Dr. Copper is speaking, and we don’t like what he’s saying.
For those long-tenured market participants, a look at the copper markets (JJC, CPER, CUPM) generally provides insight into the health of the global economy. Copper is used in just about everything related to construction and manufacturing, and the price of the metal signals the relationship between its supply and demand. A strong copper price, therefore, indicates that demand for the metal is healthy, and that in most cases and by extension, the general economy is healthy as well. What we are witnessing in the copper markets, however, is something else, and on a high level, no different than the shellacking the crude oil markets have been experiencing in recent months. High-grade copper has now reached levels not seen since mid-2009, and there may not be a prescription for Dr. Copper’s cold.
Unlike aluminum, which has been buoyed by strength in the aerospace and auto markets, concerns over excess supply and waning consumption in China have sent the price of copper meaningfully lower. As a result of a fundamental shift in OPEC’s strategy (where market share has taken priority over price stability), the reasons for copper’s decline are separate than the reasons sending the price of crude oil (USO) below $45 per barrel. Still, both provide important economic data points that should give cause for concern about the global economy. We likely haven’t seen the worst with respect to crude oil prices, and it’s probably a safe bet that the copper markets haven’t carved out a bottom yet either. Market veterans are now accepting the very real possibility that crude oil could crash to $30. That’s not a typo: $30 per barrel.
One can argue that Dr. Copper is more of a lagging indicator to gauge the health of the global economy, but the iron ore markets, which typically respond to early construction activity, are also hurting. We’ve been expecting ongoing declines in the iron-ore markets, and the fact that iron ore prices are volatile should not be surprising to any onlooker. If investors want to take the risk of owning a price-taking entity like a commodity producer, they must also accept the volatile share-price performance. Most analytical efforts within the commodities arena are spent assessing the cost structure of participants, and while this is a noble effort, the delta in profits will always be the main driver behind share price moves. The biggest driver behind the delta in profits has and will always be price, and the price of iron ore was halved in 2014.
As with any commodity, the future price outlook for iron ore is based on supply and demand. Iron ore imports by China hit an all-time high in December, but this may be more a result of the price response and inventory restocking than anything else. Our biggest concerns about the Chinese economy are in assessing the implications of its “shadow” banking system and the ramifications of falling housing prices, which have just started to weaken. The cost of Chinese real estate continues to be expensive by global comparison. The price-to-wage ratio, shown below, reveals that housing prices in Beijing are more than 3 times more expensive than those in New York on the basis of consumer earnings power (disposable incomes). In Shenzhen and Shanghai, housing prices are more than twice those in New York, by the same measure.
Image Source: Sober Look, Credit Suisse
On the supply side, BHP (BHP), Rio Tinto (RIO), and Vale (VALE) continue to produce to meet Wall Street forecasts, and the concept of a rational oligopoly is being tested. At the moment, the group is acting more like a pure competition as opposed to one that controls a large portion of the world’s iron ore assets. With economic expansion in China expected to slow and major iron ore producers “flooding” the market, iron ore prices will likely remain under pressure for some time to come. There’s nothing that BHP or Rio Tinto can do about it – they are price takers.
In the newsletter portfolios, we simply don’t have much commodities exposure (XLB, IYM). The question to ask is not whether BHP or Rio Tinto is the better idea, but how much exposure one should have to the volatile commodity-price markets. For us, we have zero, zilch, nada exposure to the energy sector (XLE) in the Best Ideas portfolio, and our weighting in Rio Tinto, which coincidentally we do prefer over BHP on the basis of valuation, is less than 2%. Excluding new additions to the portfolio, Rio Tinto’s weighting is the lowest. The weighting of each idea in the portfolios reveals how confident we are in the holding, and we’re comfortable at less than 2% in Rio Tinto. The tough sledding will likely continue.
Metals & Mining – Diversified: BHP, CLF, FCX, RIO, SCCO, SLW, VALE
Metals & Mining – Steel: AKS, GGB, MT, NUE, PKX, STLD, X, ZEUS
Related ETFs: FTSE China 25 Index Fund (FXI), Australian Dollar Trust (FXA)