Goldman Sachs has been bearish on the commodity cycle for a couple of years now and has been arguing that commodities are caught in a negative feedback loop driven by three key themes.
These themes: excess production capacity, a stronger US dollar and weakness in emerging market economies, have been coined the “3 D’s of macro”.
- Deflation — Excess production capacity and rising productivity
- Divergence — stronger US dollar and weaker emerging market currencies
- Deleveraging — significant emerging market credit and macro imbalances
Goldman says they will take years to play out, and crucially “they are mutually self-reinforcing.”
Lower commodity prices reinforce the US recovery and dollar appreciation; while weaker commodity currencies keep downward pressure on commodity cost curves (mainly through lower wage and energy costs). This deflationary impulse leads to stronger US growth and higher rates, and increasing funding costs for EMs (emerging markets), increasing the need to deleverage. This in turn adds more divergence, dollar outperformance, and downward pressure on commodity prices. Since the beginning of July the negative feedback loop created by these 3D’s has started to accelerate once again. Accordingly, we maintain our negative view across the commodity complex.
What that means depends on the commodity in question.
On gold, which hit its lowest level since 2009 last week, Goldman says: “After the recent declines, the magnitude of any further downside in gold is very much in question.”
But the bank remains bearish on the prices of crude oil, which it says producers are happily supplying more of and have “demonstrated that they can increase productivity and lower costs, maintaining a market surplus that only lower prices can fix.”
Likewise on copper and iron ore Goldman remains very bearish saying it has a “lower for longer price environment for the capex related commodities.” As a result it has materially downgraded its forecasts for copper, well below market and consensus.
On the back of the 3D’s of macro, an acceleration in copper mine supply over the next 6-18 months and high exposure to late Chinese property cycle construction, this week we also sharply reduced our copper forecasts with our end of 2016 target reduced to $4,500/t, 20% below forwards and 30% below consensus. We also see $4500/t throughout 2017 and 2018, down from $7000/t and $8,000/t respectively.
Copper, the commodity with a Phd — Dr Copper, falling with such magnitude is likely to represent a market environment that is not positive for the Aussie dollar or the government’s budgetary balance and fiscal position.
That makes Goldman’s forecasts for iron ore even more problematic.
Goldman says the next phase of the iron ore re-balancing process is happening. That means that the impact of falling prices, which until now has been undertaken by “high cost marginal Chinese mine closures”, is now switching to seaborne producers like Australia.
As seaborne producers move to the margin they are now going to bear the brunt of the re-balancing process as we see iron ore prices dropping to $40/t by 2017, down 71% from $140/t in 2013.
If his comments last week that potential growth may be lower are correct, RBA Governor Steven’s may have identified a potential $170 billion hole in the budget over the next decade. Weaker commodity prices and a lower for longer path will make Joe Hockey’s job of ever getting the budget back in balance even tougher.