By Chris Berry (@cberry1)
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If you’ve been watching financial news over the past week or perhaps reviewed your portfolio, you’ll know that something is amiss in the commodities world. By most accounts, commodity prices are at five year lows. Almost everything, from gold to silver to iron ore to wheat to corn is falling – hard.
I wrote the tweet above last Friday afternoon when a sea of red on my computer screen got me thinking more critically this weekend about what exactly was the cause for the relentless downward pressure on commodities (metals specifically).
It appears that there are three primary forces at play here:
A stronger US Dollar
China’s growth paradigm changing
Excess supply in almost every metal I am tracking
Unfortunately, these forces are all pulling in the same direction – DOWN. I view the stronger US Dollar and excess metals supply as cyclical issues, while China reforming its growth paradigm is decidedly structural.
I look briefly at these points below.
USD Strength: How Sustainable?
Recent USD strength (shown above against the Euro YTD) is due to several factors including perceived and increasing economic strength in the US. While there are positive data points such as ISM surveys and a rising US 10 year Treasury yield, the growth picture in the US is mixed. Additionally, the Federal Reserve tightening monetary policy by ending QE leaves equity markets without a support mechanism many have come to expect.
The Euro Zone continues to struggle and flirts with outright deflation – another harbinger of tough times for commodity demand. Just as QE ends in the United States, calls for some sort of stimulus in Europe grow louder. It remains to be seen what gets accomplished and how this affects equity and bond markets. Policy points towards more market intervention to substitute for a lack of overall demand.
European companies are “voting with their feet” as evidenced by Merck’s $17 billion bid for Sigma Aldrich and Siemens’ $7.6 billion bid for Dresser-Rand Group. These deals are further evidence of a lack of faith in the Euro and increased confidence in USD denominated assets/companies.
Generally, emerging markets continue to grow at above-trend global GDP growth rates, but the growth is much diminished from what it was forecast to be in coming years. As growth rates in various emerging markets have fallen, currency values have weakened, lending support to the USD.
The IMF forecasts Brazil to grow by 2.3% and 2.8% in 2015 and 2016, Russia to grow by 2% and 2.5% in 2015 and 2016, and India to grow by 5.4% and 6.4% in 2015 and 2016. It appears that the BRICs are taking a breather. From a global perspective it is critical for China (forecast to grow by 7.5% and 7.3% in 2015 and 2016) to sop up excess demand. I examine this issue in this note.
US Dollar strength has hammered gold and silver as market participants believe that inflation is well contained and the elusive economic recovery takes hold. Gold is down over 8% in Q3 while silver has been slammed by over 15% in Q3.
Gold Spot YTD:
Silver Spot YTD:
It remains to be seen how sustainable this USD strength is. More shaky economic data through 2014 could renew calls for QE-type support of the economy and push the USD lower again, though this doesn’t appear likely as of now.
Can China Lead Us Out?
China’s leaders have made it clear that they are willing to tolerate slower economic growth if that growth rate is sustainable and allows for increased domestic consumption (and hence job creation). With Chinese housing prices falling and industrial production slowing rapidly, it is clear that China’s leaders believe that the current export-driven growth model is unsustainable and can’t – or won’t – continue. The average Chinese citizen continues to urbanize which is a positive for metals demand over the longer-term, but it promises to be a bumpy ride.
Success in altering a growth dynamic while deflating a housing bubble and avoiding a credit crunch will be one of the key global economic events to watch over the next 12 to 24 months. According to Ambrose Evans-Pritchard writing in The Telegraph,
“Credit is no longer gaining traction. The extra output generated by each extra yuan of loans has collapsed from around 0.75 before the Lehman crisis to nearer 0.2 today.”
Translation: The “bump” China used to get from credit creation is not working and this is why a new growth dynamic must be embraced by the Chinese.
As you can see, it is too early to tell whether or not China will fall victim to the “Middle Income Trap”, but this is one metric that should warrant your attention. Should Chinese raw material demand slow dramatically and stay muted for several years, this would have negative implications for commodity demand and profound negative implications for the junior mining sector.
Excess Supply Conundrum
I have been vocal in recent months on my views on excess supply in numerous commodities stemming from globalization, easy monetary policies, and the ubiquity of technology. I have also been vocal on how to position going forward. My preference for low-cost producers or near-term production stories in out of favor or mis-understood metals is still intact.
To be clear, however, just because a metal’s price increases does not mean the share prices of companies that explore for, develop, or produce that commodity will follow suit. An example is uranium with the spot price recently rallying by close to 30% while most uranium companies remain stuck in neutral. This will not always be the case, thankfully, and is due solely to the excess supply choking the industry.
Uranium still remains a contrarian pick and low cost producers offer the most attractive risk/reward profile, in my opinion.
While each metal offers its own supply and demand dynamic, the general theme of excess supply (or at least balanced markets) is ubiquitous. While I still think exposure to the metals sector is warranted, finding those stories with a sustainable or disruptive competitive advantage is a must. This is why companies like EMC Metals (EMC:TSXV), Argex Titanium (RGX:TSXV), Terraco Gold (TEN:TSXV), and Lithium Americas (LAC:TSX) have featured repeatedly in this journal. I own EMC, RGX, and TEN. Until demand returns, prices for most commodities will remain muted, barring an exogenous shock.
Also, it goes without saying that a strong balance sheet is a must. Sustainability of the enterprise is key to survival for all metals companies regardless of where they are on the supply chain. Debt is anathema without the cash flows to support the interest payments.
It appears that tough times for metals and mining companies will continue. More and more economic data seem to signal deflation rather than the opposite and this is a Central Banker’s worst nightmare (as it is for a commodity bull).
The positive news is that emerging markets continue to grow, albeit at somewhat diminished rates. Long-term, however, the recent violent downdraft in most metals prices should be a blip. The confluence of globalization and ubiquity of technology are positive forces and will enable many more people in the future to lead a higher quality of life. Of course, this means different things for different commodities and is one of the reasons I am positive on the Energy Metals relative to traditional base or precious metals.
Calling “the turn” is something nobody can do, so staying on the defensive is key. To that end, I will be liquidating a portion of my portfolio to raise cash and continue to hunt for opportunities in the Energy Metals space. I will be doing so within 24 hours of receipt of this note.
The real goal is to find opportunities not necessarily directly correlated with commodities to hedge the risk and generate income until the cycle turns. I believe I have found one such opportunity and will be introducing it in a forthcoming note shortly
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