Why I Am A Commodity Bull

  • Commodities are global assets
  • The cost of goods sold in the stock market
  • A guidepost for currencies
  • Bonds and commodities- Something is going to give
  • The bottom line

Commodities may be an alternative asset class that takes the backseat to stocks, bonds, currencies, and all other mainstream investment and trading vehicles. However, price action in the raw material sector impacts all consumers as well as the other asset classes.

Over the recent weeks, the escalation of the trade dispute between the US and China and the stronger dollar which is approaching its April high and level of technical resistance weighed on the prices of many commodities. Meanwhile, bond prices moved higher, and interest rates lower as market participants sought safe havens for their capital as the probability of volatility across all assets increased.

I view the current environment of falling US rates, a rising dollar, economic growth in the US, and uncertainty over trade as a complicated backdrop for the commodities market which could lead to some wild price swings. Volatility in markets is a nightmare for investors, but it creates a paradise for nimble traders with their fingers on the pulse of markets. When fundamental supply and demand characteristics take a backseat to technical moves in markets, it can create a myriad of trading opportunities.

Commodities are global assets

The production of commodities comes from areas of the world where the crust of the earth is rich in metals, minerals, or energy reserves. In agricultural commodities, climate, soil, and the availability of water support crop growth. Therefore, the output is a local affair.

Consumption of commodities is ubiquitous. People all over our planet consume raw materials each day. Operating an automobile requires fuel or energy commodities. People around the world need nutrition, which comes from agricultural commodities. We live in homes that are constructed using industrial commodities and are heated and cooled using energy. The water we drink often travels through pipes made of copper. These are just a few examples of how we consume raw materials in our daily lives.

When it comes to businesses, energy powers their activities whether they just turn on lights, heat or cool offices, or power manufacturing machinery. Finished goods typically require raw materials that trade in the commodities markets.

Commodities are global assets that flow around the world from points of production to all people around the world each day. Even the transportation of commodities requires other commodities to power the modes of transport whether by ocean vessel, airplane, truck, barge, rail, or car.

Commodities are one of the most volatile asset classes when it comes to prices. Even if you never trade a commodity directly, knowledge about the markets and an understanding of the price action is imperative when it comes to analyzing other markets. Commodity risk is an ever-present factor for all investment classes.

The cost of goods sold in the stock market

The stock market is a tool for companies to raise capital and expand their businesses. As such, stocks are vehicles where investment capital grows alongside corporate earnings providing savers and investors with a nest egg for their future and dividend returns that can add to savings or have for short-term expenses.

Since all companies that trade on the stock market are consumers of commodities in some sense, they play a pivotal role when it comes to earnings. As an integral part of the cost of goods sold, commodities impact the price of a company’s shares.

Companies that are in the business of directly producing or refining one raw material into another, such as a metal or energy producer or refiner or an agricultural processor are highly sensitive to specific commodities prices. Those businesses that supply services or products that enable raw material production often see their profits rise and fall with the price of one particular commodity.

Indirectly, many businesses take constant risks when it comes to sourcing and paying for the ingredients necessary to offer products for sale. Starbucks and Dunkin Brands stocks can move higher or lower with the price of coffee. McDonald’s and other food companies have a risk when it comes to both the price and sourcing of animal protein. Technology companies require metals and energy to produce their products. Uber and Lyft are sensitive to energy prices. If you think about it, it is possible to pinpoint at least one commodity risk for each company that trades in the stock market. Therefore, the cost of goods sold equation when it comes to raw material prices can provide significant clues when it comes to a company’s earnings.

A guidepost for currencies

While commodities are a highly volatile asset class, currencies tend to exhibit stability and low levels of price variance. The dollar is the world’s reserve currency, so it serves as the benchmark pricing mechanism for most commodities around the globe. Currency volatility tends to be low because governments, central banks, and monetary authorities typically manage the value of one foreign exchange instrument against the other. The mission of most central banks is stability, so intervention in the currency markets tends to be the norm, rather than the exception.

In nations that are rich in raw material resources where revenue and tax receipts move higher and lower with their exports of raw materials, there is a direct relationship between the prices of the commodities they export and the value of their legal tender. Australia, Canada, Brazil, and even Russia are examples of countries whose currencies can move higher or lower with commodity prices.

Over recent weeks, commodities prices have moved lower, the value of the Australian dollar has moved from over $0.72 to under $0.69 against the US dollar. While commodities prices are only one factor in the decline in the value of the Australian currency, they can be influential.

Since commodity production is a local affair, local currency rates can impact the price of a raw material in dollar terms causing them to rise or fall. The cost of production includes labor and other expenses that are in domestic currency terms. An example of how a local currency can impact global prices comes from Brazil. The South American nation is the world’s leading producer and exporter of three soft commodities; sugar, coffee, and oranges. In 2011, the Brazilian real was at around the $0.65 level against the US dollar. Around that time, the price of sugar reached a high at 36.08 cents per pound. In 2011, coffee on the futures exchange peaked at $3.0625 per pound and Frozen Concentrated Orange Juice futures moved to a high at $2.2695 per pound in early 2012.

On May 17, 2019, the Brazilian real was at the $.024335 level against the US dollar, 62.6% lower than in 2011. That same day, the price of sugar closed at 11.55 cents, 68% lower than the price eight years earlier. However, sugar only declined by 7.4% in local terms in Brazil. The price of coffee was at 88.75 cents per pound on the nearby futures contract on May 17, 71% lower than in 2011, but only 8.4% below the price in Brazilian currency terms over the period. When it comes to orange juice, at 96.95 cents on May 17, the price was 57.3% lower, so OJ in Brazilian real terms was 5.3% higher in 2011 than it is in 2019 even though the price in US dollar has more than halved in value.

Commodity prices can serve as a guidepost and often influence the prices of commodities. If reforms in Brazil improve the domestic economy over the coming weeks, months, and years, it is likely that the prices of the three soft commodities will appreciate, perhaps dramatically. If they were to stay at the same level, the rise in the cost of production on a local basis would make the world price lower than the domestic price causing output to decline as they become uneconomic to produce.

Currencies around the world also move higher or lower against one and other when bond prices and interest rates change.

Bonds and commodities- Something is going to give

The primary determinate of the level of one currency instrument against another tends to be interest rate differentials. Interest rates move higher or lower for many reasons, but inflation is a critical component when it comes to the monetary policy decisions of central banks around the globe. Therefore, the bond market can move higher or lower on the back of commodities prices.

Bond prices and commodities have a mutually inclusive relationship. The cost of carrying inventories moves higher or lower with interest rates. The rate of financing stockpiles can drive the price of a raw material higher or lower. In a low interest rate environment, businesses often carry stocks as the cost drops. Lower financing costs often lead to increased demand for commodities as businesses are more likely to lock in prices for requirements and store them.

In higher rate environments, many businesses will purchase commodity requirements on a when-needed basis to avoid the increased cost of financing inventories. Rates of interest impact the demand side of the equation for commodities, but it also affects the supply side.

A higher rate environment can cause output to slow as producers become more wary about making investments that increase production. However, there is another element to the relationship between the bond market and commodities. Inflationary pressures cause the value of money to decline, which makes commodities more expensive. After over a decade of central bank accommodation around the world, the price for artificially low rates of interest and quantitative easing programs could eventually be an increase in inflation. Today, even a Fed Funds rate at 2.50% is low compared to the level over the past half century in the US. In Europe and Japan, negative rates continue to be a historical aberration. A sudden spike in the inflation rate would likely materialize in the commodities asset class. Central banks follow the market rather than lead so they could wind up chasing inflation with interest rate adjustments when it is too late.

So far, in 2019, bond prices have been rising, and commodities prices are higher despite recent selling. 

Source: CQG

As the weekly chart of the benchmark 30-Year US bond futures contract shows, the long bond has appreciated from a low at 136-16 in late 2019 to its most recent level at 149-21 on May 17 as interest rates dropped. Over the same period, the price of crude oil has moved from below $43 to over $62 per barrel. Copper fell to a low at just under $2.55 per pound in early 2019 and was trading at $2.7385 on May 17. The recent declines in markets like gold and precious metals, grains, lumber, and other commodities futures markets could be the result of the short-term divergence between the dollar and the bond market in the US. While the dollar is approaching a higher high, the bonds are at their highest level since early 2018.

The penchant for volatility in the commodities market is causing many raw materials to react to the dollar on one day and the bond market on the next. The recent rise to over $1300 in gold was the result of fears over the trade dispute that caused capital to flow into the bond market and other safe havens like gold and the Japanese yen. The decline in gold to under $1280 at the end of last week was a reaction to a strong dollar that appears ready to move to a higher high. Eventually, something has to give when it comes to raw material prices, bonds, and the US dollar.

The bottom line

At times, the commodity asset class can move currency, and bonds prices and at others, it becomes a follower. These days, commodities are scratching their heads, trying to figure out whether inflationary pressures are brewing in the global economy. I would argue that the current divergence between the dollar and bond market has made the tail wag the dog in that commodities have not yet decided to make a significant move.

A factor to consider when it comes to the future direction of commodities prices is the demographic pressures on the demand side of the fundamental equation for raw materials. I was born in 1959, when there were fewer than three billion people on our planet. In 2000 that number rose to six billion, and as of May 17, it stood at 7.573 billion according to the US census, an increase of over 26.2% in less than two short decades. Each quarter the world adds another 20 million people. Each year there are 80 million more inhabitants of the earth which translates to 800 million each decade. At the current rate, the global population will rise to triple the level in 1959 in under eighteen years. At the same time, global wealth and standards of living are rising as a result of the emergence of China as the world’s second-largest economy. The demographic trend tells us that more people, with more money, require more raw materials each day. Moreover, central bank policies over the past decade have increased the amount of liquidity swimming around the global financial system.

With US debt at over 22 trillion, increasing interest rates creates an extremely high price when it comes financing the growing debt which could begin to spiral out of control even if deficit spending were to end, which it will not any time soon. In Europe and Japan, the situation is even worse. And, in China, the nation is battling the trade dispute with stimulus. To me, it all adds up to a very bullish case for commodities prices, which means it is not a question if inflation will emerge; it is when. Central banks have set a 2% target rate for inflation, and that could be the ultimate punchline to the joke that has been their approach to monetary policy. Central banks have likely exacerbated the coming unprecedented environment that could change markets dramatically.  Remember, people around the world will continue to require food, energy, and shelter, meaning commodities are the ultimate assets. Individuals can live without stocks, bonds, and even currencies. They cannot survive without nutrition, energy, and shelter from the elements. For those reasons, I am a commodity bull.