Making Sense Of The Commodities Rout

Making Sense:

There is a rout going on in the commodities space. Some of this is based on fundamentals. Some of the rout is due to technical factors. Investors and advisors need to understand this before trying to become an asset class hero or consider stepping out.

Asset Class Hero

Commodity prices have been beaten down for more than a year. However, it is in the past several months that conditions have deteriorated dramatically. As with most asset routs, the crash in commodity prices begin with fundamentals. These fundamentals include:

• Lower-than-expected demand (or demand growth) for many commodities.

• Significant over supply of many commodities.

• Crowded trade conditions. Many investors and money managers bought into the China/EM growing to the sky scenario and moved into commodities en masse. Now many investors and managers are attempting to exit (for a variety of reasons) from a market with very poor liquidity.

• The collapse of OPEC. Many member nations rely on oil sales for the majority of government revenues. They will continue to pump to help pay government expenses. Some revenue is better than no revenue. Since OPEC is no longer the swing producer, cutting production would likely result in a loss of market share, possibly greater than any price increase which may result.

• A bet on China growing in the high single-digits or low double-digits caused an expansion of production capacity. There is probably enough production capacity to supply the markets if China was still building like mad. (1) (5) (6) (7)

Happy Christmas (Liquidity is Over)

Do not underestimate the effect of a lack of market liquidity on the price plunge among commodities-sector corporate bonds. I have written, on several occasions that the size of the high yield bond market has doubled since before the financial crisis. At the same time, the ability of proprietary trading desks to hold bonds has been halved. This has the potential to leave investors at the mercy of aggressive speculators.

Then there is the time of the year. It is now December. This means it is tax loss selling season. In the commodities sector, tax losses abound. This tends to put downward pressure on assets which performed poorly during the year. This downward price pressure is being magnified by the lack of liquidity in the markets. Add to the story the prospects for a continued strong, or stronger, USD and slowing economies around the globe and it quickly becomes apparent why we have seen a crash in commodity and commodity-related asset values.

This time of the year is also a sensitive time for traders. Although bonus pools have been largely set, trading losses in the last month of the year would probably result in a recalculation of bonuses. Since bonuses are rarely recalculated for stellar trading profits in December, traders have little incentive to go bargain hunting this month. Most trading books have settled in for a long winter’s nap. If there is going to be any barging hunting by the proprietary desks which still exist, it probably does not happen until the last week of the year or in January. The last week of December could be interesting.

This smells of tantrum to me. However, buying into the plunge is not for everyone. There is always the danger of a self-fulfilling worst case scenario materializing. If one is speculating in beaten-down energy, metals and mining bonds, one must go in with the attitude that receiving par at maturity is not a given. I am more concerned with investors and advisors selling at the wrong time rather than their hunting for opportunities.

I am hesitant to make blanket statements as to whether investors should sell at this time or to use it as a buying opportunity. Each investor has a unique set of circumstances. However, my gut feeling is that fundamental, technical and seasonal phenomena are conspiring to exacerbate volatility. I would be happy to discuss this further on an individual basis.