A marriage on the rocks: Copper and US equities take a break

A marriage on the rocks: Copper and US equities take a break

For the first time since 2006, correlation between the S&P500 and copper has fallen to -0.59

  • Longer term, copper and broader commodity markets should rally significantly
  • Shorter term, we expect to see lower levels for copper
  • Analysis suggests a move towards US$5500 a tonne into the middle of the year (25% below current levels)

In wake of Monday’s worse than expected China GDP data, global commodity markets look increasingly shaky, highlighted by the biggest two day sell-off in gold since 1983.

Despite global central banks printing endless amounts of money in an effort to bolster economic growth, commodity markets have largely languished sideways since 2011. Meanwhile U.S. equity markets have surged to record highs. Many investors have been left scratching their heads, as many viewed inflation levels should be a concern by now, consequently leading to a broad appreciation in commodity prices.

Divergence between copper and US equities

Since 2011, broader commodity markets have essentially decoupled from U.S. equities. Up until earlier this year, the correlation between equities and copper has been north of 0.80.

But in a rare occurrence, for the first time since 2006, a strong negative correlation between stocks and copper now exists. As seen on chart 1, correlation between the S&P 500 Index and copper has fallen to -0.59. A key reason for the divergence between U.S. equities and copper is largely related to the nature of current central bank policy settings and rising copper inventory levels amid the fastest supply growth in over a decade.

With central banks keeping corporate borrowing costs essentially near zero, corporate profitability, despite ongoing economic shocks in Europe, is at record levels (chart 2). Meanwhile, copper has suffered from falling demand levels and increasing rates of production, as miners look to match anticipated demand levels from emerging economies. Quantitative easing programs are mostly assisting corporations at this stage, and not commodity prices.

Inflation expectations and commodity markets

We’ve already seen large selling in gold on concerns that future inflation levels might be tamer than first thought, and as investors again favour US dollars as an investment currency. The sell-off in gold could be a bellwether of possible future price action in broader commodity markets, including copper.

As many investors bought commodities in anticipation of future inflation stemming from historic money supply levels, commodity markets and inflation expectations (chart 3: zero coupon 5 year inflation swap) have been inexorably linked. Reduced inflation expectations are puzzling to investors given the recent announcement that the Bank of Japan will double its monetary base, in an attempt to reach a 2% inflation target.

So regardless of increasing global money supply, market participants are pricing in slower growth rates and lower future inflation levels near-term. Therefore, further downside in inflation expectations would likely see copper fall to multi-year lows.

Inventory levels

Warehouse inventory levels for copper are at the highest levels since the early 00’s. As seen on chart 4, there is a clear inverse relationship between inventory levels and copper prices.And again, the recent surge in inventory levels has seen a sharp decline in copper prices.

As copper miners obviously respond to rising inventory levels by cutting production rates, we could see copper supply reverse in the coming months, especially with the landslide at Rio Tinto’s copper mine on April 10.

Essentially, the surge in inventory levels is likely a consequence of miners meeting perceived high levels of demand from emerging economies.  And with emerging economies such as China slowing more than expected, high inventory levels is an obvious result of slowing growth. With copper miners looking to stem production rates in an effort to curb high inventory levels, we should expect to see these normalise.

A Technical Approach to Copper

The study of price charts is a valuable tool in that it allows us to firstly ascertain which markets have the higher probability of embarking on a trend, and secondly, assessing at what levels our analysis is wrong.

Copper, based on the current chart pattern, is a market of interest at present, in that recent developments suggest an end to the recent phase of consolidation, in place for over 12 months, and a trend lower is now underway. 

Looking more in depth at the weekly price chart to the left, and despite the price having weakened by over 10% since the beginning of February, given the recent break below a large triangle consolidation pattern, there is a high probability of much lower levels over the coming months. The pattern target, determined by projecting the depth of the pattern down from the breakout level, suggests a move towards US$5500 a tonne into the middle of the year, a level some 25% below current levels of US$7406 a tonne. 

It would take a reversal back above US$8000 a tonne to negate this analysis. 

In addition to the current bearish chart pattern, we would expect the growing supply of available metal will continue to pressure prices in the near term. A good snapshot of the current demand/supply dynamic is available by looking at the changes to the available stocks in the London Metal Exchange (LME) warehouse, whereby the increase in available stocks suggests that supply is currently greater than demand.

As shown on the chart to the right, the current stock level has been rising aggressively over the past six months, increasing by as much as 180% in the 6 months from 16 October 2012 low at 0.211 million metric tonnes to a high of 0.594 million metric tonnes, moving to the highest level in 10 years.  

The chart to the left overlays the changes in LME stocks (orange line) and the price (white line). Visually, there seems to be an inverse correlation, that being that when the available stocks are rising (supply is greater than demand), the price is moving lower. In addition to the current 6 month period, significant increases in the available stocks has occurred two times previously, that being in the second half of 2009 and also from mid 2008 to early 2009.

In the first instance, the copper price actually moved higher in line with rising stocks, before then trading sideways for several months. In 2008 however, we did witness a sharp move lower in price, as stocks rose higher. 

Looking at the relationship more objectively, and we can see that the typical relationship is one of an inverse correlation. The chart on the right plots the changing correlation since 2003. Below the zero line (red), the price is moving lower as stocks are rising, while above the zero line (green), the price is moving higher as stocks are moving higher.

This is a valuable chart, in that it shows that the majority of the time, there is an inverse correlation, but that such a relationship is not constantly static. 

Outlook for Copper

Longer-term however, a strong bullish case for commodities, including copper, exists. Combining renewed growth in emerging economies with the potential for high global inflation levels, copper has plenty of upside. 

It really is a matter of time before inflation becomes an issue for the global economy. And when it does, copper and broader commodity markets should rally significantly from current beaten down levels. 

But in the short-term, with inventory levels so high, and concerns surrounding the growth of China, we could see further downside in the price of copper.

Short-term downside momentum will likely see lower levels for copper in the near-term, but with expectations production rates will reduce in the coming months, we could see the widening divergence (chart to the right) between equities and copper begin to narrow. This will come in the form of inflation expectations increasing amid falling supply levels, leading to an appreciation in copper prices while equity prices remain elevated.

Alternatively, we we see a further slowdown in global growth rates, likely leading to equity markets correcting to lower levels, more in-line with broader commodity markets, including copper.

To better understand near-term direction however, we refer to our technical analysis on the weekly price chart for copper which suggests a move towards US$5500 a tonne into the middle of the year, a level some 25% below current levels of US$7406 a tonne.

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