Last week commodity markets corrected lower. From September 18 through the 25th, most raw material prices slipped. Precious metals suffered some of the most significant losses, with silver falling almost 15% from $27.129 to $23.093 on the active month December futures contract. Platinum fell by over 10%, and palladium and gold posted losses. Copper fell by 4.65% to below $3 per pound.
While natural gas finished last week with a gain, crude oil and oil product prices moved to the downside. Corn, soybeans, and wheat prices backtracked from recent gains. At the same time, the stock market was mostly lower, and even digital currencies fell. The rising number of coronavirus cases in Europe stoked fears of a second wave, and many U.S. states reported an uptick in the number of confirmed virus infections. Meanwhile, the uncertainty of the outcome of the November 3 U.S. election that will determine the future policy path contributed to a rocky path for markets across all asset classes.
The sell-off in commodities could be another opportunity for the coming months and years. While it always a challenge to pick bottoms when markets are declining, liquidity and stimulus continue to prop up the global financial system. The economic treatment for the pandemic continues to have a bullish long-term impact on the raw material asset class. The bottom line is that the price tag for liquidity and stimulus is inflation. The Fed has already told markets that it will tolerate a higher inflation rate and are almost encouraging a return of the economic condition that eats away at the value of money.
The iShares MSCI Global Metals & Mining Producers ETF product (PICK) holds shares of many of the world’s leading mining companies that are likely to appreciate in an inflationary environment. The current correction could be the perfect time to consider adding commodity exposure to your portfolio.
A sell-off comes on the back of the dollar
The U.S. dollar is the world’s reserve currency and the benchmark pricing instrument for most commodities. A falling dollar tends to provide support for raw material prices while a strong dollar has the opposite effect. The dollar index is a barometer for the U.S. currency’s value as it measures the dollar against other leading world currencies. The index has just under 58% exposure to the euro, the other reserve currency instrument.
On September 1, the dollar index fell to its most recent low at 91.750 on the active month December futures contract. The index fell from a high of 103.96 in March, a decline of over 11.7% in the dollar’s value in just under six months. A double-digit drop is a significant move in less than half a year.
As the daily chart highlights, the dollar index found at least a temporary bottom at 91.75 on September 1. Since then, the U.S. currency has settled into a pattern of higher lows and higher highs with the latest peak coming on September 25 at 94.795. The index settled at 94.682 last Friday, which has put pressure on commodity prices. The dollar began to rise as the stock market hit a speedbump. The pandemic and U.S. election caused a return of safe-haven buying to the U.S. currency.
Flight to quality may not last too long
Currency markets rarely spike higher or lower because governments manage exchange rate differential to provides stability to the global financial system. Therefore, an 11.7% move lower in the dollar index from Mod-March through September 1 was a substantial move. While the index has bounced to just below the 95 level at the end of last week, it remains closer to the low than the March peak, which was the highest level since 2002.
Three reasons lead me to believe that the dollar’s recovery is a short-term correction rather than an emerging bullish trend in the greenback. First, political volatility in the United States is not likely to end with the November 3 election. The U.S. remains a divided nation. Protests and civil unrest have reached levels not seen since the late 1960s. Democrats and Republicans in Washington DC cannot find common ground on any issues these days. The political environment suggests that the lack of progress towards solutions will impede the economy and weigh on the dollar’s value. The second issue is that the rising dollar is also a result of a falling euro because of the potential of a second wave of the coronavirus. If the virus follows the same path, Europe will be the first to suffer, but the U.S. would likely be next. If the pandemic causes shutdowns in the U.S. over the coming weeks and months, it would probably hit the dollar as it did from mid-March through July when the greenback’s value fell steadily. Finally, the interest rate differential between the dollar and the euro supported the dollar from late 2015 though 2020 evaporated when the Fed Funds rate moved to zero in March. Simultaneously, the central bank’s willingness to tolerate rising inflationary pressures is a reason for any rallies in the dollar to run out of steam. Therefore, the flight to quality and a higher dollar may not last too long.
Meanwhile, even if the dollar were to move higher, the trend in all fiat currencies has been lower as other central banks have followed the U.S. Fed’s lead on monetary policy. A stronger dollar could wind up being nothing more than a mirage in the global economy if the dollar is the healthiest horse in the glue factory. The rise in the price of gold, an asset that central banks hold as an integral part of their foreign currency reserves, is a sign that all fiat currencies are losing value. In 2019 and 2020, gold rose to new record highs against all world currencies, including the U.S. dollar, before the most recent correction.
Central banks and governments will become even more aggressive if risk-off intensifies
In what is a catch-22 situation in the current environment, the issues that could prompt safe-haven buying in the dollar are likely to cause its decline over the coming months. Catch-22 is a term from a 1961 novel by Joseph Heller that describes a paradoxical situation from which an individual cannot escape because of contradictory rules or limitations. The virus, U.S. political discord, and other issues that cause markets to experience risk-off behavior would only increase the liquidity levels from central banks and stimulus from governments that intensify medium to long-term inflationary pressures. The U.S. Treasury already borrowed $3 trillion to fund stimulus in May 2020, a level far higher than the previous record of $530 billion from June through September 2008 during the global financial crisis. The potential for even more borrowing that creates an explosion in deficits is high in the current environment. Therefore, the reasons for a rise in the dollar’s value could lead to the policies that eventually undermine its’ value.
Copper and base metals are highly sensitive to inflationary pressures
Copper is a metal that often acts as a barometer of global growth or contraction. Moreover, the red metal tends to move higher during periods when inflation rises. Copper is the leader of the nonferrous metals that trade on the London Metals Exchange. The LME also offers forward contracts in aluminum, nickel, lead, and zinc. The metals are the building blocks of infrastructure worldwide. As China is the world’s second-largest economy and most populous nation, it is the leading consumer of the base metals.
In 2008, following the financial crisis, copper’s price fell from $4.2160 in May to a low of $1.2475 in December, a drop of over 70% in seven months as risk-off conditions gripped markets.
As the monthly chart shows, copper rose from its December 2008 low to a new record peak at $4.6495 per pound in 2011. The stimulus and recovery following the 2008 crisis pushed the price of the red metal and most other base metals and commodities to multi-year or all-time highs in the following years.
The response by central banks and governments to the global pandemic is far more aggressive than in 2008. Albert Einstein once said, “the definition of insanity is doing the same thing over and over and expecting a different result.” The tidal wave of liquidity and stimulus in 2020 makes the period of 2008 through 2012 a model for the impact of the current monetary and fiscal policies. The Fed’s toleration of rising inflation is another sign that prices are likely to increase. Moreover, the central bank could be making more than a leap of faith that they will be able to control an economic condition that has the potential to become an untamable beast. The bottom line is that the current period of weakness in the commodities asset class could be another opportunity to load up on inflation-sensitive assets.
PICK for the long-term on a scale-down basis
If copper and base metals prices are heading substantially higher over the coming years, the share prices companies that mine the metals could experience a period of explosive growth. The top holdings of the iShares MSCI Global Metals & Mining Producers ETF product (PICK) include:
Source: Yahoo Finance
PICK has net assets of $186.03 million, trades an average of 142,226 shares each day, and charges a 0.39% expense ratio. The ETF product has a blended dividend yield of around 3.05%.
The companies held by the ETF all stand to prosper in an inflationary environment over the coming years.
As the chart shows, PICK has made lower highs and lower lows over the past years, reaching a low of $16.01 in March at the height of the risk-off selling because of the pandemic. Technical resistance stands at $30.50, $32.97, and $37.91 per share. Increasing inflation and rising metals prices could push the ETF through those levels as a hot knife goes through butter over the coming months and years. At below $27 per share, the risk-reward for the ETF that holds shares of companies that extract inflation-sensitive metals from the earth’s crust remains compelling. I suggest a scale-down buying strategy for PICK if risk-off conditions intensify over the coming weeks. The Fed’s policies make the current correction in commodity prices another buying opportunity.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.