Who Cares About Tariffs?

Will rising tariffs derail the commodity bull market?

What if trade wars slow down the global economy?

Have the long-term fundamentals for the asset classed changed to warrant the recent correction?

These are all important questions as the uncertainty surrounding the use of tariffs in trade negotiations has caused heightened volatility across a broad spectrum of markets. Since peaking at over +8% in late May, commodity markets have given back a good deal of their gains for the year, leaving the Rogers International Commodity Index® up close to +2%. Over the past couple months, amid lots of speculation, the commodity markets have received heightened focus from the financial press as investors try to factor in this new variable. There is a lot of “noise” surrounding tariffs and their effects, however, we believe the recent sell off is a normal correction and has created another opportunity for investors. The bull market in commodities is firmly in place; tariffs or no tariffs! (see Bull Market Ahead – Price Asset and What A  Bull Market Looks Like – Price Asset )

Consider:

It is extremely difficult to factor in how tariffs may or may not affect commodity prices. Short term dislocations in pricing in both directions may occur depending on which country adds the tariff, to what level, on which commodities, and/or what products. It is particularly complicated for the Rogers International Commodity Index® which has 38 components diversified across 3 sectors, with components that trade primarily in the US but also on 3 foreign exchanges. Trying to factor in the ‘tariff effect’ on such a large and diverse portfolio is extremely difficult, especially since so many other fundamental factors are more important. Granted, a tariff might have an impact on prices as buyers begin to move their purchases to other countries and futures participants, including speculators, will try to profit or hedge from such expected activity. Often there might be a one-time adjustment to prices on a shorter-term basis, however, the long term price movement is dictated far more by the balance between supply and demand, as well as, the global macro effects of changes in interest rates, currencies, and inflation over time.

Are The Effects Of Tariffs Complicated? You Bet!

  1. Not all tariffs are negative. The US announced 20% tariffs on lumber imported from Canada in June of 2017. Lumber is up +26% since that announcement and, despite being well off its highs,  is up +18% year to date! The RICI® is the only major index that includes a lumber contract.
  2. The US and Brazil are the two largest exporters of soybeans with China being a major consumer. China’s move to enact tariffs on imports of US soybeans has caused a major sell off in US prices as Chinese buyers turn to Brazil. Soybeans declined over -20% from late May to the lowest prices in almost a decade by early July. However, since then, they have rallied almost +8% into the end of this month.  Brazil itself is now running short of domestic supply and has become a buyer of US soybeans. Brazil To Buy US Soybeans – Bloomberg
  3. In January of 2016, we commented on the many positive fundamentals that had developed for the asset class including for copper which was expected to enter a global deficit. Commodity Curve Blog – Price Asset . Copper went on to appreciate close to +60% by December 2017. It continued to rally into 2018, however, in July copper has declined close to -5% with concerns over the effect of tariffs and is now down approximately -15% YTD. Given the magnitude of the increase over the past couple years it is not surprising that copper is digesting those gains regardless of the reason. We believe the long term outlook remains very positive for this critical metal and we are not alone in this assessment. Copper Prices Are About To Go On Steriods – Bloomberg
  4. When crops are in short supply prices go up, tariffs or no tariffs! Europe has been experiencing a severe heat wave affecting crops. Wheat rallied sharply in July and the Chicago winter contract is now the best performing commodity in the RICI®, up close to +25%. In fact, 8 of the 9 best performing contracts in the RICI® for July are all Agriculture. Europe’s Blistering Heatwave – Bloomberg

Fundamental Inputs Should Not Be Ignored:

  1. Second-quarter US GDP jumps +4.1% for best pace in nearly four years! The global economy is expected to expand by +3.1% (World Bank estimates). US GDP Jumps – CNBC
  2. The 90 day T-bill has continued to rise over the past few months and is now at +1.96% (coupon equivalent of +2.00%) as of 7/27/18. The yield on a long only commodity index with T-bills for collateral now sports a yield higher than the S&P 500’s +1.82% yield (WSJ Market Data Center, 7/27/18)!  T-Bill Rates – US Treasury.
  3. In the 12 months through June, the CPI increased +2.9%, the fastest pace in over 6 years! CPI Rises – CNBC
  4. US Energy Information Administration reported on 7/25/18 that the US crude oil supply dropped to its lowest level in over 3 years despite the fact that the US is on target to break the all-time annual production record set in 1970 (EIA report 7/10/18). Crude Oil Inventories Slump – Reuters

Summary

Handicapping the final outcome of tariffs, their level and the ultimate influence on prices is indeed very complicated. The negotiations on trade are fluid and despite the negative sentiment, perhaps the recent announcement between the current administration and the EU is a harbinger of better trade relations! With respect to commodities, the global balance between supply and demand is a far more important factor on a long term basis for the asset class than any short term effects of the tariffs. After the major capital expenditure cuts as a result of the 2011-2015 commodity bear market, supplies for many commodities are tight around the world while demand has continued to grow. In addition, the global macro picture for commodities continues to improve with inflation creeping up, bonds underperforming, and short term interest rates up significantly.

We continue to believe the low in early 2016 represented the beginning of a multi-year reversion to the mean. (View Chart Here

Alan Konn

Partner & Managing Director of Price Asset Management