Hedge funds pride themselves in picking alpha and diversifying their portfolios. It is what commands their 1%/10% fee structure (or in some cases 2%/20% for the more reputable ones).
When the market is not experiencing levels of stress and macro anxiety, correlation among asset classes is typically below 1, closer to the 0.5 range, as asset classes move based on their own fundamental market drivers. However, at times of elevated stress, such as what we experienced this summer at the height of trade war uncertainty, all asset classes linked to the global economic cycle move closer to a correlation of 1. They all move up and down together. No distinction is made when liquidity is unwound or soaked up.
You may be playing a physical shortage in zinc, but whether you know it or not you might be taking a bet on what European Central Bank President Mario Draghi will announce at the next ECB meeting with regard to its quantitative easing program. After the 2004 China urbanization, asset classes no longer can be viewed in isolation; they all are linked.
By holding 15 positions in our portfolio, we may be able to justify the benefits of diversification, but if they all are linked indirectly to the dollar then we are taking one massive bet on the direction of the dollar. Sure, fundamentals are important, but they are only a tailwind when the headwinds are dictated by macro factors.
Base metals are a victim of these macro factors in light of their importance to the global economic cycle, specifically Chinese GDP growth, as China is one of the largest consumers of these metals for its infrastructure development. Macro (exogenous) factors tend to push commodities away from their true value. But what is their true value?
Now let's talk fundamentals. In the case of copper, the London Metal Exchange (LME) cancelled warrants stocks hit a level not seen since December 2015. Physical premiums in Shanghai just touched $120 per tonne. This is extremely bullish and shows just how tight the demand for copper at a time when inventory is at low levels. Once macro news flow and trade war news subsides, markets and asset classes have time to move on their own fundamentals.
We know how algorithms and liquidity drive markets these days. The technicals of copper have been bearish over the last few months; it has been a sell-on-bounce market. But over the last few weeks it has been forming a very bullish pattern and recently is threatening to break away from its 100-day moving average at $6,300 per tonne. If this level is breached, algos will send signals telling traders to rush to cover their shorts as the trend is about to change. It easily can squeeze up to $6,800 per tonne in absence of news, and copper slowly can converge to its rightful price, closer to $7,000 per tonne. Copper is moving slowly into a "buy the dip" mode as opposed to "sell the bounce" from earlier this summer.
What can exacerbate this situation? The U.S. dollar.
After Federal Reserve Chairman Jerome Powell spoke last week, the dollar is confused. It wants to go up given the interest rate trajectory, but that is more than priced in. It looks tired.
The euro is driven by some Italian-specific factors and budget deficits. But noise aside, given the looming issue of the U.S. deficit and the debt increase to come and the Fed's interest rate trajectory being closer to the end than the beginning, it seems the risk/reward for the dollar is down, not up. If this happens, copper will get an additional tailwind boost to an already tight market. It will be like lighting fuel with fire.
Copper is a market in deficit. Assuming basic demand growth assumptions and not a recession, the supply side has yet to play catch-up to balance the market over the next few years. Companies surely know as much as they rush to find assets to excavate. But it is not that easy. Prices need to be high enough to incentivize companies to make capital investments. And for that to happen, copper needs to rise above $7,000 per tonne or demand needs to hit a level where markets are balanced.
The former scenario has a greater likelihood of happening considering the need to produce more copper out there, especially if one listens over the last two months to China's commitment to boost infrastructure investment and spending. The credit impulse is also at a level where it is about to turn. It just needs to show up in the data over the next few weeks.
Macro traders shouldn't become too caught up in President Trump and China's trade war games and should focus instead on the market fundamentals. With the dollar falling, all commodities will get a boost, but it's those commodities with the tightest inventory balances that will rise the most. Whether we want to be in copper, zinc, gold or emerging markets, it is all part of the same trade -- the dollar. Which one outperforms boils down to which market has the best fundamentals.
