Thursday, July 21, 2016

Hard to say there will be a rally in all commodity markets - the wheat example

While there has been optimism about a resurgence in the commodity markets, a closer look at the data suggests that caution is warranted. First, each commodity market is often different. There is no common market factor that generally drives these markets. Second, any trends are often dampened by the fundamentals which are inconsistent with the price action, so basic supply and demand has to be reviewed if you want to get the longer-term direction right. 

At the core, momentum and trend are still the best signals for commodities trading but linking to fundamentals will help manage risk and expectations. A perfect example is the wheat market which is down more than 20% this year and has been in  sustained downtrend since the middle of 2012 in spite of some short-term up trends. The fundamentals give a good story for the trends.

The fundamentals are holding back any sustained rally as seen through four charts from the USDA ERS commodity yearbook for global wheat. First, production has continued to rise. Wheat had a good showing in 2012 when production fell, but world production is now just off global highs. Second, yields are increasing. Productivity continues to march higher, so the same amount of wheat requires less land. Technology drives real prices lower. The combination of production and yields suggests that no shortage is likely in the near-term.

Production has to be matched with demand or end usage, and if there is an imbalance, the residual will be placed in storage, yet storage is not passive.  Storage also serves as a signal of future high prices. If a market is in contango, suppliers can hold inventory, hedge and end up in a good financial place even if markets are priced fairly. Ending stocks are at new highs, so there is a strong stock buffer if production falls. The size of the buffer relative to production is strong. You have to go back to 2000 to see similar levels.

Trend-followers are non-predictive and only rely on price as the signal, but a more macro approach that accounts for other information suggest caution on the long side. Alternatively, consistency of signal and fundamentals on the short-side of the market have made for better opportunities.

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