Commodities | Jun 28 2016
-Brexit mostly about EU economic stability
-Fall in EU consumption could impact balances
-Some durable positives for gold
-Steel making, raw materials most vulnerable
By Eva Brocklehurst
Brexit
The response of commodity prices to the British decision to exit the EU suggests investors believe the region's industrial economy will decline. Placing initial price performances into perspective requires an understanding of the implications of the event and to do so Morgan Stanley splits the commodity exposure into three categories.
Firstly, uncertainty will prompt investors to protect capital. Hence, demand for precious metal lifts. Secondly, if regional economic activity is under threat this suggests demand for industrial & energy commodities will fall. The third aspect is that those markets which are mostly physical trades, as opposed to derivatives or synthetic trades, are likely to respond least to the event, such as steel raw materials.
While Britain's share of commodity demand, globally, is tiny, the decision threatens the economic stability of the EU, which Morgan Stanley observes consumes 10-25% of the world's commodities.
The broker estimates that a general 5% decline in the EU's rate of commodity consumption over the next 12-24 months would alter forecast balances for base metals markets by 20-40% and increase iron ore's forecast surplus by 10-20%. It would put coal markets into surplus, from being balanced to slightly in deficit. These are all potentially price-altering scenarios.
The broker does not change its view on oil, yet. Near term Morgan Stanley remains most concerned about product oversupply but the medium term trend towards market re-balancing appears intact, barring a recession. A relief rally in markets, or a pull back in the US dollar – potentially on central bank intervention, could lift oil prices.
Morgan Stanley does point to articles which incorrectly attribute a draw in Saudi Arabian crude oil stocks and stable oil exports to signs the market is rebounding. The broker contends product exports are increasingly augmenting crude oil, masking the oversupply. Tepid demand trends underscore the broker’s concerns, with Chinese demand slowing further in May.
Citi does not envisage the British vote, of itself, will de-rail a rebound in commodity prices heading into 2017. It does, nonetheless, add another complex layer of uncertainty to all markets, and will likely aggravate commodity investor outflows into the financial year end and in early July.
The broker believes investor sentiment for oil remains bullish for the medium term and price corrections are likely to be buying opportunities. Net copper short positions in Chicago may be pushed to new highs into the end of the quarter while gold should retain its status as a safe haven.
In beans and wheat, prices the broker envisages strong support for the market near current levels, with tight export markets and potential bullish risks heading into a major US agricultural release. To the extent the British pound continues to sell off this is expected to weigh on cocoa prices in New York and support London contracts.
Gold
Some of the gains made by gold in the wake of the British vote are likely to be knee-jerk reactions, Macquarie contends, but the consequences as a whole are positive for the yellow metal. The broker increases near-term price forecasts and maintains higher long-term forecasts.
Macquarie observes the impact of decision to leave the EU was magnified by market positioning, which had anticipated the opposite. The main asset affected was pound sterling but gold also retreated to US$1,251/oz ahead of the vote and then jumped to US$1,359/oz. Macquarie notes this was the largest intra-day range since gold prices slumped in April 2008.
The more durable positive aspect for gold is the increased economic uncertainty in the UK and Europe, which means central banks are likely to keep monetary policy looser for longer.
Macquarie expects gold to go higher in the September quarter, as the full ramifications of Brexit are felt, before dropping back in the fourth quarter after the US election and ahead of a likely hike from the US Federal Reserve. The broker's US economist suggests Brexit shifts the base case of a Fed rate hike to December from July.
Industrial metals and bulks
Macquarie considers the impact of Brexit is less apparent in industrial metals and bulks as direct consumption in the UK, or even the EU, is relatively minor on a global scale. Still, the broker agrees any de-stocking in the industrial chain, as uncertainty increases, could mean short-term demand is affected.
Overall, China remains the crucial element, Macquarie maintains, and a more commodity-intensive phase of growth, coupled with a delay in US rate hikes, could be supportive of prices, notably steel and iron ore.
Since China's economy has already resumed a downward trajectory and economic activity elsewhere is subdued, with Brexit adding its drag, Morgan Stanley suggests the US Fed's long-standing regard for the fragility of global growth is well founded.
Prices for steel-linked commodities have done well in 2016, spurred by seasonal re-stocking. Other metal prices have also responded to a recovery in oil and US dollar weakness but Morgan Stanley believes this buoyancy will be tested soon. The seasonal peak in trade flows, production rates and deployment has passed and the broker believes steel and its raw materials are the most vulnerable markets.
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