Commodity price forecasts 2017: ‘Tis the season for polishing crystal balls

Just as the first of many office parties begins, you’ve already had too many mince pies and you are sick of the same old 1970’s Christmas classic being played in your local grocery store, it is also the time of year when investment banks and anyone who thinks someone will listen trots out their latest forecasts for commodity prices and many other assets for the year ahead.

It is almost as if our collective sense of trepidation over the coming year requires some massaging in order to get us through the next few weeks before we ponder what the New Year will bring. Just like New Years resolutions investors will wonder what the latest ‘black’ or ‘gray’ swan will hit their portfolio over the coming year and try to position accordingly, with forecasts published during December also tending to involve vague declarations of the next twelve months.

But, to an economist at least, the 12 months between 1st January and 31st December is just a period in time. There is no reason why you and I should treat it any different from any other 12 month period. The danger is that if you let the irrational fear of a new year into your investment head then your availability heuristic will take over and your mind will reach for the most evocative commodity forecast for the year ahead.

 

So, be careful about reading too much into the latest forecasts. They are there for entertainment only. There is no evidence that forecasts delivered at this time of year are anymore accurate than at any other time of year. Come this time next year, chances are that you might regret placing too much weight on festive predictions.

 

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Bubble trouble: Is the Chinese commodity price spike about to be popped?

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The appearance of irrational exuberance in China’s commodity markets is becoming more common and the impact on global commodity markets more profound. Speculative money in China (from investment funds and then subsequently followed by retail investors) flows from one asset class to the next just as air moves from one part of a balloon to another when you squeeze it.

I say asset class, but that has a very loose meaning in the sense of what Chinese speculators will pour their money into – one of the latest speculative crazes involves glass futures.

After China’s equity market bubble was pricked last year money flowed into the country’s property market – house prices in Shenzen rose as much as 60% over the past year. But over the past few months Chinese authorities have sought to tighten restrictions on house purchases in an effort to bring the boom under control.

As with all bubbles there is a gem of fundamental truth behind the need for higher prices. At the start of 2016 authorities introduced curbs on coal plants including working time restrictions in an effort to reduce the country’s over capacity. But, things went too far, too fast and so demand for imported coal surged. The increase in the price of coking and thermal coal increased costs for other commodities like iron ore and nickel.

Recently zinc has soared to the highest level since 2011 while steel rebar, nickel, tin and rubber futures have also climbed to multi-year highs. Copper has been the latest major commodity market to be swept up, rising over 30% in the space of a month to hit the highest level for over 15 months. While a cooling the country’s property market would normally have been expected to reduce demand for copper the affect on demand for copper futures has been the opposite.

Policymakers are already trying to cool some of these prices rises by introducing more curbs on speculative trading. In the coal market they are worried that, with the onset of a cold winter, the surge in coal prices will feed through into higher power prices for industry. Meanwhile, commodity prices rise elsewhere will, if sustained also eventually feed through into higher consumer price inflation.

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A sharp drop in liquidity could be the death knell. This morning short term Chinese repo-rates surged to 6% – their highest level for 20 months. To be clear this means a Chinese bank was willing to pay 6% to ensure liquidty for the next 2 weeks compared to 2.5% just yesterday. The last time rates were this high was in early 2015. If sustained this may lead to funds moving their money out of commodity markets.

Booms in garlic and other esoteric futures markets may have been fun to watch from the sidelines, but the fact that major commodities such as copper, iron ore and zinc are caught up in speculative manias in China has big implications for the rest of the world. From higher material costs for businesses and higher revenues for commodity producers elsewhere in the world the impact of just this years boom in prices has been very strong.

In subsequent posts Materials Risk will delve into more detail about just what happens in China’s commodity futures markets.

What is the next market on the ‘gyration of bubbles’? Well equity markets are up 25% from their lows. That could be the next market on investors sights.

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Why the selloff in precious metals may be premature

Political uncertainty

The results of the EU referendum and the US Presidential Election may have passed but that doesnt mean the political uncertainty has evaporated. There are still many questions left unanswered about the UK’s relationship with the EU and Trump’s economic policies are likley to remain a source of guesswork for many months.

Even more concerning are series of elections coming up in Europe. From the Italian referendum on the country’s constitution in early December to the French Presidential elections in April next year to the Dutch general election a month before. As WSJ highlight the biggest risk could come from a little known referendum law in the Netherlands that requires the government to hold a referendum on any law if 300,000 citizens request it. Dutch Eurosceptic parties now believe they have the means to block any further integration. They have already taken advantage of this law to secure a vote that rejected the EU’s proposed trade and economic pact with Ukraine, which Brussels saw as a vital step in supporting a strategically important neighbour.

Although you should be wary of the “law of small number” and the “gamblers fallacy” in drawing too much significance from a series of events there does seem to be an underlying trend towards populist uprisings in developed countries in the west just as perhaps the Arab Spring was the equivalent in the Middle East and North Africa.

At least one hedge fund manager is betting on the break-up of the EU. Hugh Hendry, founder and chief investment officer of Eclectica Asset Management said European politics posed the biggest market risk of 2017, with an impending French election the most likely trigger of fresh market ructions. Hendry said a parallel could be drawn with Britain’s withdrawal from the gold standard in 1931, when one key member leaving prompted others to follow. “Just one member leaves and it becomes extremely vulnerable.”

Market ahead of itself on inflation

Trump’s win has sparked speculation of a surge in inflation on the back of a big boost to infrastructure spending and protectionism, through higher demand in an economy already near full employment and the negative shock to supply that trade barriers would present.

Higher inflation expectations could prompt a more rapid increase in interest rates – hence gold’s surprise slump in recent sessions.

The markets may well be disappointed with the rate of increase in infrastructure spending in the US while for Trumps rhetoric over a war on global trade it appears much more likely that once in office he just limits his intentions to reducing the impact of the status quo rather than ‘building walls’.

There is a question mark over whether inflation may remain ahead of the yield curve – that is to say, whether it will rise faster than interest rates. If it does, real interest rates would be negative. This would trigger sell-offs of assets like bonds that are already in widespread retreat. Gold would thereby benefit.

The recent strengthening in US bond yields and the US dollar may be enough to slow the economy naturally to bring inflation expectations back in track. While the prospect of higher US interest rates may provoke another “Taper tantrum” in emerging markets that scares the Fed into delaying or smoothing the rate of interest rate hikes.

War on cash

Markets are likely to see support in the form of physical buying of precious metals. India’s crackdown on corruption resulted in 86% of the notes in circulation turning into worthless paper overnight. Although this may reduce the capacity of normal Indian’s to turn to gold it will be a warning sign to other countries citizens that their governments can and will resort to all measures to crackdown on corruption and to prop up their financial systems.

The risk: A sharp rise in bond yields

The main risk on the downside to this outlook is that global bond markets suffer a sharp selloff resulting in a spike in bond yields. According to SocGen “there is to our minds significant risk of a more disorderly repricing of global bond yields. Such a scenario could have very negative spillover, not least to emerging markets.”

 

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