After a brutal run in January through to mid-February, on the surface of it the FTSE 100 Index has recovered lost ground climbing to 6,300 points having started the year at 6,242. So does this mean the January wobble and endless Brexit navel gazing has all been a storm in a tea cup?
When you scratch beneath the surface of the headline level of the FTSE 100 however, it becomes all too clear just how narrowly based the market fight back has been. As the below chart shows, this has largely been down to the incredible rally in commodity stocks. The grey line is the FTSE 100 Index, yellow line represents UK listed oil, gas and mining shares and the blue line is the FTSE 100 Index minus these shares. In other words, without exposure to these commodity sectors, the FTSE 100 has yet to catch up with the where it started the year.
The enormity of the bounce in commodity stocks has caught most fund managers by surprise, including some of the very best names in the business, with most actively managed UK equity funds having underperformed over the quarter. That’s because many managers have been underweighting or ignoring these sectors for fundamental reasons. Worse off still are some long/short funds, which have been wrong-footed by having short positions on commodities and emerging markets.
So what on earth is going on?
There are a number of factors which may explain the rally in commodities. These include more dovish statements from the US Federal Reserve which has seen expectations of a normal US rate hiking cycle evaporate, leading to a softening of the US dollar and relieving pressure on emerging markets but also commodities. Alongside this has been a further monetary expansion in China to stimulate economic activity, but which has also seen China’s debt to GDP ratio test reach new levels that will renew concerns about the fragility of its financial system. And in the case of oil, there were also pent up hopes that a deal would be reached in Doha to limit production – a deal which was ultimately quashed by the Saudis refusing to agree when their arch-foe Iran failed to come to the table.
Also at work are likely to be some technical factors. Many hedge funds with short positions on commodities will have been scrabbling to unwind these in the face of rising share prices, which means buying the shares they’d previously sold back to return them to the stock lender. That’s likely to have had the effect of boosting prices as squeezed funds have stampeded for the exit. But another factor, covered in a fascinating blog by Woodford Investment Management entitled Bubble Trouble is that Chinese private investors have been trading vast volumes of futures on the Dalian Commodities Exchange, so we could be seeing another manifestation of the speculative bubble that was lanced in the Chinese equity market at the start of the year.
The question investors face is whether this rally in commodities is warranted and sustainable, or if it is a dead cat bounce fuelled by speculative behaviour and technical factors?
In the case of oil, despite the failure to achieve an agreement to limit supply in Doha, there is a gradual rebalancing of supply and demand going on as the Saudi strategy of defending market share by strangling the US shale industry proves effective. Fracking firms are continuing to go bust in the US at a rapid pace. According to Guinness Asset Management, US oil directed rig counts have slumped to 329, down from a peak of 1,609. But the road ahead for the oil price could yet remain volatile, as Iran and Libya are a long way under their potential productive capacity and, importantly, oil is a weapon of policy in the region so future moves can be highly unpredictable. Even with a process of rebalancing, the price of oil may eventually stabilise at a level that remains substantially below where it traded at a couple of years ago, as the Saudi break-even point is well below that of Iran.
The strength of the broader rally in raw materials and industrial metals looks overdone given the anaemic outlook for global growth and overcapacity in supply, so even if the bear market for commodities has finally run its course, investors should be very careful about jumping enthusiastically on the commodities bandwagon at this stage.