Making sense of the recent commodities rally
With the recently outperforming materials and energy sectors now becoming a drag on indices, there’s growing concern among resources investors that the recent commodities rally is not supported by fundamentals in the ‘physical markets’, which only adds to downside risks in the near term.
Given the lack of longer-term sustainable deficits in any of the markets, it’s clearly premature for institutional investors to embrace these ‘green shoots’ – and shift to an ‘overweight’ recommendation in commodities per se – having been underweight in commodities for the best part of a year.
While the resources rally may indeed hold onto most of its recent gains, there are growing suspicions that it will struggle to go higher any time soon.
Adding to those suspicions, the FTSE materials space has experienced a sharp selloff, while BHP Billiton Ltd (ASX: BHP), Rio Tinto (ASX: RIO), and Fortescue Metals Group (ASX: FMG) all lost ground earlier this week, which suggests the pullback in iron ore prices could be due to some profit-taking.
While Iron ore is down ($US62.78 a tonne) from above the $US70 it hit last week – still well up on the rock-bottom $US38.30 it experienced last December – what’s unclear as yet is how much of this recovery is due to seasonal factors associated with the first quarter of the year and how much is due to cyclical strength driven by Chinese economic growth.
Interestingly, appetite for risk amongst investors with a more upbeat view on China’s improving economy led aluminum to a reach a six-month peak. The bounce in oil prices has also nudged metals markets higher, with zinc at its highest since July 2015 and copper at a four-week high.
Similarly, silver has also rallied in recent days, and in the hope of better demand from China, has also extended its gains to an 11-month peak based on technical momentum and perceptions it is undervalued against gold.
Gold (at around $US1,258.00) and other precious metals – like platinum and palladium – have also been held up courtesy of a softer dollar and dovish sentiment by the Fed.
Meantime, the great unknown is whether there’ll be a change in direction with respect to industrial production and fixed asset investment in China, or whether recent investment has been speculative in nature.
However, based on some underlying stability in its economy, analysts do expect some restocking coming through in China.
But there’s greater likelihood of the iron ore price dropping below $US60 a tonne within the next few months, and in the absence of a material increase in Chinese steel consumption – that can absorb incremental supply from mine expansions in Australia, Brazil and other regions – some analysts see it falling to $35 per tonne by the end of 2016.
However, there’s slightly greater optimism over oil with Brent crude oil trading at 2016 highs of $US46 per barrel – almost 50% up on the sub-$US30 levels it was trading at in January.
What’s driving the oil price up is government data showing that US crude stocks have risen slightly less than expected, and speculation that major oil producers would meet in Russia in May for another attempt at curtailing output.
While oil fundamentals aren’t expected to see a sustainable shift until the third quarter, a year’s end target of US$50 per barrel is looking increasingly probable.
One of the risks to the upside that analysts fear in the near term is the Fed choosing to remain dovish in the face of improving Chinese activity, which has the capacity to nudge oil above $50.