It’s Time to Sit Up and Take Notice of This Commodities Sector

Iron ore mining

Wall Street had a rough overnight session. The Dow fell around 1.2%, while the S&P 500 was down 1%. The reason for the selloff was a weak result from retailer Macy’s [NYSE:M]. That sent the sector lower, casting a general pall over the market.

In addition, the share price of Walt Disney Co [NYSE:DIS] dropped around 4% after disappointing quarterly earnings saw the company miss its target for the first time in years.

On the other hand, commodity prices continued to rise. Brent crude oil prices surged another 4%, and gold rose by US$10 an ounce. The benchmark commodity index, the Reuters/Jefferies CRB index, increased a healthy 1.7%.

Even iron ore did well, rising 0.6% overnight. This means the Aussie market should do OK today, at least relative to the US market’s performance.

The iron ore price has fallen sharply in recent days but may have received a boost from this news, as reported in the Financial Times:

The Chinese government is pump [sic] almost Rmb5tn into transport infrastructure over the next three years, in a sign of its determination to use state investment to keep the economy humming.

However, analysts said the announcement by the Ministry of Transport added to a sense of confusion about the direction of Chinese economic policy. Infrastructure spending served China well when it was growing rapidly and seeking to build a modern economy but in recent years has resulted in white elephants, industrial overcapacity, economic distortions and debt.

Yeah, yeah…we know all that. But who cares!

When you’ve got an economy to centrally plan and uprisings to stave off, you’ll do whatever it takes. Even if that means more of the same stupid policies that got you into trouble in the first place.

It’s a familiar theme the world over. It just goes to show how bereft of ideas our economic managers are. That’s because, once you get to a certain point (which is usually associated with a certain level of debt), there is nothing more you can do to achieve growth except to dig the hole deeper.

Actually, there are things that you can do, but they involve short term pain. And in the early stage of the 21st century, no government anywhere in the world wants to administer any pain at all.

Their grip on power is just too irresistible. Why threaten it with short term pain for long term gain?

It doesn’t matter whether we’re talking democracy, autocracy or theocracy. The final aim is the same…the retention of power.

Unfortunately for Australia, our main trading partner is under the global spotlight for these issues. China is absolutely out of ideas about how to maintain strong growth. But it recognises that more of the same will lead to the Communist Party’s long term demise.

In short, it’s confused. More from the FT:

“This week is a week of mixed signals,” said Andrew Batson, economist at Gavekal Dragonomics in Beijing. “They’re swinging between poles of emphasising support for growth and emphasising structural reform. It’s not clear what message they are trying to send.”

It is not clear to what extent the funding targets acknowledged this week are new or previously budgeted and approved projects. Many are likely to have been flagged in the five-year plan, approved in March at the annual legislative meeting.

Perhaps that’s why you only saw a muted response from the iron ore price?

If there’s one chart that shows China’s predicament, it’s this one from Morgan Stanley:

Source: Morgan Stanley

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It shows the increasing unproductiveness of China’s debt binge. It now takes 6.5 yuan in increased debt to produce 1 yuan of nominal economic growth.

I’ve talked about this a lot here before, so I won’t go into it again today. But the chart speaks for itself, no?

From a purely macroeconomic perspective, China looks toxic. And because of this, you’d have to be wary about the rally in commodities, right?

Well, this is where it gets interesting. There are an increasing number of charts pointing to a significant change in trend for commodity prices. Whether that is based on China growth hopes, the first signs of global inflation, or an improving supply and demand picture (after a five-year bear market) is impossible to tell.

But the reason isn’t important. The reason will become apparent (and obvious) AFTER the fact. What’s important is that commodity prices look like they are bottoming after a long and devastating bear market.

The image below is a weekly chart showing the CRB commodities index since peaking in 2011. From top to bottom, the index fell around 60%. A 60% fall over five years is a big bear market.

But if you look closely, you can see the index put in a double bottom earlier this year. Since then it’s rallied and corrected a few times. But, so far, these rallies and corrections are producing higher highs and higher lows, which is a good early indication that a new upward trend is emerging.

Source: Market Analyst

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The next thing you want to see is a rally to a new ‘higher high’. That means you want to see the index climb above the high from 29 April, which was around 185 points. Right now it’s trading at 180 points.

Keep in mind that this is an index only, made up of energy, precious metals, industrial metals and agricultural commodities. But it gives you a good overall feel for how the sector is performing.

Despite the ongoing bearish macro picture for commodities, the market is telling you to sit up and take notice. And because the market is far smarter than me, that’s exactly what I intend to do.


Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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