratio all the way back down to 66.
Platinum, meanwhile, spent the past week toying with a record discount to gold at $415/oz. The white metal has seen a steady decline against gold, from a $1,200/oz premium in 2008 to the current discount. Given platinum’s main industrial use in diesel engines, the diesel scandal a few years ago helped reduce demand. The latest weakness has come from the current trade disputes which have not only raised the cost of steel and aluminium but also helped trigger the first sustained slowdown in new vehicle sales in the world’s largest markets in China, the US, and Europe since the global financial crisis.
Gold spent the week stabilising above $1,200/oz after initially failing to challenge the next area of resistance at $1,217/oz. A break, however, is likely to open up for a move towards $1,235/oz. and first then are we likely to see short positions being reduced at a more aggressive rate.