Société Générale is the latest bank to revise its fundamental commodity forecasts in the face of deteriorating economic conditions and in the introduction to a detailed study, the bank says that the sharp correction that started in July 3rd should be interpreted as the bursting of the speculative bubble that had been fuelled by inflation and the depreciation of the US dollar. The fall has not reflected a valuation of anticipated fundamentals, but has remained dominated by purely financial considerations, and commodity prices have fallen to a much greater extent than the stock market indices over the period. The S&P 500 has fallen on average by 28%, against a drop of over 50% in the commodities, reflecting the changes not only in the financial environment, but also the change in the macroeconomic context.
With commodity prices now back to their January 2007 levels, “this portion of the purge should now be over”, but the next two quarters are likely to see further price declines reflecting the amplitude of the recession in different parts of the world.
Since 2002, however, the principal drivers of the bull run in commodities have been structural in nature, both in terms of demand and supply and the bank argues that a cyclical slowdown in demand should not reverse the long-term trend. The slope of such a trend, of course, will be a function of the severity and length of the recession and the bank’s favoured scenario suggests that several years – probably three – will be needed before prices regain their record highs.
The Société Générale forecasts (which cover a wide range of commodities apart from the metals complex) have many of the forecast averages for 2009 below the prices currently trading, although there are some exceptions in the base metals sector. The forecast averages, compared with today’s prices (average expressed as a percentage of prevailing levels) are as follows:
Base Metals Precious Metals
Aluminium +3% Palladium -6%
Zinc +3% Platinum -13%
Copper ≥0 Gold -14%
Nickel -10% Silver -20%
The outlook for the long term is brighter; in 2010 the annual averages of all the metals with the exceptions of lead, tin and silver are expected to be higher than their current levels and the picture is better still for 2011.
The bank points out that the collapse in commodities prices is the corollary of the collapse in share prices, soaring credit spreads, the rise in the dollar, the rally in US bonds and the steep fall in inflation expectations. These stem from the combination of risk aversion preference for cash and portfolio reallocations, three phenomena that have developed from a range of economic and financial realities. The study shows how commodity prices have a very high sensitivity to stock market trends, especially (and perhaps at first glance surprisingly) those in Europe. This “over-correlation” is explicable by the rise in the dollar, since commodity prices and European share prices are both positively correlated to the $:€ rate. The base metals have the highest correlation across the whole commodities platform, with copper running at a very high 87%. Copper also shows the highest correlation to credit spread and inflation expectations, because of the sensitively of industrial metals to economic growth.
The combined influence of the financial and macroeconomic environments and their impact on the commodities suggest that the bearish price trend that has developed since July is similar in nature to the bullish trend that commenced in the first quarter of 2007. The bank had interpreted the rally that started at that point as the formation of a rational speculative bubble revolving around investment in commodities as an asset class. On this basis, the recent correction should be seen as the bursting of that bubble as the rise in inflation and the fall in the dollar, against which the commodities were used as a hedge mechanism, have now been dissipated. Form this standpoint, with prices back to January 2007 levels, then this portion of the purge should now be over. The market, however, does not yet appear to be looking for the fundamental value of the asset class in general; furthermore it has yet to make the important distinctions between products according to their sensitivity to economic activity. This suggests that it will be the equity markets that will signal when a floor has been reached, as opposed to specific commodity-linked fundamentals.
For the short term the bank is suggesting that there is scope for a technical rebound in the equities markets this year and that the bounce that has already developed has further to go, especially given that a rebound in European shares may well be accompanied by an easing in the dollar and that this could support commodities. Evidence is already available that commodities have suffered heavily at the hands of hedge funds on the basis of the fundamental outlook, that more subscriber redemptions are expected between now and year-end, and that many investors in structured commodity products have already largely taken their profits. The bank is of the view that a bottom will be signalled over the short term (end-year) and then over 2009, when the “true pricing” of the economic part of the crisis begins, as opposed to the financial part thereof.