Covid makes a comeback, but this time is different
The third quarter proved to be a bullish period for the commodities complex, with soaring iron ore prices and double-digit gains in the major base metals. The general upswing also boosted gold.
Bullish drivers included a strong rebound in the Chinese economy, a weaker US dollar and very low interest rates across the world, which raised fears about inflation and encouraged a speculative surge into financial markets and hard assets such as commodities and property.
The economic backdrop remained supportive in Q3, but growth momentum faded during the period, which dampened down bullish sentiment. Flash PMI survey data for the world’s four largest developed economies (Eurozone, Japan, the UK and the US) showed that activity rose to 52.6 in August, but then eased back to 51.6 in September.
We saw the greatest weakness in the service sector, with firms struggling to grow given tightening government restrictions amid rising Covid19 infection rates. Confirmation of weaker growth came from the US non-farm payrolls data, which showed that 0.66m jobs were created in September, down from an average of 1.6m jobs in July and August.
Looking ahead, it seems inevitable that Covid-19 developments will remain a key driver of commodities demand, particular for markets such as crude oil, which rely heavily on the transport sector or anything closely tied to hospitality.
Covid infections are rising rapidly in places like Europe, but the number of people getting seriously ill is very low, and fatalities have barely risen compared to the first wave. For example, in the UK infections are now above their April peak, but the number of daily deaths is down by 95%. France has seen an even wider divergence between infections and serious illness and fatalities are also down sharply.
There are three reasons why this latest European wave is different – young people are more impacted this time; those at risk are taking more care, and medical staff and hospitals are better prepared.
Whatever the reason though, the virus is certainly less deadly than before, and hospitals still have a decent cushion of spare capacity to cope, which is creating some guarded optimism in the medical community. All of this suggests that given the current virus-backdrop, total lockdowns of many economies in Europe should be unnecessary and most likely will be avoided.
Covid-demand drivers have played their role in recent price trends in commodities. Still, there has also been an increasingly powerful link between movements in financial markets and the whole commodities complex.
In particular, commodities have been closely tracking the US dollar and US equity markets. As a consequence, the cross-correlations between copper, gold, oil and other industrial commodities have also risen to high levels showing that fundamental drivers are being overshadowed.
We can see in the following charts that the correlation between crude oil and the S&P500 was close to zero back in 2017 but has trended steadily higher since then to reach 66% in September. A similar trend can be seen for copper, with the correlation with US equities reaching 63%.
The change in gold’s behaviour has been particularly striking. Before the Covid crisis, it was performing its traditional role as a safe-haven, with a negative correlation with equities. However, in recent months the link between gold and equities jumped to a positive 44%, which is an eight-year high.
The main point is that while fundamentals will play a role in commodities market moves in the months ahead, the picture will continue to be distorted by large speculative flows.
The outlook for commodities is decidedly mixed, with volatility likely to remain high. While the US election will be decided soon, the path towards normality will be distorted by Covid-developments, but widespread lockdowns should be avoided. A vaccine seems likely to help on many fronts from early 2021, but medical experts are suggesting that the virus will be a problem for years, rather than months and there will be no magic solution for every country and individual.
For crude oil, the biggest challenge remains demand. With so much of it being travel-related, it seems likely that it will take many years to get back to where we were last year. The average US producer will not survive for long at WTI prices below US$50pb, but high-cost producers will still overshadow the industry for the foreseeable future. Oil prices look range-bound for now.
In terms of the base metals, we see more upside potential. Chinese demand has been very strong in recent months. Furthermore, Covid problems have hit supply and set back investment in the key mining areas of Latin America. Copper looks like it can make further gains, as China steps up spending on construction and infrastructure.