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Commodity prices in 2014: A strong start.

A strong start, with some firm underpinning. That’s the view of Barclay’s who note that commodity prices have increased slightly since the start of the year despite turmoil in several emerging markets, concerns about slowing activity in China and a strengthening dollar. The BRIC-40 equity benchmark index is down by over 8% since the beginning of January. As Barclays note given that this group of countries is where well over 50% of global commodity demand now comes from, and that it has accounted for nearly all the demand growth in recent years, the price performance of commodities looks very robust in comparison.

Some of the recent price support may prove to be transient. First, from an investor point of view commodities entered 2014 with speculators underexposed to the sector meaning that there could be little left to sell and minimal downside. Second, in many commodity markets prices are close to costs. Barclay’s estimate that almost 60% of aluminium producers  are unable to cover cash costs. However, that’s not to say that prices cannot remain below cost for substantial period of time as producers may be unable or unwilling to cut production. Third, the weather with extreme cold in the US supporting natural gas as well as other energy prices.

However, higher commodity prices may have some firmer underpinning.  There has been a  gradual but sustained tightening in price spreads with commodity futures curves moving towards backwardation. Of the 24 major commodity markets, 10 are now in backwardation including some of the primary markets including crude, soybeans, copper and natural gas. As Barclay’s notes the correlation between commodity fundamentals and price spreads is usually quite high, certainly tighter than between fundamentals and outright price levels. So this tightening up in commodity futures curves is likely a leading indicator that underlying conditions in commodity markets, either via gradually improving demand, supply-side attrition or a combination of both, are getting healthier.

However, as we note in another article today the canary in the room (China’s equity market) offers little support.

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China’s equity market suggests support for commodity prices may weaken

Materials Risk previously highlighted research from ANZ suggesting that the Shanghai Composite Index may be the best barometer of Chinese commodity demand in 2014. It noted that while the relationship between US equity markets and commodity prices has broken down over the past few years, it has re-engaged between Chinese equity markets and commodities.

Related article: Chinese demand key to commodity prices in 2014

Data showing a slowing in Chinese manufacturing activity in late 2013 and into 2014 coupled with turmoil in many emerging markets has revived fears of a slowdown in many markets responsible for the lions share of global commodity demand. However, as we note in an earlier article commodity prices have been one of the best performing asset prices since the start of the year.

So what does the Shanghai Composite Index have to say about the near term direction for commodity prices? Overall it appears that commodity prices haven’t fully reflected the fall in the equity index over the past few months. On this basis alone commodity prices may weaken further in coming months.

Chart: Shanghai Composite Index versus the CRB commodity index

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We previously highlighted the view from ANZ that “the new [Chinese] authorities are now in a better position to re-stimulate targeted sectors, which should restore confidence back into commodity markets.” As ANZ went on to point out – the second year of a new China government administration (2014 in this case) also tends to be a strong one, suggesting a series of positive stimulus moves can be expected to set the growth agenda for the coming years which are likely to support commodity demand.

However given recent concern about the growth in credit in China’s shadow banking sector is positive stimulus from Chinese authorities now unlikely? Recent research from Citi certainly thinks so. Citi Research suggests that credit will remain tight for at least the next few quarters in an effort to rein in the shadow banking sector. The analysts also point to increasing scrutiny on local government debt as a factor in slowing down infrastructure and real estate demand.