Commodities

A Resources Trade Update

Since the March FOMC meeting, where the Fed was surprisingly “dovish” and effectively capped the dollar rally, we have been cautiously bullish on the resources trade. The basic thesis was that between the Fed capping the dollar, low valuations, potentially bottoming inflation and 24 global central banks easing policy, the risk/reward in a bombed out resources trade was worth some risk capital.

While we’ve been following the resources trade, and keeping you updated on the FlexShares Mstar Glbl Upstrm Nat Res ETF (GUNR), we haven’t added it to our “7 Best Ideas” yet be-cause I wanted technical confirmation before getting long the resources trade.

We still don’t truly have that confirmation, as GUNR continues to ride that downtrend line (see chart below). But, while we wait for some positive technical signals, there was another anecdotal piece of positive news for the resource sector yesterday.

Resources trade

In its earnings release yesterday, which was broadly positive and caused the stock to rally over 3%, BHP Billiton Limited (BHP) said that it would be deferring a project that would have seen an increase in production of iron ore, reflecting the fact that low prices are finally starting to crimp demand.

If that is the start of a larger trend, then that could be positive for iron ore prices going forward, as well as the general commodity complex. Again, it’s only anecdotal, but between that news; better price action form the resource names; a potential bottom in the Aussie dollar, and recent firming inflation, the anecdotal positives are starting to add up in the resource sector.

GUNR remains our favorite resources trade, but volumes have dropped off lately in that name for some reason (traded about 200k shares yesterday, and have an average volume in the mid-200k).

The reason I like GUNR is because it’s not a de-facto energy ETF disguised as a resource ETF (like IGE), and does not have a ton of chemicals exposure like the better know XLB (the Basic Materials SPDR).

I realize that for some, that volume is a bit of an issue (one of my longer-term subscribers wrote in Friday asking for alternatives), so I will continue to dig for something a bit more liquid that can benefit from this trade.

As soon as we get a technical breakout, I’ll add it to our “7 Best Ideas,” as the resources trade is something I’m starting to think can outperform into year end.

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A Big Move in Oil Prices

Commodity markets were mixed yesterday, as energy continued to rally towards resistance while the metals underperformed. The benchmark commodity ETF, DBC, rallied 0.60% thanks to the heavy weighting of energy within the portfolio and the big move in oil prices.

WTI crude futures rallied 2.41% Tuesday, as traders bid up oil prices in response to a report released by the North Dakota Industrial Commission’s Department of Mineral Resources that said production in the state declined to 1.18M barrels a day, down slightly from December’s record high of 1.23M bpd.

Today, oil prices will depend on two things—the EIA, and key technical levels. With regard to the EIA, analysts are calling for a more modest 3.6M barrel build for crude oil stockpiles, but the details of the report will have just as large an effect on oil prices today. Specifically, traders will be closely watching production metrics as they continue to speculate that falling rig counts are finally leading to a drop in production (that was supported by the North Dakota data released yesterday).

Also, Cushing, OK inventories will be in focus as a continued surge at the key storage location (which is the delivery point for WTI crude futures traded on the Nymex) has had a bearish effect on the oil prices.

Technically speaking, WTI crude futures have once again approached a “tipping point” on the charts. Supporting the bulls is a month-long uptrend in oil prices that has been tested upwards of six times, and held strong each time. That trend support in oil prices is sitting at roughly $52.30 this morning.

Meanwhile, there is resistance at the upper end of the 2015 trading range between $44 and $54, specifically the 2015 high in oil prices of $54.24. Also, the 100-day moving average is offering additional resistance as oil prices have not traded above that level since mid July of last year.

Oil prices

The core fundamentals of oil prices remain bearish for now, namely due to burgeoning supply level. Longer term, oil prices are likely to stay subdued. However, looking at the near term, if the bulls can push oil prices up through the aforementioned resistance, the recent gains will very likely be extended as shorts are forced to cover positions.

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Chinese Trade Balance: Not As Bad As It Seems

The March Chinese Trade Balance numbers are in, and they badly missed expectations, at least in terms of the headline number. But oddly enough, the details of the Chinese Trade Balance report offer more anecdotal evidence that the resource space may be bottoming.

On the surface, the Chinese Trade Balance was a big disappointment: Exports dropped nearly 15% vs. expectations of an 11% gain, while imports declined 11%, largely matching street expectations.

Given the peripheral concern regarding the Chinese economy, and specifically whether it can meet the 7% GDP growth target the government has set, the bad Chinese Trade Balance was taken as an obvious negative sign.

Interestingly, Chinese stocks actually rallied more than 2% following the release. That’s because first, the Lunar New Year in February likely created a lot of m/m statistical noise; and second, “bad” economic news is seen as encouraging more Chinese government stimulus, which is good for stocks.

So for now, “bad” data such as a downbeat headline Chinese Trade Balance report is “good” for Chinese stocks, as long as that 7% GDP growth figure holds.

More specifically to commodities and resources, the key sub-indicators to watch in this report are the commodity imports, and they were actually pretty good. Iron ore imports rose 2.4% m/m (saar), copper imports rose 34.1% m/m (saar), and steel rose 3.4% m/m (saar). The only real disappointment was coal, which saw imports collapse.

Bottom line: The Chinese Trade Balance data wasn’t as bad as the headlines implied, and the details actually are another piece of anecdotal evidence that resources generally are trying to bottom. To be clear, I’m not calling a bottom in resources, but the bullish case is building and this is a space.

Chinese Trade Balance

As such, we’re watching the FlexShares Mstar Glbl Upstrm Nat Res ETF (GUNR), an ETF pegged to the natural resources segment, as a barometer of action in the space.

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Q1 Earnings Season Starts Now

Although last week was the official beginning of earnings season, this week is when Q1 earnings season really begins as we start to get some bigger names—particularly financials—reporting results. For the broad market, earnings season is critical this quarter because of the potential of a further decline in the FY 2015 S&P 500 EPS.

Consider that we started the year in the high $120s, dropped to the current $118 per share, and that’s resulted in the 18X current year earnings “ceiling” in the S&P 500 declining to about 2,100. That level has been the ceiling for stocks for months. If that S&P 500 earnings number drops materially from $118, the ceiling on stocks will move lower, and that will pressure equities.

This week, most of the important results will be financial: JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Co (NYSE:WFC) Tuesday, Bank of America Corp (NYSE:BAC) and PNC Financial Services Group Inc (NYSE:PNC) on Wednesday, American Express Company (NYSE:AXP), Citigroup Inc (NYSE:C), Goldman Sachs Group Inc (NYSE:GS) on Thursday.

There is a decent chance these results could beat expectations thanks to stronger trading volumes in “FICC” (Fixed Income, Commodities and Currencies) so we could get a bit of an early earnings tailwind. And, if there was one earnings trade to be long here, I would say it was the larger money center banks on the chance of a trading revenue beat.

earnings season

Earnings season could mean a financials bounce.

More important, however, are industrials and tech earnings this quarter—especially the multi-national industrials like Honeywell International Inc. (NYSE:HON) and General Electric Company (NYSE:GE). They don’t start to report until next week, and it’ll only be then that we learn whether the S&P 500 2015 EPS will be lowered.

To a point, analysts will look beyond stronger dollar headwinds, and everyone knows the energy sector results will be very bad. But if we see deteriorating “linear” results (meaning March results that are worse than January) and cautious comments beyond just the dollar, stocks will react negatively to earnings season—and then the valuation issue will come into play.

Earnings will affect the market this week, but financials won’t get to the heart of the earnings season worries. It won’t be until next week that earnings season gets real—and that’s when we’ll know more about valuation levels in this market.

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An Oil Price Reversal

Commodities were broadly lower Wednesday, as the near-term uptrend in energy faltered with an oil price reversal.

The oil price reversal saw crude prices drop more than 6% in the session. Perhaps more importantly, the oil price reversal took place on “inventory day,” and for the first time in seven weeks, oil fell in the session.

The EIA reported a build of +10.9M barrels vs. (E) +3.4M Wednesday, but for the past six Wednesdays (when the EIA reports inventory data) crude oil futures have rallied despite consistently bearish data being released that showed consecutive, estimate-beating supply builds to new records.

The reason for those counter-intuitive rallies was a “lopsided” market that was overcrowded with weak-handed shorts, which made futures vulnerable to sharp short-covering rallies. But, after Tuesday’s oil price reversal, it now appears the “froth” has largely worked itself out of the market.

Oil price reversal

Now, the fundamental outlook for crude oil remains largely the same as it has been all year. There is a global production surplus of over 1M barrels/day leading supply levels to continue to rise week after week while relative demand forecasts for oil and the refined products remains lackluster with suppressed global economic activity.

Looking ahead, we will keep a close eye on the aforementioned 2015 high of $54.24 as a “level to beat for the bulls,” while to the downside we are watching low time frame trend support at roughly $50.25.

If broken, the $50.25 level would likely spur a further oil price reversal selling in coming sessions. Bottom line, WTI futures appear to be falling back towards the middle of the broad $44-$54/barrel trading range, where they have been trading the entire year.

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Q1 Jobs Report Preview

The Q1 jobs report is the most important jobs report we’ve had in several months—and maybe even in a year. If the Q1 jobs report is in line to even slightly better than expected, look for a “hawkish” reaction from markets, which will weigh on equities.

The official estimate for the Q1 jobs report is for 245,000 new jobs added in the quarter, but really the key points to watch are the unemployment rate and the year over year wage growth. A “Too Hot” number in either would make a June rate hike by the Federal Reserve much more likely, and that’s important because a June rate hike is not priced into markets.

The stocks market will be closed for Good Friday, but currencies and bonds will trade, so we will be able to gauge whether the Q1 jobs report was hawkish or dovish based on the response of the US dollar and Treasuries.

Here are the three scenarios for the Q1 jobs report:

The “Too Hot” Scenario

< 5.5% Unemployment Rate, ≤ 11.0% U-6 Unemployment Rate. In the March statement the Fed lowered “NAIRU” to 5.0% and below, but if we get a sub-5.5% UE rate that is combined with a sub-11% U-6 unemployment rate (which measures underemployment), then pressure will rise on the Fed to hike in June, even though it remains above the long-term goal of 5.0% or lower.

> 2.2% YoY Wage Increase. Wages have taken a slight backseat to the UE rate but still are very im-portant. In the February jobs report the yoy wage increase backed away a bit from the 2.2% in January, but if that number moves back to 2.2% expect the market consensus for Fed rate “lift off” to move to June.

> 250k Job Adds. The job additions have been so conistently better than expectation that even just “meeting” expectations will be considered anecdotally hawkish.

The “Just Right” Scenario

Basically anything under the “too hot” scenario levels would be considered “just right,” and the market should broadly yawn in response.

Q1 jobs report

A Q1 Jobs Report “surprise” could hurt stocks.

The “Too Cold” Scenario

< 180k Job Adds. There isn’t much hope of a “too cold” scenario, but if the headline jobs number was a big miss than you might see a temporarily dovish reaction.

Almost all the risk into the Q1 jobs report is to the downside for stocks, as any surprise will be a hawkish one. Remember, a bad jobs report number (say under 180,000) won’t be bullish for stocks, because no one wants soft data and more easing from the Fed.

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Q1 Earnings and the Dollar

Last week’s stock market volatility had more to do with quarter-end positioning and lack of liquidity/volumes than it did anything materially negative. The sell-off in biotech (and to a lesser extent semiconductors) probably isn’t going to be a repeat of the “momentum” sector-led pullback of April 2014. That said, Q1 earnings and the dollar are going to have a big influence on stocks going forward.

We continue to view stocks as facing two basic headwinds that likely will continue to prevent any material gains: 1) Fed uncertainty regarding when rates will rise, and 2) Growing anxiety over Q1 earnings and the dollar.

Focusing on Q1 earnings and the dollar, remember that Q4 2014 results (out in Jan/Feb) were materially affected by a stronger dollar, and the net result was that 2015 S&P 500 full-year EPS dropped from the high $120s to current $118. That puts the S&P 500 at 18X current year earnings at 2,100, and that valuation seems to be a cap on stocks.

As we enter Q1 2015 earnings, keep in mind the average price of the Dollar Index in Q1 is easily 5%, and probably 10%, higher than the average for Q4 2014. And, the macro economic backdrop in Q1, temporary or not, wasn’t as good as Q4.

Q1 earnings and the dollar

The S&P 500’s fate will rest on Q1 earnings and the dollar.

Anxiety readings around earnings are rising steadily, so hopefully by the time results start coming in everyone has already priced in some disappointment, but the valuation issue remains. If we see further reduction to 2015 full-year EPS because of weak Q1 earnings, that will be a headwind on stocks. The bottom line is we continue to view the S&P 500 as range bound at 2,000-2,100 until we get more clarity on both of the above points.

We still do not believe that we are about to embark on a material leg down in stocks, and as such will continue to buy dips in the market towards 2,000 in select cyclical sectors, including—regional banks, retail, job recruitment/placement firms, and more broadly, small-cap growth names.

Still, near term we continue to watch think Q1 earnings and the dollar will be the main driver of stocks (barring any further breakdown in the biotechs or semiconductors). It’s not a coincidence that when the dollar began to rally last week stocks also sold off. If the dollar rally resumes following this week’s jobs report, that will become a headwind again on stocks.

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Will Yemen Hurt Markets?

Bombing and a potential invasion of Yemen by a Saudi-led coalition, shocked markets late Wednesday night /early Thursday morning, and that has sent oil prices to multi-week highs. But, while it produces scary headlines, the answer to the question of will Yemen hurt markets due to this military conflict is “not likely.” Well, at least not directly.

By now you know that a Sunni Muslim coalition led by Saudi Arabia is bombing and likely invading Yemen. The reason is because the Sunni government there has basically been overthrown by a Shiite tribe called the Houthi, who are largely backed by Iran.

There are two characteristics of this conflict I need to point out to give it proper context: First, despite the urgency of the headlines, understand that this conflict is not new. Yemen has been basically in a state of civil war since last September, and the capital of Sanaa has largely been in control of the Houthi for months. Second, this is the latest iteration of a decades-long proxy fight between Saudi Arabia & Iran (so Sunnis and Shiites) for control of the region.

I don’t mean to be dismissive of the event, or the likely human tragedy that will unfold, because I am not. However, my job is to tell you the potential market impact, and to answer the question of whether Yemen will hurt markets. And, beyond the temporary concern and spike in oil, there simply won’t be much of one unless one of two things occurs:

Market Disruption 1: Strait of Mandeb closes (very unlikely)

Yemen is actually a very small oil producer, so the risk of a supply shock is not what sent oil higher. Instead, it’s that Yemen is on the eastern edge of the Strait of Mandeb, which is a main thoroughfare for oil exiting the Persian Gulf. Fears naturally have risen that the Houthi may shell tankers entering the strait, which would result in a supply shock—and that’s why the price of oil went higher.

Will Yemen hurt markets?

Will Yemen hurt markets? Brent crude prices surged 4.27% Thursday.

Theoretically this is a possibility, but it’s not likely. Part of the Saudi coalition have already dispatched war ships to the area to ensure no disruption, but also it’s unlikely the Houthi, which control most of the country, are probably receiving whatever meager revenue Yemen gets from oil exports (and they travel through the Strait). Bottom line, it’s something to watch, but the likelihood of this becoming a supply issue is low.

Potential Market Disruption 2: Yemen spirals into a larger Sunni vs. Shiite conflict

The battle for Yemen leads to a larger regional conflict between Shiites (backed by Iran) and Sunnis (backed by Saudi Arabia). This is the general fear everyone has, but again, the likelihood of that happening is small. This is mostly the latest battle in a centuries-old religious and cultural proxy war in the Middle East.

Yemen is having an effect on markets; however, but not directly. You’ll notice yesterday that bonds sold off hard (30 year down 1.3%). The Yemen issue will likely keep oil prices elevated, and that’s going to continue to put upward pressure on inflation indicators (CPI/PCE), which could make the Fed more prone to hiking rates sooner (June or July) than later (September).

In this Fed dominated world, even geopolitical events need to be considered in the context of Fed “lift off.”

So, will Yemen hurt markets? No, but it will contribute to more elevated prices than we’ve seen over the last two months. That could help inflation indicators rise, and make the Fed more prone to raising rates in June—and that’s the real reason we need to watch Yemen.

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Did the Fed End the Commodity Collapse?

The Fed just ended the commodity collapse. Well, maybe not overtly, but the single biggest takeaway from the FOMC meeting last week was that they effectively capped the US dollar rally, and because of that an opportunity may be developing to buy value in the commodities sector.

To be clear, we do not think the Fed is actively trying to engineer a weaker dollar, but they are trying to cap any further rise. And, if that’s the case, then there are several potential investment consequences that stem from that change, as a lot of trades across asset classes and sectors over the past seven months were basically different forms of the “stronger dollar” theme. That means we could see some substantial unwinds in different places.

One of the biggest potential shifts coming could be in the commodity and basic materials complex. And, while too early to be definitive, it’s not unreasonable to say that if the Fed has indeed capped the dollar rally then it may also have ended the commodity collapse.

In most commodities, the supply/demand dynamic is still negative, but commodities don’t just trade on supply/demand, so consider a few points in the context of the recent historic commodity price collapse:

Coordinated Global Easing May Lead to Stronger Demand

Remember that 24 central banks have cut rates this year, China is aggressively supporting its economy, and now the Fed is more dovish than expected. As we have covered with our “long shippers/tankers” call—Claymore/Delta Global Shipping (SEA)—there is a chance they actually stimulate global growth more so than is currently expected, leading to a potential uptick in global demand for commodities.

Inflation Statistics Should Begin to Rise Quickly if the Dollar Index is Capped

Rising global deflation fear has been driven mainly by plunging oil, and to a lesser extent, by other falling commodity prices. But, we already know that away from commodities, inflation pressures are starting to slowly trend higher. Wage inflation in the US is rising, service sector inflation is running near the Fed’s 2% annual target, and with oil stable (and potentially rallying form here thanks to a capped dollar) there is now upside risk in real inflation and inflation statistics. Rising inflation is good for commodities, and it’s good for materials stocks.

Commodities Have Collapsed

From a valuation standpoint, commodities have already largely priced in a worst-case scenario: No uptick in global demand and a constant dollar headwind. Point being, this is a very shorted and unloved space, so the potential for a rebound is there.

As you know, we look at everything from a risk/reward standpoint. And, given low valuations and a potential positive game changer of a capped US dollar and an uptick in global growth (not to mention how shorted and oversold the commodity complex is) the risk/reward profile for gold particularly, and commodities in general due to the Fed ending the commodity collapse, is starting to look better and better everyday.

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A Dovish FOMC Surprise

Wednesday’s dovish FOMC surprise took the markets by storm, as Fed chair Yellen and company removed the word “patient” from the FOMC statement, but simultaneously “moved the goal posts” out on economic conditions that would result in a rate hike (meaning the jobs market has to get even better than was previously thought and inflation has to accelerate higher).

I said last week one of the Fed’s problems was that it said it was “data dependent” and that the data said a rate hike was necessary. Well, the dovish FOMC surprise was the solving of that problem by changing the “data dependent” requirement to reflect desired lower unemployment and higher inflation.

Of course, there were multiple reasons why this Fed meeting turned into a dovish FOMC surprise. First, “patient” was removed but qualified by saying the Fed needs “further improvement” in the labor market and needs to be “reasonably confident” inflation will move back to 2% target. Going forward, “reasonably confident” is the new “patient” with regards to the wording of the FOMC’s statement.

Second, the dollar wasn’t explicitly mentioned, but the FOMC did note that “export growth has weakened,” which means that they are paying attention to the US dollar strength. Third, the Fed changed from “solid growth” to “economic growth has moderated somewhat” in describing economic activity.

dovish FOMC surprise

The Dow jumped on the dovish FOMC surprise.

Finally, the interest rate “dots” were moved decisively lower, especially with regards to 2015, substantially closing the gap between market expectations and the Fed projections. Bottom line, the majority of Fed Presidents now expect Fed Funds to end 2015 around 0.625%, which is nearly 50 basis points lower than in December, and reflects just two rate hikes.

Additionally, the “longer run” unemployment rate was reduced to 5.0% to 5.2% from the previous 5.2% to 5.5%. (These were perhaps the two biggest reasons the statement amounted to a dovish FOMC surprise.)

The much bigger issue of whether the Fed will hike in June, July or September remains very much unresolved, and more importantly, we still have no clue how markets will react when that happens. So, unless economic data turns decidedly weaker in the near future, we can continue to have the “June/July/September” rate hike debate for the next few months, and that will cause more volatility in stocks.

More broadly, the path to a sustainable rally isn’t through perpetual 0% rates and a dovish Fed, because we all know that at some point (and it can be debated as to whether we are there already) 0% rates will start to do more harm than good.

Bottom line, this was a dovish FOMC surprise, but I do not think it opens the door to materially higher stock prices as the major uncertainty surrounding the Fed remains unresolved.

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