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Commentary & Analysis

JPMorgan on Commodities: Right, Wrong or Early? covered a recent move by JPMorgan – they moved their forecast to “OVERWEIGHT” for commodities.

Considering the technical setup of some individual commodities, I can’t help but think this is very much a “catch the falling knife” type of forecast (which JPM too acknowledges very briefly). But it’s not necessarily a bad idea unless your hand (or someone else’s) gets sliced off.

But JPMorgan has put together a whole bunch of evidence (i.e. charts) to make their case.

You can read the very long post and view the charts on Zerohedge. Or you can take my Cliffs Notes version and know exactly what to do with commodities in the coming days and weeks (wink, wink!)

Besides the knife catching, JPMorgan also assumes this time is not different. Again, maybe there is nothing necessarily wrong with that view. After all, people tend to get in trouble in the market when they think this time actually is different.

But this time is different.

Sure – maybe the market outcome won’t be different, but the variables certainly are different.

Let’s look at what JPMorgan said [my emphasis]:

"Like other global markets, commodity prices are buckling on rising concerns about China and the Federal Reserve. It is important to be specific about what these concerns are. The new fears are not that Chinese growth is slowing or that the US central bank will taper its QE3 asset purchases. Both are inevitable outcomes that have long been embedded in commodity forward curves. The actual concerns are: (1) the large shadow banking sector in China might soon trigger an unexpected financial crisis, like the one that emerged in Asia in July of 1997, and (2) the FOMC might simultaneously be making a policy mistake in putting its own growth and inflation forecasts ahead of the markets’ fear about Chinese finance and the evidence that disinflation in the real economy is bulldozing inflation expectations in markets. These concerns are legitimate. A sturdily low-vol commodity regime has suddenly been asked to assign probabilities to these two scenarios. Neither is a zero probability. Nor is either likely a baseline outcome in 2013."

Ok, fine. Good. JPMorgan correctly points out two very legitimate concerns. So now let’s look at what else they said about this fresh “OVERWEIGHT” call:

The last time we recommended moving to overweight was on September 30, 2010, or about a month ahead of the announcement of QE2 on November 3, 2010. In the nine months that followed (we turned neutral in June 2011), the S&P GSCI total return index produced a 16.5% total return against a 14.9% total return for global equities and a 2.5% total return for global bonds.

I think JPMorgan would be foolish (or devious) to look past the glaring problem, i.e. things ARE different this time.

Last time they made such an about-face with their view on commodities, the quantitative easing era was still in its infancy. Clearly that is not the case now. (While I don’t suspect the Fed is on its way out of markets just yet, the seed has been planted by Fed tapering rhetoric and the latest BIS annual report to suggest QE cannot actually go to infinity lest its benefits become risks.) Basically, expectations have changed enough to question the relevancy of their last overweight forecast.

And things are different in China as well. First, back to JPMorgan’s words [emphasis theirs]:

… metals prices have reached levels that are demonstrably forcing involuntary production cuts and fresh demand. Against one-sided sentiment and following 15 months of destocking, Chinese buyers are going to realize very soon this is the opportune moment to back up the truck and to restock supply channels where China is import dependent. A surge in Chinese buying of a metal at a lower price has already been observed in gold. We expect renewed vigor in imports of copper and oil. It is quite obvious what the Chinese should do here in physical markets, in pursuit of China’s long-run economic and social self-interest.

One of the charts JPM uses to prove this point is of Chinese copper restocking and destocking:

They point out a copper price below $5,500 tends to generate restocking and drive the price back higher. But the near-term correlation between price and restocking is not strong. And I would say it’s dangerous to think about going long on copper right now:

But their point is duly noted.

Recall the first section of JPM comments posted above recognizes a legitimate risk: the potential for a financial crisis triggered by China’s shadow banking sector. They even went as far as to differentiate said risk from a mere economic slowdown risk. And I think they were right to do so.

But to me that epitomizes “this time is different.”

A financial crisis in China would put the spotlight squarely on a China-specific problem. In other words: it’s not China’s external exposure that will hinder growth rates; it is China’s internal financial/economic structure that can no longer generate growth without significant risks. Oh, and China’s external exposure is still an issue as well.

Now I imagine JPMorgan has sufficiently hedge itself with its comments. So they’ll be able to turn on a dime if QE concerns or Chinese financial system risks fester.

To their credit, they did make some other interesting points:

Like why hasn’t the price of crude oil fallen despite bearish fundamentals? To which they answered by pointing to the steep backwardation in the crude oil futures curve now versus comparable levels back in 2007 before crude oil’s price shot off like a rocket.

My basic technical chart also suggests the path of least resistance is to the upside:

JPM also produced a whole list of fundamentals they think will influence price action soon:

  1. Seasonal factors drove the 2Q correction in spot crude oil, and seasonal factors will reverse it.
  2. Fresh demand for storable commodities, in response to the steep price corrections
  3. Price-driven, involuntary production cuts in crude oil, copper, and gold.
  4. Inflation in production cost economics.
  5. Spare capacity is tight and non-economic supply risks are rising.
  6. Lagged benefits to commodity demand from rate cuts and other stimulative measures.
  7. Stealth shift in US export policy already at work is further linking WTI with international prices.
  8. Chinese shift in policy: ‘go green’ does not mean what it means in Seattle. It means go to oil&gas.
  9. Stronger USD against what? The DXY does not include the CNY.
  10. Global growth and inflation rates will likely soon bottom. Rising values in these rates, even from low bases, provide a favorable economic environment for commodity index total returns.

Now be careful with this. I would suggest that these fundamentals mostly apply if the “this time is not different” scenario plays out. Should unrestricted Fed accommodation expectations be restored and should China’s financial system warning flags be lowered, then these fundamentals could prove useful in pinpointing the direction for commodities.

But that still requires getting past the rest of the global economy’s growth hurdles. That’s been the reason for such poor commodity market performance. And I wonder if commodities can recover in any meaningful fashion if investors believe the halcyon days of global economic growth are behind us.

Be selective in the commodities you buy. Perhaps stick with agriculture. Perhaps dabble in crude oil until higher prices change its fundamentals. Perhaps wait, as JPM says, for the technical setup on metals to change before jumping in.

And keep in mind: this time is different!