Quantix Q3 2024 Newsletter

Commodity markets recently reached a notable turning point as three significant events injected renewed interest into the asset class. First, the US Federal Reserve (“Fed”), finally started on a cycle of interest rate cuts. Second, the Chinese followed suit on the easing of financial conditions with a massive stimulus package of their own. Finally, geopolitical tensions in the Middle East have seemingly reached a critical level as Iran has been brought directly into the fray.

We believe that each of these events might have significant bullish implications for commodity markets. In this quarter’s newsletter, I will discuss each of these catalysts and why they can provide substantial tailwinds for commodities and attract investment capital through the end of 2024 and beyond.

In the third quarter of 2024, investor interest in commodity markets continued to wane as prices in many sectors made multi-year lows, volatility was remarkably muted, and positioning continued to decline to historically low levels. However, the aforementioned catalysts have led to a sizable recovery in many areas.

The Turning Point

Despite some individual signs of life in May, notably Copper achieving an all-time high, broad commodity markets gradually declined for most of the third quarter. In fact, the Bloomberg Commodity Index (“BCOM”) hit a three-year low on 10-Sep-24, marking a 32% decline (gross) from the June 2022 peak.

The lackluster price performance and light positioning has also contributed to subdued volatility for most of 2024. In fact, through the first three quarters of 2024, BCOM did not register a single day with an absolute move greater than 2%; through September the biggest gain was +1.57% on 17-May-24 and the biggest loss was -1.65% on 30-Apr-24. For comparison, the same period in 2022 featured 36 days (roughly one fifth) with daily moves over the 2% threshold.

In late September, however, three significant events jolted the commodity market out of its doldrums. The US Fed finally began to cut interest rates and did so in a notable way by delivering an accommodative 50 basis point cut. Not to be outdone, the Chinese followed suit in easing financial conditions with a massive stimulus package of their own. By taking a combination of unusually bold measures of rate cuts, lower bank reserve requirements, lower mortgage rates, lower downpayment requirements, and equity buy-back support, they sparked not only a Chinese equity rally but also a significant recovery in many commodities.

Finally, the escalation of geopolitical tension in the Middle East with Iran’s direct involvement sparked a 5 day, 13% rally in oil prices. With a now credible threat of a genuine loss of crude oil supply, there exists the potential for significantly higher prices if the conflict widens to oil infrastructure.

While each of these catalysts is broadly supportive for commodities, we believe their impact should be felt most acutely in separate and distinct sectors. For example, lower interest rates should benefit the Precious Metals sector; Chinese stimulus should provide a boost to the Industrial Metal sector; and any loss of crude oil supply could send Petroleum prices higher. This diversification of drivers makes the bullish argument even more compelling.

In the 17 trading days from 10-Sep-24 to 03-Oct-24, every commodity in the BCOM index had positive returns. Usually, a correlated move would result in higher basket volatility; however, the index rallied an impressive 9% with an annualized volatility of only 7.8%. This is less than half the three-year average annualized volatility of 17%, as independent catalysts in each sector meant that daily returns were not as correlated.

Source: Quantix Commodities

US Interest Rate Cuts

There is a considerable amount of data that evidences strong historical commodity performance in past rate easing cycles. This has been particularly true if the cuts do not coincide with a recession, as is currently the case. A recent Goldman Sachs research report (chart below) suggests that the boost to some commodities and sectors of a policy-induced, 100 basis point drop in US 2-Year Yields could be as much as 5% of immediate price impact.

Interest rate cuts in a non-recessionary environment typically lead to higher commodity prices

Source: Goldman Sachs Global Investment Research, “GOAL Kickstart: China catch-up - tracking cross-asset repricing in the bullish reversal”, 30-Sep-24, COMEX, ICE, NYMEX, Federal Reserve Board

While US interest rate cuts appear supportive for nearly all commodities, we believe they could be particularly beneficial for Precious Metals. Central bank “de-dollarization” helped support Gold while rates were high over the past two years and rate cuts have now been responsible for bringing private sector investors back into the mix. Inflows into Gold ETFs and Precious Metal COT positioning are the exception to the lackluster investor interest as each has rebounded quite strongly over the past quarter.

Some commentators see extreme positioning as a reason for caution; I believe this data is misleading. Such metrics are relevant if you assume that previous Gold ownership peaks represent maximum potential Gold exposure. However, there is substantial incremental private sector buying that can occur outside of ETFs and Gold futures markets. Bloomberg recently ran an article¹ highlighting the incredible demand for gold bars at Costco, which are sold out across the US. This physical demand is not captured in previous Gold ownership metrics.

Even more compelling is the asymmetry of this type of flow. I have noted before that central bank gold holdings typically only change over long cycles so prices are not typically at risk from a sudden mass liquidation from that market segment. Similarly, retail buyers from Costco are also likely in for the long-haul if, for no other reason, that they have no easy way to sell their exposure (Costco does not offer a two-way market!).

An additional supportive element for commodity prices from lower rates is their capacity to incentivize inventory builds. High financing costs have discouraged market participants from storing commodities and, as a result, inventories across many sectors are at historic lows. While lower rates could also spur consumption, inventory builds could be an additional source of commodity demand.

Chinese Stimulus

Beijing’s aggressive policy shift is the second potential tailwind for commodity prices. As China is the largest consumer of Industrial Metals, this sector should benefit most from their actions and Copper had an immediate bounce since it was announced.

Some are questioning the permanence of this move if the monetary easing is not accompanied by substantial fiscal stimulus, but I personally am not as concerned. China has long sought to grow through personal consumption rather than manufacturing for export. The current weak demand numbers have largely come from a populus that has lost confidence and chosen to save rather than spend.

While the household wealth effect from higher asset prices is certainly less powerful than in the US, higher prices can easily lead to a much-needed sentiment shift in consumer psychology that could ultimately be bullish for onshore commodity demand.

For those concerned about the current state of Chinese economy, it is worth remembering that commodity markets are spot assets, and that reality has likely already been priced into markets. Therefore, any stimulus measures that are implemented are most likely more bullish.

Geopolitical Tensions in the Middle East

While hostilities in the Middle East have sadly been a near constant for more than twelve months, the conflict has previously been largely contained to Israel, Gaza and Lebanon. Iran’s missile attack on Israel in response to the Israeli attacks on Hezbollah has now brought a major oil producer directly into the fray.

While there remains tremendous uncertainty on the outcome, several plausible scenarios put a significant amount of oil supply at risk. Wall Street analysts have been writing extensively on this topic and JPMorgan recently outlined 4 possible Israeli response options and offered their view on the effect on oil prices:

Source: JPMorgan, “Daily Market Comment”, 07-Oct-24

While I agree with the potential different responses, I am not nearly as bearish on price if the retaliation is “limited” to a strike on air defense facilities. It is notable that each response is an escalation from the action taken post the Iranian missile attack in April 2024. I do not believe the market will be comfortable discounting further escalation enough to push oil prices materially lower than $70 in almost any scenario. I also believe the odds of the higher price scenarios are higher than the market is pricing.

It appears to me that Israel is attempting to achieve regional objectives that it has desired for years and it now feels it has at least enough implicit acceptance - if not outright approval - to execute on these plans. The extension of Israeli Defense Force (“IDF”) action against Hezbollah in Lebanon and the spy-novel pager attack is evidence of the sophisticated techniques they have at their disposal and are willing to use.

Source: Goldman Sachs, “Oil Analyst: Q&A on Risks to Supply in the Middle East”, 04-Oct-24

By evoking an Iranian missile attack, it’s easy to believe that this will green-light further retaliatory aggression from the Israelis that may go well beyond what other actors (such as the US or China) might desire with an ever-greater risk of attacks on oil infrastructure.

Iran produces 3.5m barrels per day (mbpd) and exports roughly half that amount². Because of sanctions, most of that oil goes to China but, if that supply is crippled in an attack, China will be forced back into global markets to compete for barrels. In the most bullish potential scenario that was not in JPMorgan’s list, it is conceivable that Iran could attempt to socialize the losses by attacking production facilities in Saudi Arabia or other Gulf states. In my mind this is not as far-fetched as some make it seem.

On the political front, the Ayatollah is 85 years’ old and the Iranian regime seems desperate. They clearly do not have the sophisticated weaponry that Israel possesses and their principal ally in the region, Hezbollah, has been badly impacted. This level of desperation has the potential to escalate the conflict.

Goldman Sachs estimates that a persistent 1mbpd disruption to Iranian supply could push prices at least to the mid USD80s, depending on OPEC’s response. A 2mbpd disruption to supply could raise Brent Crude Oil prices to at least USD90 a barrel by 1Q25, depending on OPEC’s response.

Conclusion

Commodity markets enter the fourth quarter of 2024 with a potentially bullish plethora of distinct catalysts. I believe that the policy actions in the US and China, as well as the geopolitical tensions in the Middle East, to be significantly impactful for commodity markets, each providing a supportive tailwind for different sectors of the market.

I would be remiss if I do not comment on the upcoming US elections. Depending on the outcome, this could be yet another jolt to commodity prices, with different impacts on different sectors. The most bullish outcome would be a single party sweep (for either side of the aisle) which would likely lead to much greater fiscal spending. The corresponding increased deficits would almost certainly add to the bull story for Precious Metals. If that increased spending prioritized growth initiatives, it could have a knock-on effect on Industrial Metals. Tariffs could impact agricultural markets. An increase in US Natural Gas production and the potential for Russian natural gas to either remain off or come back to the market would affect global gas prices. Volatility could pick up in the short term as the market reacts and prices in these different scenarios.

In closing, I wanted to express my appreciation for the individuals I get to work with as part of this business. We recently celebrated the 6-year anniversary of Quantix and it gave me an opportunity to reflect on the growth of our firm.

While I am incredibly proud of our business achievements, the most rewarding part of the experience has been the people I get to interact with on a daily basis. From our (now) 23 hardworking Quantix team members to the partnerships with our impressive investors, the personal interactions are forever interesting and inspiring.

Sincerely,

Don Casturo CIO, Quantix Commodities LP

Important Information

1. Goldman Sachs, “Oil Analyst: Q&A on Risks to Supply in the Middle East”, 04-Oct-24

2. Goldman Sachs, “Oil Analyst: Q&A on Risks to Supply in the Middle East”, 04-Oct-24

The views expressed herein are those of Quantix Commodities at the time the comments were made. These views are subject to change at any time based upon market or other conditions, and the author/s disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions are based on many factors, may not be relied upon as an indication of trading intent. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

Performance data shown represents past performance and is no guarantee of future results.

The Bloomberg Commodity Index (“BCOM”) is designed to be a highly liquid and diversified benchmark for commodity investments via futures contracts. The index listed is unmanaged and does not reflect fees and expenses and is not available for direct investment.

The Quantix Commodity Total Return Index is calculated on a total return basis, which combines the returns of the futures contracts with the returns on cash collateral invested in 13-week U.S. Treasury Bills. This unmanaged index does not reflect fees and expenses and is not available for direct investment. The Quantix Commodity Index was developed by Quantix Commodities LP and is owned by Quantix Commodities Indices LLC.

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions.

Forecast and estimates are based on hypothetical assumptions and for informational purposes only.

A basis point is one hundredth of 1 percentage point.

References to specific company securities are for illustration only and should not be construed as an offer or solicitation from Harbor Capital to buy or sell any securities.

Commodities Risk – The value of commodities investments will generally be affected by overall market movements and factors specific to a particular industry or commodity including weather, embargoes, tariffs, or health, political, international and regulatory developments.

The Rigobon method, also known as the Forbes and Rigobon method, is a method for analyzing contagion and adjusted correlation. It's a basic approach that compares the correlation during a crisis period to the correlation over the entire sample period.

Ordinary Least Squares (OLS) regression is a method for estimating the relationship between a dependent variable and one or more independent variables by minimizing the sum of the squared differences between observed and predicted values.

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