China slowdown makes global commodities bearish

16 October 2013
Commodities remain the world's worst-performing asset class this year, with the benchmark Dow Jones-UBS Commodity Index falling 8.95% year-to-date. 
A number of factors have conspired against commodities like gold and copper this year, but a key reason is China's slowing growth.

The Asian giant accounts for more than 40% of global demand for iron ore, lead, copper, aluminum, zinc and nickel, and its economic slowdown has hurt production and demand for a number of commodities. 
"Also note that China represents 40%-50% of global industrial metals demand, compared with just 12% of global oil demand, and year-to-date base metals prices are down 15% versus just 3% for oil," said PIMCO, a major investment financial institution. 
With the global economy forecast revised down to 2.9% in 2013 and 3.6% in 2014, the commodity markets are expected to remain soft over the medium term. 
"Emerging market and developing economy growth rates are now down some three percentage points from 2010 levels, with Brazil, China and India accounting for two thirds of the decline," said the International Monetary Fund in its latest report on the prospects of the global economy. 
Emerging market equities, as measured by the MSCI Emerging Markets index, are down 8.53%, very similar to the performance of the DJ-UBS commodity index. 
Barclays Capital, which recently held meeting with commodity investors, reports that there is "lack of conviction" among the investor community. 
"Feedback from our meetings showed that market participants are neutral-to-bearish zinc and aluminum, neutral on copper, becoming more constructive on nickel and bullish on lead and tin." 
PIMCO believes the deceleration in emerging market growth relative to the US has also helped strengthen the US dollar at a time when the prospect for reduced stimulus from the Federal Reserve was already a tailwind for the dollar.  
"With commodities largely priced in dollars, a stronger dollar depresses those prices, which is particularly true for commodities with large production costs in non-dollar currencies."


Meanwhile, of the four broad commodity sectors, precious metals have endured the heaviest losses with excess returns on the precious metals index down 23.5% since the end of last year.  
"While losses on precious metal returns stabilized in the third quarter, we still view exchange rate, interest rate and equity market trends as problematic for precious metal returns and specifically gold heading into next year," said Michael Lewis, strategist at Deutsche Bank. 
Gold bugs - a common term for investors who believe in the inherent fundamental strength of the commodity - were hoping that a US government shutdown and faltering global economic growth will lead to a surge in gold prices, but that has not materialized to date. 
Indeed, investors seem relatively sanguine about US debt ceiling crisis, and are looking for other safe havens than choosing to pile into gold. 
"Despite gold's ammunition, prices have struggled to garner interest with ETP outflows continuing to dwindle," said Barclays Capital. "Net redemptions have reached 8.5 tons in October thus far, taking outflows for the year to date to 708 tons, with metal held in trust remaining at May 2010 lows." 
Physical demand for gold has also hurt prices. India, a key gold market, has seen government restrictions on gold hurt demand, but the World Gold Council estimates imports could rise by 15% year-on-year to 300 tons due to pent-up demand and traditional wedding season in the country.  
In China, gold market has also seen an improvement in sales, with gross imports up 2% month-on-month and 146% year-on-year at 131.3 tons, while net imports were down 5% month-on-month (but still up y/y) at 11.5 tons. 
"The lackluster performance in gold returns in the midst of a US government shutdown and concerns towards the budget ceiling may reflect the relatively sanguine approach of financial markets currently," said Deutsche Bank's Lewis. "Indeed of the several measures of risk we track, there has so far been little escalation in risk aversion. Unless this changes we would expect gold prices to remain under pressure." 

Oil and natural gas prices have held up for the most part this year, but analysts expect the strength to dissipate during the remainder of the year as geopolitical risk fades and as a number of supply disruptions moderate. 
However, the latest International Energy Agency indicates a tight market in the fourth quarter as OPEC production falls to a two-year low. 
Production from Iraq and Libya has fallen 650,000 barrels per day last month, and even though the Saudis have cranked up production, the group's spare capacity has fallen to 2.9 million bpd - lowest since 2012. 
However, non-OPEC supply has also made up for the loss, with more than 1.2 million bpd of new supply flowing in this year. 

More significantly, the IEA boosted its 2014 non-OPEC supply outlook by 260,000 barrels per day to 56.4 million bpd, reflecting North American unconventional production that continues to exceed expectations, and representing growth of 1.8 million bpd (3.2%) over 2013.

With global growth slowing and supply increasingly coming on to the market from non-OPEC sources, oil prices may struggle in the medium-term. Deutsche Bank says Brent crude is expected to fall from an average of USD 109 per barrel this year to USD 106.25 per barrel in 2014 and trending even lower to USD 105 in 2015. 
The slowdown in oil and gold prices may be part of a bigger trend. 
PIMCO notes that while the commodity "supercycle may be dead," the outlook for commodity returns today seems broadly consistent with historical returns, and commodities remain an important tool for hedging inflation risk. 
"Since 1970 - a period that includes the ending of the gold standard and severe inflationary shocks - commodities have added an average annual return of 3.59% on top of the return on collateral.  Investing in a commodity index, which includes the return from collateral as well, may result in returns in excess of inflation. Even with the end of the supercycle, it doesn't seem that today the future of commodity returns looks that much different than the past." 

© 2013


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