COMMODITY BULLS IGNORING A FEW LARGE ELEPHANTS / THE WALL STREET JOURNAL

Commodity Bulls Ignoring a Few Large Elephants

Commodity markets see no evil, hear no evil—that’s not necessarily comforting

By Nathaniel Taplin


RED ALERT
Commodity price indexes vs China real estate

What are the classic signs of an overheated market? Theories are as legion as the horde of Wall Street analysts hawking them, but the most obvious—amply illustrated by the furor over Bitcoin—is a tendency for investors to adamantly ignore evidence that all may not be well.

Commodity markets today bear some worrying similarities to this state of mind.

In particular, investors are focused on two positive developments: forced factory closures in China, which are driving metal prices higher, and better growth in the U.S. Two big questions, meanwhile, have received far less attention.

First: can China’s campaign against small and polluting metal furnaces keep boosting prices even though the real-estate market, the ultimate driver of demand, is now clearly in retreat? Copper and Chinese steel prices are both up roughly 20% since early June. Sales of residential floor space have moved from growing nearly 10% to falling 9% on the year over the same period.

That would be less worrying if capacity curbs were truly deep and broad. But they are not: output cuts of 10% or less have been matched by outsize price reactions in both coal and steel, says economist Chen Long at Gavekal Dragonomics. Capacity cuts beginning in early 2016 happened to coincide with a big pickup in real estate. But if the current pollution-related crackdown on industry eases this spring, just as construction activity really starts to slow, metal investors will experience the flip-side of this dynamic.

Second: why are commodity inventories in the U.S. so stubbornly high, even though the growth picture is brightening? Oil inventories, which looked like they were poised to finally drain this summer, are starting to creep up again, and have now risen in three of the past four weeks according to U.S. Energy Information Administration data.

LIFT OFF
U.S. copper inventories (COMEX)

Meanwhile U.S. copper inventories have more than doubled since Trump’s election and now stand at their highest level in more than a decade—in part, perhaps, in anticipation of an infrastructure stimulus or trade restrictions that have failed to materialize. Big falls in Chinese stocks have offset this and allowed prices to move higher. But if inventories start rising again in China too as growth slows, traders may start to wonder why prices are so high if all that copper is just piling up in warehouses.

Given the sharp fall in mining investment since 2012 and still-strong global growth, a commodity bloodbath is unlikely. But by the same token, it isn’t clear why commodities should be testing current levels when the biggest consumer is slowing and copper and oil are piling up in tanks and warehouses in the second biggest.

If commodities are going to keep charging ahead, these questions need a satisfactory answer. Otherwise, the mild selloff in recent days could be a prelude to a more substantial correction in the months ahead—and investors might start to look askance at all those richly valued growth stocks too.