Commodities are “From Venus” Too

Ivan Martchev  |

ZeroHedge, in its typical eloquent fashion, noted last week that stocks are from Mars, but bonds are from Venus, in describing the downdraft of U.S. Treasury bond yields and the significant rebound in the stock market. The two do not rhyme very well, which should be expected when the economic ramifications of a protracted trade war with China are difficult to quantify – as we have no idea how long it will last.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

To that, I can only add that commodities are Venetian, too, as they clearly agree with the message of the Treasury market. The London Metals Exchange Index has now taken out the lows from December 2018 when oil was near $42. There is a heavy correlation between industrial metals’ prices and crude oil. Sometimes they lead, sometimes they lag, but they typically correlate heavily with crude oil, as they are both highly economically sensitive.

The rebound in the stock market is clearly related to both Fed Chairman Powell’s indication that the next move from the Fed is likely to be an interest rate cut, as well as the averted crisis in the immigration standoff with Mexico, as the stock market understood the 5% tariff would not be imposed. Even though the official news came after the close on Friday, there were plenty of leaks suggesting a benign outcome.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Clearly, if interest rates keep dropping fast and the price of crude oil declines below $40, it would be unlikely that the stock market would keep making headway as those events would indicate a rapidly deteriorating global economy, catalyzed by the trade war. For the stock market to make progress this summer, the trade situation with China would have to be resolved.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We have not seen the May numbers yet, but diesel demand in China fell 14% and 17%, year over year, in March and April, respectively, falling to levels not seen in 10 years. The caveat here is that 10 years ago the Chinese economy was much smaller, with a GDP of $5.1 trillion. At the end of 2019, China’s GDP should be over $14 trillion. Something is clearly wrong here.

The Chinese are famous for massaging their GDP numbers. I know of an economist based in Asia who thinks the 1993 devaluation of the yuan was linked to a bad recession in China that showed in banking sector loan-loss numbers but never really was officially admitted by the Chinese authorities. It would not be a stretch to consider that right now the Chinese economy is doing a lot worse than what the official economic releases indicate.

The thing about doctoring economic numbers is that you either have to doctor them all or otherwise one runs the risk of having a situation of showing improving PMI indexes and loan growth numbers and diesel demand that is falling off a cliff, which clearly is not a possibility in an “undoctored” world.

It is unlikely that there will be any big developments in the trade situation with China before the G20 meeting in Osaka on 28-29 June. There are no serious ongoing trade negotiations with the Chinese between now and then, so investors will be carefully watching U.S. economic numbers for further signs of softening, particularly given the weak May employment report last Friday.

You Can't Fake Oil Demand

The thing about the price of oil, or industrial metals for that matter, is that pricing data does not come from the Chinese organization that releases economic statistics. In that regard, it cannot be doctored. I would view any further decline in commodity prices with great suspicion, particularly if Chinese economic numbers do not show any deterioration. Keep in mind that oil demand is very seasonally strong in the summer, so a weakening price in a seasonally strong period suggests a much faster deterioration in demand than previously thought.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It has to be said that the most sensitive sector to oil prices, namely oil service stocks, did not buy the rebound off the $42 per barrel December 2018 low. They did have a feeble rebound as oil went from $42 to $66, and now they marginally undercut their December low near the 74 mark on the OSX Index.

Does the action in the OSX Index mean that oil is headed below $42? We’ll find out soon enough, but oil service stocks have been waving red flags about where oil prices are headed since mid-2018.

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