Materials Risk

Some indicators are available in real time, every second, every working day of the year. These are understandably attractive to anyone wanting to understand the state of the global economy. Taken at face value they can be downright misleading as observers ignore the influence that supply-side factors can have on the price. This article looks at three of these real-time indicators – the price of US lumber futures, the copper futures price and the cost of shipping balk commodities around the globe (the Baltic Dry Index).

Timber!

House purchase activity is an important signal as to the health of the economy. It’s not just the cost of the house but spending on all the other things involved with a house; renovation, construction and utilities etc. Together housing represents around one-sixth of the US economy.

A house is by far the largest single purchase that most people will ever make and so it’s an important signal of consumer confidence. Who wants to buy a house when they are worried about where their next pay check will come from?

Housing starts are a terrific leading indicator of the US economy. It can take several months for homebuilders to construct a new property and homebuilders are reluctant to break ground on new projects if they fear the economy may slump later in the year. Every recession in the US since 1960 has been preceded by decline in housing starts of on average around 25%.

Could there be an even better, even longer leading indicator? Well, the price of lumber is often seen as a leading indicator of the US housing market. Construction companies need to purchase materials to build new houses and the cost of the lumber is a key factor influencing the overall build cost.

If you start to see lumber prices decline sharply and for a prolonged period it typically means that a slowdown in housing starts is around twelve months away. However, the price of lumber is very volatile and supply as well as demand influences the price.

The dramatic drop in lumber prices since the middle of 2018 (down 45%) is being used by some to predict a sharp slowdown in the US economy. On its own that piece of information sounds scary enough, but it ignores the factors behind the previous surge in lumber prices.

The catalyst for higher lumber prices came in 2017 when the U.S. Commerce Department announced anti-dumping and anti-subsidy duties on lumber imports from Canada. The duties were implemented in early 2018 and average 20.23% for most Canadian lumber producers.

This was not the first time that the US has picked a fight with Canada over the price of imported softwood lumber.  On previous occasions in the early 1990’s and early 2000’s tariffs were imposed, lumber prices spiked yet the impact on prices proved temporary. As of today lumber futures prices are back at the same level they were two years ago – before the tariff announcement.

Housing market demand has indeed weakened, but the dramatic drop in lumber prices over the past year is creating the impression that the situation is much worse, and is going to get even worse than the underlying fundamentals suggest. Also, beware that the lumber futures contract is one of the most illiquid commodity futures contract, and so it becomes an even larger leap of faith to draw fundamental conclusions from movements in the price.

Dr Copper

Copper is often referred to as “Doctor Copper” with trends in the copper market often touted as being a useful indicator of the state of the world’s economy. Rising copper prices — and by implication, rising demand for the indispensable metal — signals that the future is bright and shiny. Conversely, if copper prices decline, that’s a sign that the global economy is losing steam; lower copper prices may suggest faltering demand, which in turn implies that less of the metal is going into manufacturing and construction.

However, the evidence suggests that the copper market isn’t as smart as many would believe. It’s possible to find numerous “bear” markets in copper, with price declines over 20 percent. In most of those cases, no recession followed. If anything, copper prices more consistently rose in advance of recessions and continued to rise during the economic downturn. This was true for recessions that began in 1970, 1973, 1980, 1990 and 2008.

Why might this be the case? One study of commodity prices found that copper prices are sensitive to positive news about the economy, but much less sensitive to negative news. That may help explain why copper prices continued rising even as the economy enters recessionary territory.

All of this ignores the fact that all commodities are a function of supply, as well as demand. Meanwhile, the copper price is also affected by investor sentiment, which means that significant price fluctuations can occur even though there is no reason for price movements on pure fundamental demand grounds.

The Baltic Dry Index

The Baltic Dry Index (BDI) is a measure of the cost of shipping coal, iron ore and other commodities around the world, and it is often seen as a leading indicator of economic growth and commodity demand. However, using the BDI to predict changes in economic activity as well as financial and commodity markets is a fool’s game.

The BDI is an indicator of short-term demand and supply for ships, and as so if the cost of shipping increases it is because there are not enough ships available and there is too much demand for commodities at a particular moment in time. With the supply of ships being sticky in the short term (ships can take many weeks to travel to the port where they are needed) and demand for commodities being volatile, any mismatch can easily be reflected in a sharp movement in the BDI.

As an example, imagine you have ten loads of iron ore and nine ships, and that every load of iron ore must be sent, no matter what, and every ship must be filled, no matter what. Imagine the bidding war between those ten iron ore consumers fighting over just nine ships. Shipping costs would rocket, since they all need to ship regardless of the cost.

As with the price of copper the BDI is also affected by supply – the supply of ships. If the number of ships increased (perhaps because earlier strong shipping rates incentivised shipbuilders to manufacture more ships) then the BDI may still fall even if demand for ships has increased.

In early 2019 the BDI fell to its lowest level for three years. Demand for ships fell leading some to believe that the index portend a collapse in world trade and the global economy. In reality a combination of disruptions affecting over 80% of the seaborne iron ore supply reduced demand for bulk shipping.

Those who have followed this blog long enough will know that I have often been critical of those that claim to be able to forecast commodity prices. My concern was initially spiked after it appeared that many investors, companies and governments had been fooled into believing that commodity prices would continue infinitum. That sparked me to write my second book, Crude Forecasts: Predictions, Pundits & Profits in the Commodity Casino which set out to provide the evidence, lay out the incentives and offer some ways that things could be improved for the better.

I’m certainly not the only one who is skeptical of the abilities and claims of Wall St forecasters. In a recent piece for Bloomberg, Barry Ritholtz of Ritholtz Wealth Management offers 5 suggestions as to how the forecasting business could be made a whole lot more transparent and potentially more successful.

No. 1. Share the underlying model’s past performance: As Ritholtz highlights, “if the forecaster has an audited track record showing how the prognostications stacked up versus reality during the past five years, and can demonstrate how these made clients some money, that might be worth notice.”

But he rightly caveats this by saying that past performance is no guarantee of future results since “a good track record may not be repeatable; that those winning outcomes could have been the result of luck or that specific era or some other random element.”

In my book I analysed the forecasting ability of investment banks and other institutions over a 10 year period to 2016, which of course covered commodity booms, busts and financial crises. But that was only one cycle, and just one commodity. It tells you nothing about whether that institution was just lucky, or unlucky. It may of course just be survivorship bias.

No. 2. Acknowledge the unknown variables: The article highlights the importance, and the rarity of the caveat, “Not locking oneself into any single outcome because things might change is simply common sense. Unfortunately, that is a rare characteristic in too many forecasters.”

The financial media being what it is (although there are welcome exceptions such as Real Vision) rewards the confident, no doubt about it, banging on the table kind of forecast. It just doesn’t have time (nor the appetite) for a forecaster saying, “on the one hand this or that could occur.”

No. 3. Acknowledge inherent biases: According to Bloomberg Business Week, economic forecasters are “more likely to miss recessions than to predict ones that never occur.” Ritholtz rightly highlights that there are other incentives at work, “it wasn’t because the economists were necessarily bad at economics, but rather, because of basic game theory. Career risk for being wrong is very real.”

To examine what the age and experience of the forecaster has on the degree of herding, research published in the RAND Journal of Economics examined over 8,000 forecasts by equity analysts between 1983 and 1996. They found that younger analysts tend to herd more than their more experienced colleagues do. Less experienced analysts, meanwhile, are more heavily punished for getting their forecasts wrong and so they have every incentive to stick with the herd. In contrast, older analysts, who have presumably built up their reputations, face less risk of termination. The researchers also found that, contrary to expectations, making bold and accurate predictions does not significantly improve a young analyst’s career prospects.

No. 4. Use errors to make better forecasts: Accurate predictions are held up as evidence of forecasting prowess, and a great marketing platform to sell clients something else. Poor forecasts are quietly swept under the carpet, where, hopefully no one will notice. But we can all learn from failure, and so maybe we shouldn’t be so quick to sweep the evidence away.

As Ritholtz explains, “All models do is take a series of data inputs, sprinkle a little fairy dust on them, and then generate an output. But even if the model does OK, how has the forecaster used its output? Can they make money for clients with it? Alternatively, do they anchor themselves to these predictions, regardless of subsequent data? There is a specific skill to adjusting to errors and failures in order to improve. It is a skill used too little by economists and financial analysts.”

As I explain in Crude Forecasts, “Cognitive dissonance is a psychological phenomenon that refers to the discomfort felt at a discrepancy between what you already believe to be true and new information that presents itself. This is an especially big risk for forecasters of all types, but essentially means that the forecaster will either discount new information that conflicts with the stated forecast or attempt to reframe the evidence to validate the success of the forecast.”

5. Learn from the pros: Finally, the article highlights the work that Philip Tetlock has done on why so many forecasts fail, “His 2006 book “Expert Political Judgment” studied thousands of forecasts, and came to the conclusion that people simply are not good at making predictions about much of anything. With one caveat: Buried within Tetlock’s huge dataset of failed forecasts was a surprising subset of superforecasters. Those in this group stood out for their ability to make more accurate predictions than others.”

According to Tetlock pundits typically fall into categories – “foxes” and “hedgehogs”. Foxes pursue many different ends, often unrelated and even contradictory; they entertain ideas using divergent thinking (ie, looking at many possible outcomes), rather than convergent thinking, and they also don’t seek to fit these ideas into, or exclude them from, any one all-embracing inner vision.

However, many of the pundits courting the financial limelight are hedgehogs. You can easily spot a hedgehog – they are characterised by an attitude of relating everything back to a single vision, and they over simplify and come across as much more confident in their outlook on the world in order to produce a compelling narrative.

Overall, I sense that the process employed by forecasters has improved over recent years. Nevertheless, as the economic forecasting world debates the possibility of a global recession over the next few years these questions are unlikely to stray too far.

Palladium has been the stand out performer in commodity markets over the past three years – up 160%. Palladium, mainly used in catalytic converters to control emissions from gasoline engines has been supported by a switch away from diesel vehicles and by the introduction of tighter vehicle emissions standards in China and elsewhere in the world.

Investors look to play the price differential

Investors reluctant to follow the bull market in palladium have been looking at alternative ways to bet on increasing emissions standards. The other main metal used in catalytic converters is platinum. Platinum demand has been under pressure since 2015 following the Volkswagen diesel-engine emissions cheating scandal in the US.

Platinum is extremely cheap  compared with palladium. Platinum prices have declined by 17% over the past three years while the platinum/palladium ratio has declined to its lowest level since 2001.

Chart 1: Platinum/palladium ratio

However, that of course doesn’t mean the ratio has to correct through higher platinum prices. Lower palladium prices and/or a combination of the two works just as well.

Switch to platinum will take time

Some investors it seems are backing the former. Holdings in platinum-backed ETFs have surged by 15% this year to reach a 4 year high as investors bet that carmakers will start to use the metal in petrol car catalysts.

But according to the car industry a substitution towards diesel is far from being a done deal. Rahul Mital, global technical specialist at General Motors suggested at a London Bullion Market Association meeting late last year that it would take some time to switch and even then the price benefits don’t necessarily warrant it:

“Any time you want to make a substitution like that, it is at least 18 months to a two-year cycle if we’re going to switch. We have to be careful that by the time we do all that.”

According to the World Platinum Investment Council (WPIC) a 5% substitution would mean a 14% increase in platinum demand from the automotive demand segment. However, given that catalyst demand is roughly half as important to platinum demand as it is for palladium (40% vs 79%) it may take a large switch to have a material impact on overall platinum demand.

Chart 2: End market demand

Fog of uncertainty

The car industry is battling declining sales in China and other markets. If auto-sales growth really does fall off a cliff (perhaps if a global recession hits) then demand for both palladium and platinum decline.

Chart 3: Annual growth in car sales in China

The car industry is facing increasing demands to invest in electric vehicle capability to head off the perceived threat from Tesla and others who have a head start. Is now really the time that they will be tinkering with the amount of metal in their catalytic converters?

History is also not on the side of price booms in metals thought essential continuing indefinitely. Just look at the price of cobalt over the past year and rhodium a decade ago.

Related article: What lessons does rhodium have for commodity investors?

Constrained supply after one-off boost

A new report by the WPIC predicts that platinum mine-level output will rise by 6% increase in 2019 to 6.46 million ounces on top of a 3% boost to recycling. The WPIC said supply growth would come mainly from the release of material stockpiled by mines and smelters in South Africa (responsible for 70% of global mined output) during upgrades and maintenance over 2017 and 2018. If this occurs it will clearly be a one-off boost to supply.

More generally platinum output from South Africa is frequently disrupted by power cuts, strikes and unrest. There seems little chance of that changing. More than 60% of South Africa’s platinum mining industry is loss-making or marginal according to Minerals Council South Africa. Labour costs have been increasing faster than inflation, whilst revenue from metal sales has been declining due to low platinum prices.

Chart 4: Forecast change in platinum supply

An industrial metal but a precious one too

Both platinum and palladium have their uses in applications other than catalytic converters. Jewellery for one but they are also held by investors as a ‘beta’ version of more commonly held precious metals like gold and silver. If gold prices come under pressure (perhaps because of reduced geopolitical tensions, lower inflation expectations and / or higher bond yields) then investor demand for palladium and platinum will also suffer.

Unlike gold and to a lesser extent silver, the PGMs suffer from poor liquidity and an opaque market. The PGM group of metals (palladium, platinum, rhodium and others) are very small markets relative to gold or indeed even silver. This means that prices can go from being an investors best friend to their worst enemy in the blink of an eye.

Related article: Platinum prices: The top 10 most important drivers

Platinum prices have been on a downward trend since 2011 frequently coming up against trend line resistance along the way. Since August prices have attempted to push up towards the trend line again (rising $100 per oz to reach $875 per oz) before failing to push past in in late February and then retracing half of that run-up in just a few days.

Chart 5: Platinum prices

Although speculators have recently turned net long it is going to take a break of this trend-line combined with confirmation of car-makers intent to seriously switch towards platinum for investors to run platinum higher.

Chart 6: Managed money positioning