Why commodities are sinking even as small caps surge

A rate-cutting cycle is soon to begin, stabilizing the economy and helping to support more cyclical parts of the equity market like small caps. That’s the new market meta these days.

The commodity market certainly hasn’t gotten that memo.

The Bloomberg Commodity Index hit its lowest level of the year this morning and is down double-digits from its May 2024 peak, with a retreat in energy prices fueling today’s slide.

One critical difference is that US small caps are domestically oriented, and commodity markets are global in nature. In most commodities, China is either the dominant consumer or the chief source of expected demand growth. And the world’s second-largest economy is still in a sluggish state, with little signs that policymakers are pushing for a meaningful acceleration in activity.

“Chinese [oil] consumption growth is slowing, if not now outright contracting, across most major product categories.” writes Rory Johnston, author of the Commodity Context substack. “Chinese consumption needs to reaccelerate in the second half of 2024 to hit consensus growth expectations, with the latest high frequency tracking data indicating that said reacceleration hasn’t yet materialized as of mid-July.”

Johnston warns that poor Chinese demand growth would raise the risk that OPEC+ producers return oil to the market in a position of weakness – looking to regain market share and protect domestic budgets – rather than from a position of strength (responding to higher prices).

One welcome side effect of the downturn in commodities (and in particular, energy) is that it’s improved the near-term inflation outlook at a time when central banks are cautiously embarking upon easing cycles. The one-year US inflation swap (a gauge of the market’s expectations for CPI inflation) is sitting at 1.9% – its lowest level since 2020. Typically, inflation swaps are highly sensitive to gasoline prices, since that drives a lot of the volatility in headline inflation.

There’s a similar story of lackluster Chinese activity in industrial metals. 

Across the space, the futures curves for the likes of copper, aluminum, zinc, nickel and lead are all in contango (i.e., upward–sloping). This is not a sign that the market expects these commodities to move higher in the coming months, but rather is a signal that these markets are oversupplied.

The seeming copper shortage that sent prices spiking in April and May has been revealed to be more of a technical mirage at one exchange (Comex) than a reflection of the underlying fundamentals.

China’s monthly “apparent” copper demand (a measure of how much the country consumes based on how much it produces along with net trade) has dipped to its lowest level since March 2023. Refined copper exports have exploded by 542% over the past two months, through June (though the nation is still a net importer).

Copper’s role in catalyzing decarbonization efforts, thanks to its high conductivity, is a very well-understood long term theme. 

But another key difference is that commodity markets cannot afford to be as forward-looking as the stock market because the asset must clear in spot based on current supply and demand conditions. (Most of us aren’t equipped to be able to physically store a barrel of oil, for example.)

In the here and now, markets have to grapple with the long, nasty hangover in Chinese housing.

In real estate, steel is more sensitive to starts, while copper is more tied to completions. Unsold housing inventories are approaching their 2016 peak, note TD Securities macro strategists Alex Loo and James Rossiter – so that’s little reason to expect a robust turn higher in starts, or, down the road, completions. 

“Beijing is not signaling the kind of aggressive stimulus that would be necessary to supercharge weak domestic demand, break out of deflationary pressures, and alter a subdued macro outlook,” writes Michael Hirson, head of China research at 22V Research. 

Amidst the seeming gloom, hedge funds are contrarian buyers of this dip in commodities – but in the stock market. According to John Flood, managing director at Goldman Sachs, energy and materials were the most bought US sectors among the bank’s hedge fund clients over the past week and past four weeks.