The Factory Daily Letter
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Commodities have broken their bullish trend...
...as investors have switched focus from the threat of inflation to that posed by recession
Investors have been shifting their attentions from inflation risks to those associated with slowing growth - which have been exacerbated by the tightening in financial conditions in the US and Europe along with large squeezes on real incomes. While the mood music at the beginning of the year was for moderate growth in 2022 (albeit slowing down from what we had seen in 2021) the financial press is now awash with the word recession, and as we write, the key question is no longer whether we are heading towards one, but when it might occur - and how deep it might be. The US recession probability forecast gauge (as presented below) has been on the rise since October 2021, but has steepened markedly since March 2022: it has now reached 33%.
Our own economists now put the probability of recession in the US at around 70% - expecting the US economy to enter a “mild” recession in Q1 2023. They have accordingly lowered their GDP growth expectations to 1.9% in 2022 (down from 2.9%) and -0.4% in 2023 (from 0.8%) and put the unemployment rate at 4.5% by the end of 2023. They also expect to see a “mild” and technical recession in Europe in Q1 2023, citing rising prices and squeeze of real incomes as the biggest risk, revising their 2023 GDP growth estimates here too (from 1.8% to 0.8%). However, they expect the same to be short lived on the basis that wage growth helps to offset falling purchasing power and therefore supports private consumption.
Should these scenarios materialize, the same might encourage both the Fed and the ECB to pause their tightening trajectory over the course of Q1 2023. (See yesterday's letter "What can we learn from the commodity markets").
Longer-term inflation expectations have been moderating
At the June FOMC meeting, Fed Chair Jerome Powell cited the larger-than-expected increase in inflation expectations from the University of Michigan survey one of the reasons for the 75-basis point rate hike. Last week, however, the final reading of the survey for June was revised down from 3.3% to 3.1% (almost erasing the jump that had so alarmed the Fed). Combined with the slowdown in economic momentum, it could be that investors may see market expectations for future rate hikes as too aggressive, and consider it less likely that the Fed will opt for another 75 basis point rate hike in July.
Yesterday’s final GDP figures also put personal consumption well below-expectations (the revised figure at 1.8% vs. cons 3.1%). This may also strengthen the case for a 50-basis point hike in July, rather than another 75-basis point hike.
In this sudden shift from inflation concerns to recession fears, base metals could suffer
In October last year (see our letter "Mine the GAAP“), we were talking about how the inflationary pressures linked to the supply/demand imbalance at the end of the pandemic brought about a rally in metals, helping aluminum and copper to outperform their peers. We also suggested that a long-term rise in base metals was a headwind for the metals & mining sector, which was then sporting a neat combination of attractive valuations, rising cash flows and low debt.
Since then, we have seen the sector enjoy a period of substantial outperformance between the end of 2021 and April 2022, supported also by its use as a hedge against rising inflation. The price of certain base metals such as copper and zinc, which are barometers of the economy, have however recently suffered sharp declines and the relative momentum of the metals & mining sector now appears to be on the verge of reversing. The chart below illustrates how the relative performance of the metals & mining index has historically tended to move in tandem with the price of base metals (copper). With base metal prices falling, the metals and mining sector has been giving up its recent outperformance, and the relationship between the two suggests that we could see more deterioration in terms of sector performance on this basis should investor focus indeed continue to shift from inflation concerns to worries about recession.
The shorter-term chart below shows how the two indicators have been particularly closely correlated over recent years – further underpinning how the sharp fall in copper could herald further underperformance on the part of metals and mining stocks.
It is also an unfavorable context for the materials sector: whether inflation is rising or falling, the materials sector tends to underperform when the ISM slows
By way of the charts below, we present the past average monthly performance of the S&P500 sector indices across the four different combinations of inflation and activity circumstances on data going back to 1989 (using historical CPI data for inflation and ISM Manufacturing as an indicator of economic activity).
What is clear at first glance is how all sectors perform in the context of rising inflation and economic activity, each showing high average returns over these periods – the cyclical sectors in particular.
On the basis however that the US economy is likely to fall into the set of circumstances illustrated top right (US inflation continues to rise while the ISM comes down from its peak) you can see how historically such periods have brought about disappointing returns across most of the cyclical sectors, and only the most defensive sectors have historically managed to post positive returns. Moreover, even if inflation does start to slow meaningfully, history suggests that if the ISM continues to deteriorate, materials' performance is nonetheless still likely to remain disappointing (as illustrated bottom right):
Commodities are falling
During the post-pandemic period, commodities have recorded one of their strongest periods of gains in the last 42 years; and not only in terms of performance, but also in terms of momentum. To illustrate this, the chart below highlights the number of 52-week highs recorded over the past year. On 18 April, the Bloomberg Commodity Index reached a peak in momentum with 51 new highs recorded in the past year, the highest since 1980.
We note that historically, when commodities lose momentum, it usually coincides with a weakening in prices... with a major exception being during the Volker zone in 1973 when prices continued their rally.
Other than across the energy space, the fall across commodities has been severe and broad-based
As the chart below illustrates, industrial metals (in red) have been underperforming the rest of the commodities market (which strength in energy has arguably been supporting):
Our commodities breadth indicator has experienced a rare sharp reversal
The sharp decline in commodities last week resulted in a sharp reversal in the breadth across the Bloomberg Commodity Index. We calculated the following breadth measure by taking the 23 members of the Bloomberg Commodity Index relative to their respective 50-day moving averages. The breadth reversed from 100% on 23 March to 34.7% on 24 June: a deterioration of 653 basis points over 3 months and the largest decline in a decade:
If we look back at data going back to the 1990s, we find 10 other instances of commodity breadth deteriorating at least 50% in 3 months:
How do commodities tend to perform following such a strong breadth reversal?
Although the sample is tiny, forward returns have always been biased to the downside after such a clear deterioration in breadth. The current episode so far follows the historical pattern with a 3.9% decline after one week. We are now entering a favourable window – being that between the second week and a month after the initial event - during which a rebound has historically tended to occur (with 60% positive occurrence rate after two weeks). But after that prices then tend to resume their downward trend until the second month. Of the 10 occurrences, in only two instances has the index seen a gain (and no greater than 1.5%) with average and median performance of -4.8% and -1.6% respectively.
Volatility is evident for a year after the event, with only one incidence of the index gaining more than 10% 12 months later:
From a technical perspective, the pullback in industrial metals may have further to go
After the Covid-market crash of March 2020, the price of copper enjoyed a continuous rise up until May 2021 when it reached a local top at around USD 4.9/lbs before falling back to evolve in a range between USD 4/lbs (acting as a support) and USD 4.8/lbs (acting as a resistance).
However, after it broke below a rising short-term support line back in April, a new period of negative momentum sent the index back down on below a series of short-term moving averages and then the former support at USD 4/lbs.
The short-term indicators are now looking a bit oversold suggesting that a rebound may occur. However, the technical outlook remains challenging and the price could fall toward USD 3.5/lbs (the 50% Fibonacci retracement of the post-Covid rally).
This negative price action has been widespread across industrial metals
Zinc has also recently broken technical support that has held since the pandemic low in the same manner, taking out its 200-day SMA and the ascending support line connecting the lows since 2020 in the process. It is currently falling towards the next technical support at 23,248 (the 38.2% Fibonaacci retracement of the entire bullish sequence). A move below this level would trigger a more significant decline in zinc towards the next support at 21,570:
The S&P metals & mining index; short-term oversold; long-term pain
From a technical perspective, the S&P1500 Metals & Mining Index appears to have formed a bearish “inverted cup & handle” pattern, a bearish continuation signal after the initial decline and the subsequent relief rally that occurred in May. It has since broken below a series of supports including the rising support line connecting lows since the 2020 and the 38.2% Fibonacci retracement of the entire post-covid uptrend.
While in the short-term, a rebound from oversold may occur, the break of support could trigger a decline on towards 40 and then 30 (being the 50% Fibonacci retracement of the post-covid rally, and the target of the bearish pattern respectively):
While the recent selloff in commodities could take a breather in the short term (as it has historically been the case as we have shown), we wouldn’t suggest chasing the rally. And in fact we present below a screening of ETFs and company names with 6 month implied put volatility below the 1-year average or trading at a small premium. While volatility has already sky rocketed across most asset classes, such names are still showing resilience and could suffer most in the event that the negative price action across the commodities space resume in H2.
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