Commodities complex worsening

My argument has been that the US economy is not yet at stall speed and that recession is not on the horizon. However, I believe the US is slowing, and that, in conjunction with a strong dollar and the ongoing global growth slowdown, this presents a challenge for US-based corporates. With the Fed poised to raise rates, a recession in 2016 is not out of the question. That’s the macro story.

The micro story is that investors, starved for yield by zero rates, are reaching for yield in places like high yield and emerging markets. And these markets have more downside risk than present market conditions would suggest.

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My argument has been that the US economy is not yet at stall speed and that recession is not on the horizon. However, I believe the US is slowing, and that, in conjunction with a strong dollar and the ongoing global growth slowdown, this presents a challenge for US-based corporates. With the Fed poised to raise rates, a recession in 2016 is not out of the question. That’s the macro story.

The micro story is that investors, starved for yield by zero rates, are reaching for yield in places like high yield and emerging markets. And these markets have more downside risk for investors than present market conditions would suggest.

That story is getting processed in the news and data today in a way that reflects more the global weaknesses than the US ones.

The first place to look with regard to the global growth slowdown is commodities and China. What we need to see to reverse price falls and slowing economies is less supply and more demand. We aren’t seeing that yet – just the opposite, in fact. Look at what Reuters is reporting, for example:

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World shares headed for their best week in over a month on Friday, though alarm bells over global growth were ringing in metals markets as copper hoovered at its lowest level since 2009 and nickel since 2003.

The commodities crunch was compounded as the dollar .DXY began to flex its muscles again after a quiet couple of days, gold XAU= slipped back toward a 5-year low and as a major sea freight index .BADI hit its lowest level on record.

Commodities are at multi-year or decade lows, yet shares are seeing their best week in a long time. That’s not a sustainable trend. What I found most worrisome in this account was a section on the Baltic Dry Index, indicating that measure of shipping volume had fallen to a record low, 58.3% from its high this year. In the absence of explanatory data, we have to take this as a sign of continued weakness in external demand for goods. And it, therefore, suggests that the decline in commodity prices will continue.

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Piggy-backing on this story is the one from FT Alphaville on your pending local currency-commodity downfall using an analysis by SocGen’s Kit Juckes that suggests the supply demand imbalance will not corrected through a lessening supply because of the currency effects in play. Kit noticed that despite the fall in commodity prices this year in US dollar terms, the falling emerging market currencies means some of those prices are actually rising in local currency terms.

Sugar prices have fallen by over 8% this year in USD terms, but the Brazilian real has fallen by 29%. Copper prices have collapsed, down over 20%, but the Chilean peso is down 15% and trying hard to keep up. Gold is down 9%, but the South African rand has fallen by twice as much and in rand terms, the gold price is near its highs. The fall in iron ore prices (over 30%) is twice the fall by the Australian dollar, but you get the picture (Charts 1 and 2).

The cost of production is not hurt by the decline in price – and of course, companies have debts to pay. So they will continue to produce at full tilt until doing so is no longer cost effective. Kit thinks this means the commodities complex will undershoot to the downside. A lot more pain is to come on that score.

None of this means crisis, by the way. In this world, you need a trigger for contagion. And I don’t see one just yet. In April, I asked how markets would deal with a Petrobras default because that’s the kind of trigger you would need to see. And on that score, Bloomberg is reporting that the cash flow negative company has $24 billion worth of debt to roll over in the next 24 months.

The debt clock is ticking down at Brazil’s troubled oil giant, Petrobras. Next up: $24 billion of repayments over 24 months.

That’s a towering hurdle for a company that hasn’t generated free cash flow for eight years and whose borrowing rates are soaring. Annual debt servicing costs have doubled to 20.3 billion reais ($5.4 billion) in the past three years.

The delicate task of managing the massive $128 billion mound of debt accumulated by Petroleo Brasileiro SA — 84 percent of it in foreign currencies — falls to the two banking veterans parachuted atop the company earlier this year, CEO Aldemir Bendine, 51, and Chief Financial Officer Ivan Monteiro, 55. The pair came from the state-controlled Banco de Brasil SA to contain the damage from the biggest corruption scandal in the country’s history.

While prosecutors continue to grind away at years of suspicious dealings, Act II for the boys from the Bank of Brazil will further test their mettle. The challenge of Petrobras’s runaway debt, which has grown four-fold in five years, has been exacerbated by low oil prices, a weak currency and the Brazilian government’s own fiscal travails.

“If you considered them to be totally independent and there were no chance of any kind of government support, I think the risk of default would certainly be there in a big way,” said Jason Trujillo, an Atlanta-based fixed-income analyst at Invesco Ltd.

But can the Brazilian state pony up for Petrobras? I don’t think it is good to make the assumption that Petrobras will get a bailout. Remember, Brazil is being downgraded by ratings agencies because it has a serious fiscal problem. It is not at all clear to me, the state would step in to bail Petrobras out. So we do have to be concerned with default here. And the fact that this company issued 100-year bonds just this past summer tells you how starved for yield investors are – and how traumatic a default would be.

The long and short of all of this is that the situation for the commodities complex is worsening. There is no crisis, but there is also no relief in sight for commodities-dependent countries. Moreover, the supply side will likely not provide any relief over the medium-term. The best we can hope for at this juncture is a reversal in the demand outlook. But, as yet, there is zero indication that this reversal is in the offing. Bottom line: we should look for more downside pressure on emerging markets in due course.

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