Transitioning From Liquidity To Growth

Commodity strategy for the rest of the 2010 will need to take into account that global economy is shifting from liquidity to growth phrase and from expectations to reality. In 2009, we had a broad rally in commodities due to oversold conditions, ample liquidity, and expectations of strong demand from China. However, none of these three conditions hold any more – the rally in 2009 removed oversold conditions (except perhaps in some softs), liquidity is slowly withdrawing or at least increasing more slowly, and strong demand from China has been fully priced in. On the other hand, we expect to start seeing strong growth in economic economy, especially in emerging markets, increased bearishness regarding non-commodity currencies, and continuation of industrialization in China, which are all bullish for commodities. These forces will not take effect immediately, and we wouldn’t be surprised to see consolidation and increased volatility in first half of the year, as we transition from liquidity driven rally to rally based on fundamentals. Breadth will almost certainly deteriorate, and picking the right commodity sectors will be critical. We favor precious metals over base metals, tactical plays in energy sector, and non-grain softs.

Base Metals
The LMEX Metals Index doubled last year due to ample liquidity, dollar weakness, rising global leading economic indicators and Chinese stockpiling. However, LME metal inventories are at a cyclical high and exports from Asia are just starting to recover. This suggests that a major chunk of economic recovery has already been discounted and base metals should lag precious metals.

It is important to note that at this stage of the cycle, growth-sensitive sectors such as base metals should take leadership from liquidity/defensive sectors such as precious metals which should start to underperform. But it seems that this time might be different, as base metals have anticipated the growth rebound, and both price and inventory levels increased dramatically during the liquidity stage in 2009.

From absolute return point of view, we are neutral on base metals in the first half of the year. While net speculative positions as share of open interest have almost reached complacent levels last seen in 2008, the bullish sentiment and the level of open interest are still far below the 2008 highs. The biggest risk is Chinese tightening, which could cause hard landing for Chinese economy and base metals. However, Chinese policy shift is occurring at a time when price inflation is tame and when exports are expected to surge. It is more likely that Chinese policy tightening will cause problems in real estate sector in eastern provinces, but will not cause a hard landing for the overall economy. In the second half of the year, strong growth, relatively generous monetary policy, and secular bull market in metals should push base metals higher.

Copper, lead, and mining stocks remain our favorite plays in this sector, but there might be a better entry point in next few months. We are long-term bullish on Zinc and aluminum, but they are extremely energy-sensitive (energy accounts for 43% of zinc production cost and 41% of aluminum production cost) and their price might be “pegged” to coal until bullish secular trends start taking over.

Precious Metals
Low interest rates, escalating problems with government debt around the world, availability of gold ETFs, and emerging market jewelry demand, and tight supply continue to provide tailwinds to gold on strategic horizon. Desire of Asian central banks to diversify out of the dollar (central banks have turned to net buyers for the first time since mid-1970s) also provide support to gold prices. On shorter time horizon, interest rate expectations and raising dollar due to trouble in Europe could keep gold in $1000-1050/ounce range. However, the Fed will not start withdrawing liquidity in next couple of years, and we expect gold to continue its uptrend within next couple months.

Strategic positions should be held, but we have liquidated high-beta plays such as gold miner shares in mid December and re-entry into these positions might be premature. Net speculative long positions relative to open interest have fallen below their highs, but not yet to a level which would eliminate “stale longs” and coincide with intermediate-term bottom. We would also like to note that gold has fallen below its support of $1075 in first week of February, which should have triggered a lot of sell stops; however, it immediately bounced back which might indicate that “smart money” is buying and might indicate that intermediate-term bottom has been reached. This bullish reversal poses a threat to our base scenario (of continuation of correction) and it might be prudent to start slowly scaling back into high-beta plays.

Energy
In the long term, oil and energy prices (except perhaps natural gas) are certain to increase significantly, due to extremely easy monetary policies and declining oil production. However, in the intermediate term, we have very little conviction on the direction of energy prices and prefer to stay on the side in this sector.

We do however, still like being long distillate cracks through refinery stocks. We expect to see increased U.S. import volumes, which will in turn increase trucking activity. In fact, the Trucking Tonnage Index is already firmly off its 2009 bottom (this is the key indicator of distillate fuel use).

Softs
Prices of all agriculture commodities have become extremely depressed in beginning of 2009, and they have underperformed other commodities since. We are especially bullish on non-grain softs (coffee, cotton, livestock, and sugar) where fundamentals are extremely strong:

• Cotton stock-to-use ratio will be at 15-year low by July 2010; in addition, we are seeing strong demand recovery from China, India, and Pakistan (which account for approximately 70% of world cotton consumption)
• After two consecutive years of crop disappointment in India and problems with crop in Brazil, sugar stock-to-use ratio is at 50-year low. We are also seeing raising demand from other consuming countries which might push sugar significantly higher. The main question remains whether we will have enough sugar to get to the next season or not. While we are holding our strategic positions in sugar, we believe that risk/reward of adding to positions at current levels is not high enough.
• Coffee stock-to-use ratio will fall to the lowest level or record in the next few months. At the same time, Great Recession has limited impact to coffee demand, due to strong consumption growth in emerging markets.
• Calf production this year will be the smallest since 1994 and cattle inventories will be the smallest since 1975. In addition, we should be seeing increased demand due to economic recovery.

Unlike fundamentals for coffee, cotton, livestock and sugar, fundamentals for grains are relatively bearish. Inventory levels are ample, and supply in 2010 will increase. On the other hand, grain prices remain extremely depressed by historic standards and any unexpected weather or increased demand from livestock producers (due to increased demand from expanding middle-class in emerging markets) could push them up significantly. Overall, we are slightly bullish, but would keep our sell stops extremely tight.