Following the drubbing in commodities in Q2 it is was only a matter of time that the pendulum swung the other way. At least that is the view of JPMorgan’s commodities team led by Colin Fenton who says to “go overweight commodity indices now.”
JPM’s summary: “It’s our first OW call on commodities since September 2010… we turned underweight commodities as an asset class in November 2011, shortly after it became apparent that Europe and Australia had entered manufacturing recessions and commodities were likely to underperform equities and bonds over the following 6 to 12 months, likely yielding negative returns in 1H12. Over the past year, we have grown more positive on the asset class, as energy has improved, expected menaces in bulks and metals have arrived, and sentiment across commodities has belatedly soured. However, our strategies have sought to be directionally neutral. Now, we move to recommend a net long, overweight exposure for institutional investors for the first time in more than two years, based on ten fundamental factors we quantify in this note.” Yes, that includes gold, although as a hedge JPM adds: “Liquidity could fall quickly in summertime. Buy 25-delta puts in oil, copper, and gold to protect a core position in commodity index total return swaps.”
Why does JPMorgan come out with this overweight reco now, when Commodities are sliding?
“Like other global markets, commodity prices are buckling on rising concerns about China and the Federal Reserve. It is important to be specific about what these concerns are. The new fears are not that Chinese growth is slowing or that the US central bank will taper its QE3 asset purchases. Both are inevitable outcomes that have long been embedded in commodity forward curves. The actual concerns are: (1) the large shadow banking sector in China might soon trigger an unexpected financial crisis, like the one that emerged in Asia in July of 1997, and (2) the FOMC might simultaneously be making a policy mistake in putting its own growth and inflation forecasts ahead of the markets’ fear about Chinese finance and the evidence that disinflation in the real economy is bulldozing inflation expectations in markets. These concerns are legitimate. A sturdily low-vol commodity regime has suddenly been asked to assign probabilities to these two scenarios. Neither is a zero probability. Nor is either likely a baseline outcome in 2013.”
Concerns having been dispatched, JPMorgan’s advice to institution clients is simple:
Our analysis concludes that it is in the best interests of most commodity index investors to buy immediately. For the first time in more than 2 years, we recommend an overweight allocation to commodities. In our own methodology, we define this allocation as a 5% to 7% net long exposure in an institutional portfolio, up from the 3% to 5% directionally neutral exposure we have been recommending.
Keep an eye on crude backwardation:
We anticipate that when commodity markets move higher, they will likely move more quickly than seems possible today, led by a seasonal pickup in global crude oil runs. One of the strongest clues lies in the current term structure of the NYM WTI forward curve.
If oil demand is so soft and oil supply so ample, why is this curve in the strongest backwardation yet observed in this business cycle? The M3-M6 and M6-M12 spreads are the most positive they have been in 6 years. The last time these structures emerged, in 2007, the curve steepened so rapidly and powerfully that the spot price moved from $65 per bbl to the all-time nominal high of $147 per bbl in less than nine months. To be clear, we do not expect as strong a move this time. But we are saying that buying the backwardation in NYM WTI (26.6% portfolio weight in the S&P GSCI) is one of the best commodity investments we have seen available in this asset class in years.
What are JPM’s 10 “fundamental factors?”
- Seasonal factors drove the 2Q correction in spot crude oil, and seasonal factors will reverse it.
- Fresh demand for storable commodities, in response to the steep price corrections
- Price-driven, involuntary production cuts in crude oil, copper, and gold.
- Inflation in production cost economics.
- Spare capacity is tight and non-economic supply risks are rising.
- Lagged benefits to commodity demand from rate cuts and other stimulative measures.
- Stealth shift in US export policy already at work is further linking WTI with international prices.
- Chinese shift in policy: ‘go green’ does not mean what it means in Seattle. It means go to oil & gas.
- Stronger USD against what? The DXY does not include the CNY.
- Global growth and inflation rates will likely soon bottom. Rising values in these rates, even from low bases, provide a favorable economic environment for commodity index total returns.
Where does gold fit into all of this?
In the first week of April, we warned of a one in three risk of a 2Q2013 ‘flash crash’ in commodity markets, with oil, gas, gold, and copper being the most likely focal markets and April 15 to May 15 being the most likely timing. That this warning correctly presaged the collapse in gold was not alchemy. It was not even truly a good forecast. It was an acknowledgement of the message already blindingly evident in options prices, in particular the put skew in the Jun-13 and Aug-13 CMX gold markets (Exhibit 25). The lesson for institutional investors from this experience is to watch volume and open interest in OTM commodity options at crucial turning points for growth and inflation. What has been more surprising to us is that oil has not shuddered the way gold and copper have. We had warned that WTI could drop to $75 per bbl and Brent could drop below $90 per bbl. To the contrary, for reasons we explain above, crude differentials have been narrowing (see Exhibit 7). This compression is a bullish signal. It is completely inconsistent with the popular conception that the outlook in commodity markets has no sunshine. It also spotlights the critical importance of evaluating commodity investments in terms of structure and volatility, not just spot prices.
Given the steep selloff in gold and the impaired condition of metals, we would prefer to see a turn in technical indicators before getting too aggressive in that sector, out of respect for the high likelihood of catching a falling knife. However, metals altogether have a low weight in the S&P GSCI (9.0%) and gold’s is especially negligible (2.35%), given current prices. So, downside path risks in metals are more an issue for the risk manager more exclusively focused on a specific metal, rather than on a larger commodity basket, either in the investor world or the corporate world.
At the same time, metals prices have reached levels that are demonstrably forcing involuntary production cuts and fresh demand. Against one-sided sentiment and following 15 months of destocking, Chinese buyers are going to realize very soon this is the opportune moment to back up the truck and to restock supply channels where China is import dependent. A surge in Chinese buying of a metal at a lower price has already been observed in gold. We expect renewed vigor in imports of copper and oil. It is quite obvious what the Chinese should do here in physical markets, in pursuit of China’s long-run economic and social self-interest.
This conclusion represents a significant change in view. The last time we recommended moving to overweight was on September 30, 2010, or about a month ahead of the announcement of QE2 on November 3, 2010. In the nine months that followed (we turned neutral in June 2011), the S&P GSCI total return index produced a 16.5% total return against a 14.9% total return for global equities and a 2.5% total return for global bonds. At the same time, downside risks today are still scary, especially in metals. Owning 3M 25-delta puts on crude oil, copper, and gold is prudent. Conventional wisdom is clearly thinking in spot price terms; its blind spot is failure to evaluate risk through the lens of structure or volatility.
To recap, we recommend going overweight the commodities asset class through the strategic purchase of commodity index total return swaps. Recognizing that the consumers are likely already starting to act on their incentive to buy the 20%+ swoon in gold, copper, oil, and other commodity markets, we recommend immediate action. However, in acknowledgement that we are likely early in metals and possibly even oil, especially ahead of the more illiquid markets of the summer months, we also think it prudent to hedge net length by buying 25 delta puts on Aug-13, Oct-13, and Dec-13 NYM WTI and ICE Brent. That is a strike price of about $93, $89, and $87, respectively, for WTI and $100, $95, and $92, respectively, for Brent.
Of course, all of the above could well be moot, and JPM could merely be pulling a Tom Stolper/Goldman FX trade “recommendation”, using this “once in three year” opportunity to dump to clients ahead of what it sees as a huge deflationary plunge, which has as much a probability of happening as does what JPM believes will happen should Bernanke proceed with a September tapering leading to wholesale liquidation. Keep in mind the last time JPM went “bullish” was just after Bernanke announced QE2 following Jackson Hole when, once again, everyone was assuming a surge in all asset classes. This time not only is Bernanke not promising more easing any time soon, but the threat of a monetary stimulus slowdown (however brief) is just around the corner.
Or they may be sincere.
Who knows: we look forward to these questions being asked of Blythe Masters when she is cross examined in court now that she is a suspect in JPM’s electricity manipulation scheme as reported previously. We are confident she will respond honestly, or maybe not.