While one of the bigger commodity funds out there, in this case Fortress Commodities Fund, has not done too hot recently (down 7.4% in October), which it humbly admits to and says, "the month of October was a wakeup call for us and we are adjusting accordingly" here are some must read perspectives that lead the Fortress Commodity group to conclude that "We're Long Gold, Short Base Metals, Patient Crude Strength Seller & Buyer Of Corn On Any Real Flush In Prices." Oh, and that it's "macroeconomic outlook remains pessimistic."
First, a general market outlook:
The market environment of the last several months has been aptly described by one of our top research consultants as one of ?inhuman volatility?. We can see this in the frequency of so?called ?one polarity? days in the S&P 500. From 1990 to 2000, there were 29 days on which at least 400 of the 500 S&P constituents had the same directional move. Since July of this year, there have been 34 such days. This is clearly a new regime of volatility for market participants. This volatility, we believe, is a product of what has been a very long process of global deleveraging that has spread from the consumer, to the corporate sector, and finally to the realm of the sovereign sector. With a world economy that has been predominantly reliant on central banks to write put options against financial calamity, the instability in the sovereign sphere has represented a real shift in the volatility paradigm. In a sense, historic market conventions and institutions are being challenged both in terms of their efficacy and their potential longevity in this world of profound imbalances. This necessitates a reevaluation of the current investment processes and an evolution in risk management techniques so that our portfolios can continue to adapt to the new reality of the end of the great moderation in economic and asset price volatility. The month of October was a wakeup call for us and we are adjusting accordingly.
One of the most significant challenges of the current market environment has been the disproportionate importance of policy and political overture, as opposed to fundamentals, in determining price action. This creates a highly indeterminate period in which volatility is elevated and investment decisions amongst our community can tend to become incredibly myopic, living from one political announcement to the next. Whole political and financial regimes are at stake. This process of deleveraging is nowhere near complete, so we expect this ?inhuman volatility? to persist for the foreseeable future. We expect to adapt through much more short?term focused risk measurement techniques and trading horizons to capture extremes in price action and market positioning. Although our fundamental discipline will not be altered, we will now more prominently recognize the new reality of the inverse relationship between volatility and fundamental relevance.
Our macroeconomic outlook remains pessimistic. Global linkages in trade and finance amplify changes in growth dramatically now, and we continue to believe in a negative growth event with China at its epicenter. We believe this will be materially exacerbated by the rapid decline emerging in European activity, with any bounce in US activity likely to be qualified as ephemeral. Coupled with mounting sovereign stress, this backdrop leads us to maintain our negative bias for markets. We are looking to re?enter our short positions in highly cyclically?geared commodities on continued price strength and we anticipate that we will continue to increase our gold position opportunistically.
And after that cheerful introduction, let's dig in a little into the firm's asset allocation:
Our commodities views remain negative for cyclically?oriented products like base metals and crude, though recent micro developments in the oil market keep us more balanced/agnostic in our near?term price outlook. We are especially bullish gold and Euro?gold and also believe that corn will present a compelling opportunity in the near future. It is hard to see how any cyclical rebound in prices could be sustained with such instability in the macroeconomy and continued weakness in the anecdotal information we are receiving from so many pivotal supply chains across the world. This is why the variance between price action in many of our markets of focus and what we see as fundamental trends on a forward?looking basis is so challenging at times. In these volatile times, we think it is essential to stick to our core top conviction beliefs and keep the portfolio simple and liquid. Thus, we are long gold, short base metals, a patient seller of strength in crude oil, and a buyer of corn on any real flush in prices.
The answer why Fortress is especially worried about industrial metals is one word: China (well two- add copper).
The investment landscape for industrial metals is becoming increasingly more difficult to navigate. As highlighted in last month’s letter, we are continuing to see a rapid deceleration of growth in China, specifically within the cyclical industries. A recent trip to visit steel companies outside Beijing underlined the impact of extremely tight liquidity and continued restrictive policy in the Chinese housing market. Steel capacity cuts – through idling or accelerated maintenance outages – are now commonplace and the speed of these cuts has certainly surprised the market. Construction is the principal end?market blamed for this weakness; given the very large inventory overhang and the continued lack of liquidity, this is not surprising. In our equity universe, we have also seen numerous companies expressing concerns regarding China construction demand. Zoomlion, China’s second largest construction machinery company, recently said, ?Demand for construction machinery has shrunken drastically and growth will no doubt continue to slow next year.? We see how quickly the steel market has adjusted for a lower growth scenario in the chart below.
Within the context of declining housing starts, plummeting transaction volumes and the beginning of a meaningful move down in housing prices, these shifts in the steel market have been an interesting harbinger of more substantial problems in the Chinese economy. Our principal concern is the extension of housing weakness into the banking system through the mechanism of both failing developers as well as the opaque and informal lending system.
We are concerned that the recent strength in iron ore, steel and copper has been misinterpreted by the market. In our view, any suggestion that the Chinese market is undergoing a substantial restock is misplaced. The case of copper is an interesting one: throughout September and October, we saw an unprecedented rise in cancelled copper warrants. This is usually interpreted as a positive signal, indicating that the market is in need of metal for immediate delivery. However, the principle reason why these tons are being removed out of the London Metal Exchange warehouses and into China is that they are to be used for trade finance when the arbitrage gap opens up sufficiently for traders to do so. This became apparent in September, but is more an indication of a serious lack of liquidity in China than a rapid improvement in end?demand. We have heard that copper stocks in bonded warehouses have subsequently risen by a meaningful amount, which suggests that end?demand remains subdued. Despite substantial disruptions in the global supply in copper, we feel that rising inventories in China – in the face of declining demand – do not suggest that the metal should trade 25% – 35% above marginal cost. We believe that downside risk remains. Going forward, we anticipate that import demand from China could fall in what is usually a seasonally strong period. Additionally, with virtually no demand growth elsewhere in the world, we believe this could put some pressure on prices.
Going forward, it is important to correctly interpret how Chinese policy response will affect demand for the commodities within the industrial metals space. We have seen very specific policy to address extremely critical issues within the Chinese economy. First, there was the support for the bond issuance of the Ministry of Railways. This is the result of banks unwilling to lend to this ministry, which ultimately puts their working capital at risk. With a huge employee base, the government could not afford to be in a situation where these employees were not getting paid. Second, we have seen some support for small? and medium?sized (SME) businesses that have been affected by extreme tightness in liquidity and exposure to elevated borrowing costs in the informal lending sector. We see both of these instances as reactive policy easing and believe that the government is not yet in a position to implement full?scale easing on a national level. Furthermore, any assumption of a return to a 2008/09 stimulus scenario seems highly unlikely. Moreover, the government has said on multiple occasions that property will continue to be explicitly excluded from selective easing, which makes it difficult for us to be constructive on any commodity that relies heavily on construction demand.
As for Crude:
While we remain cautious on the global economy and its implications for oil demand, we have to respect the rather dramatic improvement witnessed in the global ?micro? crude landscape over the past several months. For example, the seasonal upswing in US implied distillate demand – which frankly has surprised us to the upside – has been more than twice the 5?year average and even stronger than last year’s very impressive performance, largely due to unprecedented strength in export demand from Latin America.
Moreover, the high?frequency data on distillate stocks globally (e.g., US, ARA, Singapore and Japan) reveals an inventory picture that is now nearly as tight as it has been at any point in the past five years. This is a big change from just two months ago when inventories were above the 5?year average.
As a result of these factors, we would rather be sellers of crude on any major rallies from here.
And finally... gold:
Our view on gold is essentially based on what form and function the fundamental resolution of the US and European sovereign imbalances will take. However, the focus is really on Europe. Ultimately, the likely outcome of the Euro?sovereign crisis is that there has to be willingness on the part of the ECB to essentially monetize or backstop the balance sheet liabilities of the nations that are at risk. In the current state of affairs, this is a very large number. However, if Europe slips into a recession and the deficits of these countries surge (as would be expected in that type of economic environment), then the ECB will very likely be forced to abandon several of the original tenants of the Eurocurrency in order the save the currency union itself. Our central case is that if this were to occur, we would find this monetization to be unambiguously bullish gold and bearish the Euro. This is why we think that the Euro?gold position is quite attractive at current levels.
Given the next several months will potentially be a historic time for markets, we expect levels of volatility to remain elevated relative to historic norms. The concern we have and why we continue to believe that there is a material risk of real downside, left tail market outcomes, is that we are in a zero?sum world with incredible asset price volatility. By zero?sum, the issue is that monetary policy responses are creating serial bubbles in markets. This process of bubble propagation is a destabilizing force for markets and increases volatility when these programs conclude. The lesson to be learned is that monetization is leading to commodity price inflation through the mechanisms of global financial linkages. However, without true organic growth in Western economies, these liquidity measures may reduce tail risk but do not solve the long standing structural issues of employment and potential output growth that plague the West. If politics and policy are the prevailing bias in markets, we will need to adjust elements of our process. After last month?s performance, we have initiated changes and additions to our risk measurement process in order to be more in rhythm with the intraday and day?to?day volatility of markets. We also are now more actively trying to book realized profits – when they exist – as cycles have been reduced from what appeared as weeks or months to hours and days. We have to adapt to these new realities and endeavor to extract profits accordingly.