Earnings drove the headlines last week, along with some minor updates on Chinese market concerns and commodity worries. Meanwhile, Greece has practically vanished from the news to make room for fundamentals, and the S&P 500 so far has delivered moderately positive results. According to FactSet, 187 companies have reported earnings as of July 24th, of which 76% have beaten earnings estimates, while 54% have reported sales above expectations. The factors driving these numbers is what makes them intriguing, though – international weakness remaining the biggest one. International trade now accounts for nearly 2/3rd of world GDP, up from less than half just 10 years ago, according to the World Bank. Earnings have no shelter; the impact of currency moves, fiscal policies, and overseas markets can quickly dampen the short term progress of blue chip stocks. On that global note, this week, we decided to look into the most universal asset class of them all: commodities. Here’s our take on where things may be headed for them:
Oil, gold, and precious metals have been hammered over the recent months. The primary factors to blame are pretty simple (as usual with commodities) – oversupply, and the lack of demand. The explanation stems from Chinese growth worries, low global inflation and sustained dollar strength, in our opinion, and the trend doesn’t suggest any respite moving ahead.
Let’s start with oil, for example. US WTI crude is down over 40% compared to the same quarter last year, and continues to languish near the YTD depths. The completion of Iranian negotiations was the major catalyst, as investors now factor in the slow, yet sure Iranian oil supply onto an already oversupplied global marketplace. According to the International Energy Agency, highlighted by the WSJ, on any given day, the world already produces more than 2 million barrels more than there is demand for. Meanwhile, as the shale gas revolution redefined the industry, Saudi Arabia decided to bet on the long haul by keeping output steady, if not higher, in recent months. The supply has kept prices low, in a bid to stave off the increasing interest in renewable energy. The balance is delicate, but so far, they seem to have gotten it right. The US oil rig count isn’t drastically changing, and per Wall Street, it’ll take several months for US supply reduction to actually impact prices. Oil storage utilization continues to remain at near-record levels, and the cost of renting supertankers, highlighted in our June 7th column, remains sustained – indicating firms are continuing to store oil, hoping to release it when higher prices come around. Need evidence? Check supertanker stocks such as Nordic American Tankers Limited – it’s up over 59% YTD. When the market speaks, listening can pay off pretty well.
Nevertheless, US airlines, among several other sectors, stand to benefit along with consumers if oil prices stay low. However, energy firms contribute the largest share of capex in the US – an important catalyst that we felt would inspire the next leg of growth for the economy. As a result, we’re becoming a bit cautious. Alongside, Espen Erlingsen from Rystad Energy recently stated that North America’s shale industry has seen the biggest cost declines, of nearly 25% compared to 2014 levels. Most big oil majors have limited exposure to shale, and falling costs in the shale basins have kept output high, capping oil prices – a double blow to the industry, in his opinion. Falling productivity has plagued the industry in recent years, and fundamental changes will be required to right the ship. We had earlier attempted to call the bottom around the low 40s the last time WTI oil reached those levels, and sided with analysts stating that crude would end the year higher, closer to $70/barrel. Frankly, we see no sign of that happening as of right now.
Gold: Prices for this precious metal continue to suffer in today’s market; the well-followed GLD ETF is down over 7% this year. Despite slight signs of inflation, for reasons we noted in our June 28th column, gold continues to languish near its multi-year lows. Other precious metals that held steady until mid-July have now decided to join the downhill trend as well. A remarkable report from Morgan Stanley recently highlighted the major factors extremely appropriately – ‘the passing of deflation risk, the anticipation of the US Fed’s first rate hike, another debt resolution for Greece, and the collapse in China’s equity markets – which prompted loss-covering asset sales’, have all hit prices, according to the firm. The bottomline? Despite massive Greek turmoil, Chinese market shocks, increasing inflation expectations and potential volatility due to rate hikes, the value of gold as insurance just doesn’t seem to exist as it did in the past. Anthony Grisanti, a trader, coined it well on CNBC last week by pointing out that physical demand for gold in China is down 9%, while worldwide, demand for gold coins and bars is down 17% YTD. The buyers aren’t stepping in even though prices are going lower. That’s a very bad sign, in our opinion – and yet another reason to be careful with the deceptively shiny attractiveness of this commodity.
And finally, we look east, to China. The nation’s real estate boom defined the commodity cycle and led the global economy over the past decade, with iron ore, copper, and other imports in massive demand. Today though, we find a shaken market, overladen corporate debt levels, and a real-estate market where each price is being carefully scrutinized by overseas investors for signs of a bubble. We’re closely watching the multinationals that have exposure there this earnings season, and are uneasy with what we’re seeing. Whirlpool report a 3% decline in demand last week. Otis (part of UTX) – the inventors of the genius appliance called the elevator, reported that orders were down over 10% compared last year. Now, the question is if construction is down, so be it – but are existing real estate prices at least holding up? We hope they do. If not, it’s an even larger bubble than previously thought, and the impact would be far greater, further affecting nations such as Thailand, Vietnam, Australia, and other major trading partners. The cool-down of the commodity churn is impacting the world in more ways than just prices. With data from the WSJ, we see that the US Labor Department reported that the overall price of imports to the US from China was down 1.2% from a year ago. This is likely another contributor to inflation being low – and a consequent barrier for Fed interest rate hikes – which in turn will define asset flows to emerging markets and currencies in the coming months. It’s not a coincidence that the Dow Jones Industrials Average – note, ‘industrials’ – composed of the 30 US titans deriving revenues globally, is far underperforming the more diverse S&P 500 or Nasdaq.
What it means for you: Commodity prices don’t have much reason to go higher. As a result, our recommendation is to stay invested with the broader market, and avoid doubling down on metals, mining, large industrials or energy firms at the moment. Selectivity is important – and in a market where global growth remains sluggish, the full extent of Chinese weakness remains to be understood, and a binary philosophy regarding Fed rate hikes dominates, investors should avoid trying to time the markets. The trouble with commodities is they themselves don’t lead innovation or productivity; its all about supply and demand for these universal products. Rather than betting on the bottom, a more sure way is to choose firms that have shown innovation and trend-setting capabilities – whichever sector they’re in. Stay in sync with economic data and keep an eye on earnings as such companies define the direction on Wall Street in the coming week’s reports.
