Cygnet Commodity Markets Update, September 2020

Gopper:Gold Ratio Chart

Commodity markets have continued to drive higher in the past month, with any market exposed to China, and Chinese construction and infrastructure, getting a boost.

Iron ore prices surged by another 15% m/m in August, while nickel and zinc both made double-digit gains. Copper and oil also both rose modestly on the back of higher risk appetite, spurred by improving economic data and fewer Covid-related headwinds.

Bullishness was widespread and could be seen in many financial markets, with the S&P500 equity market, for example, up 7% m/m and the Shanghai Composite up 3% m/m.

The economic story continues to improve. One important milestone was reached in August with the global manufacturing PMI reaching 50.3 in July, up from 47.9 in June. The most recent figure shows that the world is finally back on a growth path for the first time in six months. New orders are also growing, indicating that the outlook for the months ahead is also favourable.

In terms of Covid-19, the evidence is building that the worst is behind us. The number of new infections is falling from a high level, and an increasing number of analysts expect that a vaccine will accelerate the move back towards normality sooner, rather than later. Several countries around the world have had early success with new vaccines and treatments, which are likely to be widely available within the next 12 months.

China has made rapid progress on this front, and there seems to be a decent chance of a private company called Sinopharm having a vaccine ready for sale by December. Other companies in China and abroad are not far behind. The risk of a renewed acceleration in infections remains high though, as tourists in the northern hemisphere return from summer holidays and schools restart.

While the short-term economic situation is improving due to aggressive government and central bank stimulus, the longer-term trend is less clear cut. One of the critical issues for commodities and many financial markets is to what extent should we be concerned about the threat of future inflation. In particular, will the recent bout of higher US inflation and USD weakness extend into next year?

The US Federal Reserve made a significant change to its stance in August. At its Jackson Hole meeting, it revealed that it would now have the option to allow inflation to exceed its 2% target, formally adopting a more flexible approach to monetary policy and reducing the need for tighter policy when the unemployment rate is low. Some have argued that inflation risks are therefore higher and USD weakness may follow, helping to drive up commodity prices.

Even if the USD retains its value, investors seem keen to buy hard assets such as gold and copper, as a hedge against inflation in other parts of the world. One way of tracking concern about inflation is with the markets implied forecast for average US inflation over ten years from US Treasuries – the breakeven rate between Treasuries and Treasury Inflation-Protected Securities (TIPS). This indicator has risen sharply in recent months, but we are now just back to where we were at the start of the year.

Concern about inflation is up, but there has not yet been a structural shift upwards in terms of expectations thus far, but this is another development that is worth monitoring closely in the months ahead.

US Inflation chart

Another way of tracking the mood in commodity markets is to look at the copper:gold ratio. Gold tends to rally when the USD is weak, but also when investors become fearful. On the other hand, copper benefits more directly from improved risk appetite and better economic conditions. A rising ratio is, therefore, a good measure of optimism as copper prices are outpacing gold prices.

Gold outperformed copper through the recent downturn, but then the ratio levelled out through Q2. We can see that during Q3 copper has been outperforming gold, which suggests that copper optimists are winning the battle against fearful gold investors, but this may prove to be more challenging in the months ahead.

Copper:Gold Ratio Chart

Looking ahead to the remainder of 2020 we expect a return to more volatile, sideways trading conditions. Commodities and all financial markets have been boosted in recent months by a tidal wave of fiscal and monetary stimulus and strong rallies have been seen across the board from equities to copper and gold. However, we are rapidly reaching the point of ‘peak stimulus’ when central banks and governments will have to rely on the economy to find its own feet. While global GDP looks set to grow well for the year ahead, sentiment could easily be damaged by virus-related setbacks or frictions ahead of the US election.

Dan Smith, Director – Special Projects, Swann Group