$RJA It's Time For The Agricultural 'Treasures' To Shine Again
http://seekingalpha.com/article/4040074-agric...;dr=1#alt2
Harry Kourouklis
Summary
Agricultural commodities have underperformed hard commodities for a long time, completing a mult-year cycle.
Baltic Dry Index broke its principal upward trendline to the downside, signaling that soft commodities might be ready to outperform hard commodities again.
This triggers a spread trade involving a long position on agricultural commodities versus short positions on base metals and energy.
This spread strategy has an excellent risk-reward profile and its performance is uncorrelated with the rest of the risk assets.
Agricultural commodities have been out of fashion for some time now. However, they seem poised to shine again. Sure, soft commodities have not been without gains recently. Still, they have severely underperformed the rally in the rest of the basic commodities spectrum, leaving a substantial gap that needs to be filled. Now, it seems that the time has come for agricultural commodities to turn on the engines and respond to an accelerating global business cycle, taking the lead from energy and metals. Soft commodities will most certainly benefit the most from any further acceleration of the global reflationary cycle, while they will get hit the least in case of a less likely worldwide downfall. This opens a window of opportunity for a synthetic spread strategy consisting of a long position in agricultural commodities coupled with a short position on base metals and energy. This strategy utilizes a combination of positions which is quite uncorrelated with the rest of the risk assets, reaping the benefits of diversification. It also has an excellent risk/reward profile, since its entry point is close to the lows of the multi-year cycle of soft versus hard commodities, and is triggered by very credible signals.
Triggering The Soft vs. Hard Commodities Trade
As a matter of fact, the trigger for entering into this spread strategy comes from the behavior of a very important shipping Index. The upward trend of the Baltic Dry Index [BDI], a gauge of shipping costs of dry materials across popular sea routes, underpinning an accelerating industrial demand for basic raw commodities, is challenged. For the first time in the last twelve months the BDI broke its upward trendline to the downside. Almost every time in the past that the BDI sent similar signals of uptrend exhaustion, soft commodities outperformed their hard counterparts by a wide margin.
Since the Great Financial Crisis, there have been five distinct occasions when the BDI crossed its upward trendline to the downside. The median over-performance of agricultural products against metals and energy was 5.7% one month since the crossover date. The outperformance increased to a median 6.4% over the following two months since the crossover date. These statistics make the latest penetration of BDI's uptrend a very interesting one, since it provides the proper trigger for the initiation of the soft versus hard commodities spread trade. Why should we expect agricultural products to outperform metals and energy? Because BDI's behavior has two possible interpretations both of which are more supportive for soft rather than for hard commodities.
Macro Interpretations
The first macro interpretation of the BDI signal is that last year's excessive speculative activity on basic industrial commodities, originating mainly from China, is finally curtailed. This came as a result of the meticulous effort of Chinese authorities to curb financial bubbles in their economy. However, the normalization of base commodities price behavior comes at a time of an on-going acceleration in the global business cycle. This means that regional demand for food will ultimately shift upwards, especially in EM economies.
In this optimistic scenario, any increase in energy demand from the emerging world will coincide with strong counterforce. Firstly, Japan's strategic turn towards atomic power for the first time since the 2011 supply shock, could leave the global demand for fossil fuels short of a crucial player. After all, it was Japan who became the largest coal importer in the world last year. Secondly, the energy market would definitely face increased supply from Saudis' intention to produce oil at full capacity as soon as possible, in order to finance their revenue-starving budget, and prevent oil prices from forming the devastating bubbles of the past. Thirdly, Donald Trump's pursue of accelerated US oil and gas production, through a series of initiatives such as the signing of major pipeline projects and the deregulation of the domestic mining and drilling industry, could unleash another big supply shock.
The other interpretation of BDI's behavior is that it is an early warning signal about the peak of the global reflationary cycle, and the ultimate return of deflation. This scenario, though, seems less probable since the global bear steepening market in government bonds, i.e. a faster rise of long-term in relation to short-term yields, is still in full force.
In either case, though, agricultural commodities seem positioned to benefit the most against the rest of the commodities spectrum (including the precious metals). This makes the spread trade very attractive, since it has the capability to perform well in the optimistic as well as the adverse macro scenario. If the growth cycle does accelerate from current levels, then soft commodities will most certainly pick up the slack they have left against their hard counterparts. If on the other hand, the world growth engine hits on a wall, then hard commodities will definitely get hit much harder than their soft peers.
The relationship between agricultural commodities and base metals as well as energy, has been quite volatile in the past, and has moved in a cyclical way. The latest such mega-cycle began back in early 2014 and peaked in early 2016 with soft commodities reaching their best prices in relation to metals and energy. Then agricultural commodities started to devalue in relation to hard commodities until early this year. The completion of this major cycle brought the ratio of soft to hard commodities to test the support of its multi-year upward trendline, which has successfully held so far. This move allows investors to take advantage of an alluring investment case.
Investment Implications
Currently the ratio of agricultural commodities to base metals and energy offers a unique point of entry for a strategy which bets on its rebound, because the stop-loss level can be quite tight with respect to the upside potential. A strategy consisting of a long position on soft commodities (NYSEARCA
BA) on the one hand, and an equal-sized short position split between base metals (NYSEARCA BB) and energy (NYSEARCA BE) on the other, could take advantage of the upside gap that metals and energy have created. The basic advantage of this spread position is that it minimizes the risk from a downfall of the global economic cycle, since in such a case the short positions on hard commodities would outperform. Base metals and energy would be the first in line to plummet and return to their multi-decade lows again, while soft commodities have certainly less downside potential. On the other hand, of course, a genuine acceleration of the global economy would support the extension of hard commodities bull market for sure. Yet, it would also turn investors' attention towards the neglected agricultural sector and would fuel a big rally in their prices down the line.
All these point out that the timing has most certainly come for the neglected agricultural "treasures" to shine again. A smart strategy which bets on the relative outperformance of soft versus hard commodities is the proper way to bet on the optimistic global macro scenario. However, this strategy entails enough cushions to handle even the pessimistic one as well. Having said that, one of the biggest anomalies in global markets is most certainly located in the discrepancy between soft and hard commodities; and it's only a matter of time before this anomaly attracts enough investor interest.
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.
http://seekingalpha.com/article/4040074-agric...;dr=1#alt2
Harry Kourouklis
Summary
Agricultural commodities have underperformed hard commodities for a long time, completing a mult-year cycle.
Baltic Dry Index broke its principal upward trendline to the downside, signaling that soft commodities might be ready to outperform hard commodities again.
This triggers a spread trade involving a long position on agricultural commodities versus short positions on base metals and energy.
This spread strategy has an excellent risk-reward profile and its performance is uncorrelated with the rest of the risk assets.
Agricultural commodities have been out of fashion for some time now. However, they seem poised to shine again. Sure, soft commodities have not been without gains recently. Still, they have severely underperformed the rally in the rest of the basic commodities spectrum, leaving a substantial gap that needs to be filled. Now, it seems that the time has come for agricultural commodities to turn on the engines and respond to an accelerating global business cycle, taking the lead from energy and metals. Soft commodities will most certainly benefit the most from any further acceleration of the global reflationary cycle, while they will get hit the least in case of a less likely worldwide downfall. This opens a window of opportunity for a synthetic spread strategy consisting of a long position in agricultural commodities coupled with a short position on base metals and energy. This strategy utilizes a combination of positions which is quite uncorrelated with the rest of the risk assets, reaping the benefits of diversification. It also has an excellent risk/reward profile, since its entry point is close to the lows of the multi-year cycle of soft versus hard commodities, and is triggered by very credible signals.
Triggering The Soft vs. Hard Commodities Trade
As a matter of fact, the trigger for entering into this spread strategy comes from the behavior of a very important shipping Index. The upward trend of the Baltic Dry Index [BDI], a gauge of shipping costs of dry materials across popular sea routes, underpinning an accelerating industrial demand for basic raw commodities, is challenged. For the first time in the last twelve months the BDI broke its upward trendline to the downside. Almost every time in the past that the BDI sent similar signals of uptrend exhaustion, soft commodities outperformed their hard counterparts by a wide margin.
Since the Great Financial Crisis, there have been five distinct occasions when the BDI crossed its upward trendline to the downside. The median over-performance of agricultural products against metals and energy was 5.7% one month since the crossover date. The outperformance increased to a median 6.4% over the following two months since the crossover date. These statistics make the latest penetration of BDI's uptrend a very interesting one, since it provides the proper trigger for the initiation of the soft versus hard commodities spread trade. Why should we expect agricultural products to outperform metals and energy? Because BDI's behavior has two possible interpretations both of which are more supportive for soft rather than for hard commodities.
Macro Interpretations
The first macro interpretation of the BDI signal is that last year's excessive speculative activity on basic industrial commodities, originating mainly from China, is finally curtailed. This came as a result of the meticulous effort of Chinese authorities to curb financial bubbles in their economy. However, the normalization of base commodities price behavior comes at a time of an on-going acceleration in the global business cycle. This means that regional demand for food will ultimately shift upwards, especially in EM economies.
In this optimistic scenario, any increase in energy demand from the emerging world will coincide with strong counterforce. Firstly, Japan's strategic turn towards atomic power for the first time since the 2011 supply shock, could leave the global demand for fossil fuels short of a crucial player. After all, it was Japan who became the largest coal importer in the world last year. Secondly, the energy market would definitely face increased supply from Saudis' intention to produce oil at full capacity as soon as possible, in order to finance their revenue-starving budget, and prevent oil prices from forming the devastating bubbles of the past. Thirdly, Donald Trump's pursue of accelerated US oil and gas production, through a series of initiatives such as the signing of major pipeline projects and the deregulation of the domestic mining and drilling industry, could unleash another big supply shock.
The other interpretation of BDI's behavior is that it is an early warning signal about the peak of the global reflationary cycle, and the ultimate return of deflation. This scenario, though, seems less probable since the global bear steepening market in government bonds, i.e. a faster rise of long-term in relation to short-term yields, is still in full force.
In either case, though, agricultural commodities seem positioned to benefit the most against the rest of the commodities spectrum (including the precious metals). This makes the spread trade very attractive, since it has the capability to perform well in the optimistic as well as the adverse macro scenario. If the growth cycle does accelerate from current levels, then soft commodities will most certainly pick up the slack they have left against their hard counterparts. If on the other hand, the world growth engine hits on a wall, then hard commodities will definitely get hit much harder than their soft peers.
The relationship between agricultural commodities and base metals as well as energy, has been quite volatile in the past, and has moved in a cyclical way. The latest such mega-cycle began back in early 2014 and peaked in early 2016 with soft commodities reaching their best prices in relation to metals and energy. Then agricultural commodities started to devalue in relation to hard commodities until early this year. The completion of this major cycle brought the ratio of soft to hard commodities to test the support of its multi-year upward trendline, which has successfully held so far. This move allows investors to take advantage of an alluring investment case.
Investment Implications
Currently the ratio of agricultural commodities to base metals and energy offers a unique point of entry for a strategy which bets on its rebound, because the stop-loss level can be quite tight with respect to the upside potential. A strategy consisting of a long position on soft commodities (NYSEARCA
BA) on the one hand, and an equal-sized short position split between base metals (NYSEARCA BB) and energy (NYSEARCA BE) on the other, could take advantage of the upside gap that metals and energy have created. The basic advantage of this spread position is that it minimizes the risk from a downfall of the global economic cycle, since in such a case the short positions on hard commodities would outperform. Base metals and energy would be the first in line to plummet and return to their multi-decade lows again, while soft commodities have certainly less downside potential. On the other hand, of course, a genuine acceleration of the global economy would support the extension of hard commodities bull market for sure. Yet, it would also turn investors' attention towards the neglected agricultural sector and would fuel a big rally in their prices down the line. All these point out that the timing has most certainly come for the neglected agricultural "treasures" to shine again. A smart strategy which bets on the relative outperformance of soft versus hard commodities is the proper way to bet on the optimistic global macro scenario. However, this strategy entails enough cushions to handle even the pessimistic one as well. Having said that, one of the biggest anomalies in global markets is most certainly located in the discrepancy between soft and hard commodities; and it's only a matter of time before this anomaly attracts enough investor interest.
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.
