MACQUARIE BANK: The era of commodity prices all moving in the same direction is coming to an end

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If you like to dabble in commodity markets, or are thinking about it, you may want to brush up on your old economic textbooks.

According to analysts at Macquarie Bank, fundamentals will play an increasingly important role in determining where prices move from here.

Yes, supply and demand is about to make a comeback.

“Having spent much of the 1990s and early 2000s showing little correlation, from around 2005 metals prices increasingly rose and fell together,” says Macquarie.

“Various theories were given to explain this, but in particular it was argued, the ‘financialisation’ of commodities and growth in popularity of commodity index funds, saw investors buy commodities, and metals, as a collective asset class.

“At the same time there were increased symmetrical shocks, such as the economic rise of China, which increased demand for metals across the board. And lower interest rates and QE meant globally all assets were being driven by liquidity flows.”

The impact of booming Chinese demand and ultra-loose monetary policy settings, which saw capital flow into every corner of asset markets, including commodities, is shown perfectly in the chart below from Macquarie.

Source: Macquarie Bank

It shows the correlation across base and precious metals going back to 1995, detailing the increased prevalence of prices all moving in the same direction from the beginning of 2005.

However, the relatively high correlation in prices seen between 2005 to 2012 has started to wane in recent years, interrupted only briefly by China’s decision to devalue the Chinese yuan in August 2015, which lead to renewed concerns about the health of the Chinese economy.

To Macquarie, the recent trend of prices moving independently of each other is likely to continue as fundamentals drivers come to the fore.

“We think this trend has further to run,” it says.

“Over the medium term, we think the decline owes something to less ‘financialisation’. In particular, investment in commodities fell on the back of disappointing returns. This trend has perhaps played out, but we think investors continue to become more discriminate, with fewer funds flowing into aggregate indices.”

And it thinks this will continue with the unwinding of ultra-easy monetary policy settings from major central banks, along with the likelihood of less financial and economic shocks.

“The QE era is slowly coming to an end. The Fed is furthest down this path, raising interest rates and reversing QE, but the ECB is likely soon to follow,” it says.

“At the same time we think that global macro shocks — those which affect all commodities alike — have been lessening and will continue to lessen.

“With a slow but robust global economic recovery, and strong but stable Chinese demand, we expect this to continue.”

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