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The Big Conversation

Episode 71: Commodity prices, margin debt & inflation

This week we look at the two themes which are dominating market talk: the surge in commodity prices and the rise in the use of margin debt to fuel the US equity rally. Many commodity prices have risen over 50% in the last year,  fueling fears about future inflation, whilst a record surge in margin debt over the last couple of months has stoked fears that the equity market may now be rising on excessive leverage. In this week's Chatter, Bruce Alway, Refinitiv’s Director of Metals Research, looks at the supply and demand factors that have been driving the rise in copper prices. 

  • Speaker 1 [00:00:00] There are two themes that have been building a real momentum in recent days. One is the rise of margin debt in the US equity market, as well as a decline of short interest on the New York Stock Exchange, and a record low level of mutual fund cash balances. The other theme is the continuing surge in many commodity prices, such as US lumber, which is fueling expectations that consumer inflation will take off in earnest, risking higher bond yields and tighter financial conditions that could reverse the leverage that's helped equity market performance.

    [00:00:28] Are both of these concerns a risk for current markets? And can the US continue to experience these extremes when other countries are not? These are the topics for this week's Big Conversation.

    [00:00:42] There's been a lot of talk about the rise in margin debt levels. Margin debt has reached a new high, and there's been even more focus on the year-on-year change in margin debt, which has reached record levels. Some of the data released by the Financial Industry Regulatory Authority are even more extreme, and this has led to concerns about an overheating equity market. We've already noted in previous episodes that the shadow banking system in the US was benefiting from a surge in credit. Total bank credit has risen to a new record of 15 trillion US dollars, with a surge in the proportion going to Wall Street activities, which now accounts for nearly one third of the total. Some of the recent hedge fund and family office issues were fueled by this easy availability of capital. But in the retail space, when we look at relative rather than absolute numbers, then the surge is not quite so dramatic. The percentage rise in household margin debt is high, but below the peaks of the last 20 years. In many ways, the retail sector is just making up for lost time, having been largely absent from the market since 2015, when the S&P performance was dominated by buybacks and 401k pension flows. Margin debt is a ratio of the S&P, whilst not necessarily being the best way to look at the metric, at least shows that household margin debt had stagnated even as the S&P soared. This ratio still remains close to the 20 year lows, despite the recent surge in absolute numbers. While the S&P 500 more than doubled from the 2016 lows, margin debt barely moved until the last few months. Furthermore, margin debt is generally a coincident indicator with higher equity prices. Too much leverage can clearly be a problem if a market goes into reverse, as it did in 2008. But margin debt is not the catalyst for a reversal, and neither are low levels of mutual fund cash or short interest. But it is true that some of the reflation trades may be running out of steam, but that would be a cause for rotation rather than reversal. Flows into emerging market equities have been dwindling since mid-March, whilst flows into emerging market bonds have started to pick up with the pullback in US benchmark yields. Emerging markets are usually the beneficiaries of a global reflation, but the rebound in the US and parts of Asia have not been replicated globally. In the US, the ISM composite of both services and manufacturing has hit an all-time high, but further upside is limited. The year-on-year change in the S&P 500 has largely matched this move, though the two are probably coincident data points. This doesn't mean that the S&P has peaked, though the momentum of the last 12 months will likely subside. On the plus side, the US equity market is now emerging from the buyback blackout period as the earnings season progresses. The cash rich tech stocks continue their buyback programs throughout the pandemic, and now more and more companies are intending to join them. Balance sheets were not as impaired as expected, with a number of bankruptcies failing to take off despite the rise, and still high unemployment levels. For listed entities, government support appears to have canceled the insolvency phase experienced in the previous cycles. Of course, there are always risks to the market after an extended run like the present, having had so few pullbacks since October with one wobble ahead of the March expiry, exceeding five percent on an intraday basis. Furthermore, the 'sell in May and go away' adage doesn't really stack up anymore. Between 1950 and 2013, the May to October period for the US market averaged a gain of only naught point three percent, whilst November to April racked up an average gain of seven point five percent. But between 2010 and 2020, only three of those 11 years saw a decline during that period. And even prior to that, the May to October numbers were often distorted by extreme events in that September to October timeframe. Two of the biggest risks for equities today are a surge in nominal and real rates or a surge in the US dollar. Both of those have stepped back into ranges in the last couple of weeks, and US financial conditions are close to the bottom of the 50-year range, which is supportive of risk assets. Margin debt, therefore, is only a real concern if we get a catalyst for a reversal. And that's why the focus has again turned to some of the extreme price action that we're seeing in U.S. commodity markets, and the inflationary risks that many expect that this will bring.

    [00:04:49] Sentiment Trader, an independent research house, notes that in the last 252 days, over 50 percent of the main U.S. listed commodities have risen more than 50 percent for the first time since 1970. The year-on-year rise in the broad based Refinitiv Commodity Total Return Index is with a gain of over 50 percent, just below the highest reading of the last 30 years. Is this a typical rebound off an economic bust like we saw after the Asia, the dotcom and the great financial crises? Perhaps these are simply supply chain issues caused by the pandemic, or will this be sticky inflation due to excessive policy intervention? COMEX copper futures are just below their all-time highs set a decade ago when China was driving its credit fueled rebound from the financial crisis. US lumber futures continue to storm to new all-time highs, with a couple of the peaks following the big surges in the price of Bitcoin in 2018 and now again today. Is this monetization of one fueling demand in the other or are both being driven by the same risk on risk off liquidity? Now, of course, that could simply just be a chart crime, but the point here is that the liquidity and asset prices are linked by policy in a way that we've probably never seen before. And we're also now starting to see a surge in agricultural commodity prices such as corn and soybean futures on the back of rising drought concerns. Corn has doubled in price since the middle of last year, and soybean futures are not far behind. The broad rise in commodity prices is now prompting CEOs during the current reporting season to say that they are going to increase prices to consumers. But at the broadest level, how many of these issues are still a legacy of the massive distortions created by the pandemic in its response? These will take a very long time to work their way through the system. In fact, many parts of the global supply chain are seeing a deterioration in conditions due to the pandemic. Normality on a global level is still a very long way off. In the US, PMI surveys indexes for delivery times have reached 20-year highs, indicating the struggles that purchasing managers are having with outages along the supply chain. Current inflationary surges at their broadest level are still more about a legacy of supply than of runaway demand. US gas prices could rise not because of a lack of crude oil or refined product, but because of a 20 to 25 percent shortfall in qualified tanker truck drivers. Similar issues are being experienced by small businesses, where the index for job openings becoming hard to fill has reached a 30-year high, despite the total participation rates in the US for employment remaining well below pandemic levels. Fiscal support packages have distorted incentives and created massive imbalances despite a relatively high unemployment rate. And if this was a truly demand led phenomenon, then levels of world trade would have bounced back to well beyond their former trajectory in order to create these sorts of moves. They have recovered prior levels, but there is still slack in the global system. Europe may have accelerated its vaccination rollout, but the summer economy is still precariously balanced. Therefore, it's dangerous to extrapolate the current jump in commodity prices into a permanent change for inflation. And if the US continues to go it alone on the fiscal side, some of this inflationary pressure will dissipate into the global economy. And in the meantime, the US will have to absorb some of the deflationary pressures coming out of China, whose manufacturing overdrive during the last 12 months will need to find a market on the world stage. The actual year-on-year change in China's social financing, one of the broader measures of China's credit support, is now showing the negative base effect of the surge in support a year ago. For China perhaps also, more importantly than the level of credit is the target for that credit. Pre pandemic, China was edging towards a model of internal consumption and away from all out growth. But she still will be a world leader in the demand for commodities. But the rate of change will continue to slow, even though there will be a global focus in certain sectors, as we'll discuss later. Other US assets have not aggressively responded to the recent moves in high commodity prices. 10-year inflation expectations have edged to a new high, but most of the rise came last year in anticipation of many of the issues we're now seeing. Nominal yields have peaked at one point nine percent in the short term, and have now also drifted lower. And this has helped cap real yields, which is beneficial to many other risk assets. So far, the market has taken the risk of longer-term inflation in its stride. Financial conditions are still very loose, whilst market participants are watching central bankers for signs that they may start to taper, but it's unlikely that they'll tighten anytime soon. Debt levels are too high to risk significantly higher yields, and the Fed will probably roll out yield curve control if those yields do move too quickly. The biggest risk is probably a sudden and unexpected surge in the US dollar, which continues to build a large basing pattern in the DXY, the dollar index. If the dollar did find a bid, that would be another reason to quickly fade the commodity based reflation trades. Emerging markets have already struggled with only a small bounce in the dollar and a sustained move higher would put significant pressure on positioning and drive investors back towards tech stocks.

    [00:09:58] Now, when we look at the commodity complex, copper is building a very strong structural bull case. Copper prices have diverged from other related sectors such as the Australian dollar and China credit, helping support the thesis that new factors are driving demand. Bruce Alway, Director of Metals Research at Refinitiv, discusses the macro backdrop for copper and whether the recent price action can maintain its momentum.

    [00:10:25] Many commodities have been performing incredibly well over the last six months, but copper is seeing a confluence of many different factors that are combining to create a real buzz in the space.

    Speaker 2 [00:10:35] For me, the key driver for copper is the global transition to clean energy.  A three megawatt wind turbine contains up to four point seven tons of copper, solar technology uses around five point five tons per megawatt, then there is energy storage, grid infrastructure and of course, electric vehicles. Consider a standard vehicle uses around 20 kilos of copper, hybrid 40 and a battery electric vehicle 80 kilograms per vehicle. So on top of this green energy transition, you've also got the post-pandemic stimulus packages to boost economic growth. Recently US President Joe Biden unveiled the long-awaited infrastructure plan, worth two trillion. A surge in building, covering roads, railways and airports and naturally metals intensive. But the real game is in China, it accounts for over half of global copper production. Last September, the Chinese president surprised the world by announcing the country would reach net zero emissions by 2060 and would peak their carbon use before 2030. And in March, we got the details of the country's 14th five-year plan. It sets out an 18 percent reduction target for CO2 intensity, and a 13.5 reduction target for energy intensity. The plan also presented a list of construction products for the modern energy system, and it forecasts that the urban-rural population split is to hit sixty-five percent from sixty point six in 2019. So that's an extra hundred million people moving to cities by 2025, and the requirement, of course, for the extra infrastructure, housings, etc.. So in short, I think China delivered a much quicker than anticipated recovery post-pandemic, while elevated physical buying, combined with this narrative of metal's heavy global green recovery, has pushed copper to near 10-year highs.

    Speaker 1 [00:12:36] As well as the demand story, copper has experienced supply issues, many of which pre-date the pandemic era,

    Speaker 2 [00:12:42] if you consider a slightly longer time horizon, there is certainly support for copper's bull case on constrained mine supply, mostly due to a lack of investment and the long lead time required to bring on new mines. So certainly on a three to four year view, we could be seeing some sizable deficits in the copper market as supply growth stagnates, while at the same time demand for copper in the green energy sector starts to become more meaningful. I think on a shorter time frame, there's already real tightness in the copper market, evidenced by the collapse in treatment charges. Now, this is the fee levied by a processor for converting concentrate into refined metal, and treatment charges rise when there's plenty of material and fall when there's a shortage. And right now there's a real shortage. Now, it's not so simple because smelter economics are complex, they're impacted by market prices for the free metal content, credits from gold, silver and the market conditions for sulfuric acid that's generated. So I'm a little bit hesitant to conclude that there's going to be a lot of smelter capacity coming off-line, and therefore clearly an impact on refined metal production. But certainly, it is a real risk, and it's a narrative that the super bulls are using to justify copper breaching ten thousand dollars per tonne in the coming months.

    Speaker 1 [00:14:02] China has been the primary copper consumer for a couple of decades. During 2020, they implemented a supply-side response to the pandemic and took advantage of early weakness in copper prices to rebuild inventories.

    Speaker 2 [00:14:13] I think as the world's largest consumer, China is always centre stage when we're talking price discovery, and most importantly was just after the first quarter, which was hit by the pandemic. In May 2020, Beijing launched a three point six trillion yuan, or five hundred billion dollar fiscal stimulus package, a package that was yet again very investment and business orientated with relatively little support for households. So high activity in the infrastructure and energy sectors boosted copper consumption. Now in the fourth quarter, and this is estimated by BRGRIMM, it's a domestic consulting company, increased by thirteen point five percent year on year. While for 2020 as a whole, consumption was up by two point nine per cent. On top of this, there was some restocking. So if you look at refined copper imports, they amounted to four point six seven million tonnes in 2020. That's an increase of just over 30 percent year on year. And this rise was mostly due to a surge in imports in the June to September period. And that's around an extra nine hundred thousand tonnes from the usual run rate. About two thirds of that volume is rumored to have been purchased by the State Reserve Bureau or the SRB, which is in charge of building the country's strategic reserves. Now, the SRB does not publicly disclose its activities, but the acquisition price during the June to September period in a range of around five and a half to six and a half thousand dollars per tonne for copper certainly looks attractive versus previous purchase patterns.

    Speaker 1 [00:15:51] The bullish ferver behind copper is picking up a head of steam, although the long-term outlook is extremely robust, is there any danger that prices have become overextended in the short term?

    Speaker 2 [00:16:02] Yeah, I think, you know, it's more about profit-taking, than outright bearish positioning now. So if you look at the commitment of traders report, we've seen the longs unwind in February and March while the short position has slightly increased. So on balance though I think you've got to consider that Q2 is a seasonally strong quarter for copper consumption in China, and the fact I've already mentioned regard to the tight concentrate market and possible risk of losses on the refined metals side, I think at least for the short term, price risk is still skewed to the upside.

    Speaker 1 [00:16:36] Copper prices are approaching their all-time highs. China's still urbanizing, whilst the green revolution is global. Many leading commodity investors echo Bruce's outlook for the metal. Perhaps the biggest risk in the short term would be a surge in the level of the US dollar, or a sudden rise in real yields. But for now, both of these appear to be on the back burner.