Head of Commodity Strategy
Summary: While rising bond yields and falling global stocks have been grabbing the headlines, the agriculture sector has started to display green shoots of renewed demand.
While the market has been preoccupied by the uncertainty related to rising bond yields and the sell-off in global stocks, including the US, the agriculture sector has begun to show signs of renewed demand.
The two biggest exchange-traded funds with a broad-based exposure to the sector have both witnessed a strong pickup during the past few weeks. The Invesco DB Agriculture Fund which tracks the DBIQ Diversified Agriculture Index (Ticker: DBA) and the ETFS Agriculture ETC, which tracks the Bloomberg Agriculture Subindex (Ticker: AIGA) have rallied by 4% and 7% during the past month. DBA’s lower performance is due to a near 25% exposure to the livestock sector which as per the below chart has struggled to keep up with grains and soft commodities.
Performance has been be led by sugar and coffee which have both recovered strongly after hitting a 10-year and a 12-year low last month. The 25% rally from the lows in both came following months of selling. With Brazil being a major producer of these two commodities, the weakness in the Brazilian real in recent months was the main driver behind the continued weakness which helped attract some aggressive short-selling by hedge funds, especially in coffee.
Apart from the general dollar strength against emerging market currencies this year the Brazilian real sold off and reached a record low ahead of October 7 when the first round of the general elections to elect the president, vice president and the national congress was held. The real recovered strongly once it became clear that Jair Bolsonaro, a market friendly candidate from the Social Liberal Party, was on track to win the first round. He will now face Fernando Haddad, the Worker’s Party candidate, in the run-off on October 28.
The reason why both coffee and sugar reacted so strongly to the recovering real was due to a major buildup in hedge funds' short positions. Once the technical and to a certain extent the fundamental outlook began to turn more favourably they were forced to reduce their short positions and the rally took off.
While coffee fundamentals would argue against a major price extension to the upside, sugar may find more support. India has in recent months signalled its intent to allow an increase in exports to support sugar mills under pressure from high stock levels and low prices. However, following the major price jump the urgency to boost exports may have lessened. In addition, a change in government policies on gasoline pricing in Brazil, the world’s largest consumer of sugar cane towards ethanol production, have made the cane-based fuel more competitive.
The US grains sector has, despite a troubled growing season elsewhere, been on the defensive this summer. This was due to strong harvest pressures and the negative impacts from the trade war between the US, a major exporter of agriculture products, and China, a key global buyer of agriculture products. This month, however, both soybeans and corn have seen support begin to emerge, not least due to some troubling harvest weather leading to concerns about crop quality, strong export data and signs that Chinese soybeans buyers have begun to book US cargoes again. Wheat, meanwhile, has continued to establish support ahead of $5/bushel in the belief that a tightening global market will attract more export business to the US.
In cocoa and cotton a negative return during the past month hid the fact that both have begun to recover. Cocoa received a lot of attention earlier this year when it rallied by more than 50% during the first four months only to surrender most of those gains during the following four months. Cotton has been a similar story with the eruption of the trade war earlier this year raising global growth concerns, as a GDP downtrend typically signals softer cotton demand ahead.
The latest ENSO (El Niño/Southern Oscillation) update from NOAA’s Climate Prediction Centre dated October 15 said that an El Niño (70-75% chance) is favoured to form in the next couple of months and continue through the Northern Hemisphere in the winter of 2018-19. El Niño shifts rainfall patterns across much of the Pacific, very often negatively impacting agricultural yields and exportable surpluses of wheat, sugar cane, palm oil and coffee particularly in South East Asia and Australia. The US meanwhile is likely to witness a wet spring which could delay the sowing progress and winter wheat harvest. The impact on South America is mixed with the north general dry and conditions wetter to the south.
Hedge funds have maintained a net-short across the three agriculture sectors since the beginning of the year. The below table from our weekly “Commitments of Traders” report show how a net-short position is currently held in more than half of the 14 major commodities tracked in this. Funds were still short both coffee and sugar in the week to October 9 and as long these markets remain bid short-covering is likely to continue whether or not fundamentals support such a move.
Using the Bloomberg Agriculture Subindex we find that October has provided the best monthly returns during the past ten years. This year has so been no exception with the performance on track to be the best since 2014. A combination of the fund net-short, emerging momentum, El Nino risks and our belief that the dollar eventually will peak and turn lower, could see this performance extend beyond October.
A potential investor should keep in mind how volatile these commodities often are and proper risk management is therefore required in order to avoid major headaches. A broad-based ETF may be a better option as it will reduce but not remove the elevated price swings that this sector often presents.