Macroeconomics

U[Pd]ate

Topics - Macroeconomics

${ numberSection } ${ text }
U[Pd]ate

Investors like to divide metals into two categories: base and precious. Base metals are used in industry to build things, while precious metals look pretty. 1 1 Close Precious metals are used in jewelry, coins and as a store of value. For the most part precious metals are precious because people think they are. While this distinction is almost universal in pricing monitors and research reports, it isn’t as clear as it may seem. Many supposedly precious metals have practical uses. Palladium is one such metal. 2 2 Close If you were wondering, the element symbol for Palladium is [Pd]. Palladium was named after an asteroid. The asteroid was in turn named in honor of the Greek goddess Athena who slayed Pallas. It’s rare and has a lustrous silvery texture which makes it a fine choice for coins and jewelry. But while ostensibly precious, palladium is primarily used in catalytic converters which perform the not-so-glamorous task of cleaning car exhaust. Demand for this dirty industrial use has sent Palladium’s price to four times where it was in 2016. It has made palladium more precious than most other precious metals.

Palladium may not be the most heavily traded metal, but it has had some extraordinary price moves. Most palladium is mined in Russia and more recently South Africa. 3 3 Close They account for 77% of global production (Bloomberg). For many years, Russia (and back when it was the Soviet Union) had been secretive about its stockpiles of the metal. In the late 1990s rumors circulated that Russian supplies were nearly depleted, and that the world faced a potential palladium shortage the likes of which had never been seen before. 4 4 Close Investors like to be dramatic!  , 5 5 Close WSJ, “Rhodium Prices Soar on Worries Russian Supplies are Dwindling”, 2/26/1998. Prices doubled, then doubled again. Then they doubled another time. At some point, folks realized that there was more Russian palladium than they had been led to believe. 6 6 Close Were they intentionally misled? We may never know. The market experienced what we quants refer to as “mean reversion.” It seemed like palladium would never reach those peak levels again – and it didn’t for almost another twenty years.

Since 2012 the palladium market has been in chronic deficit, meaning that consumption has exceeded production and stockpiles have been decreasing. 7 7 Close Reuters, “Graphic: Unstoppable palladium flirts with $2,000 for first time,” 12/18/2019. Recently there have been shocks in both supply and demand. On the supply side, troubles at the public electricity utility in South Africa have caused rolling blackouts at mines and hurt production. On the demand side, tougher environmental rules in China and other places have increased use of palladium in clean cars. The diesel scandal has also helped palladium. Diesel car exhaust systems are generally made from platinum rather than palladium, but consumers and regulators seem to prefer gasoline vehicles now.
Despite the enormous rise in prices, we’ve gotten very little reaction on either the supply or demand side. Higher prices should mean increased production. In the case of palladium and many other metals, it’s not so simple. New mining projects are expensive, risky and take time to become operational. It is even more difficult with palladium, because it is so rare. Much of it is extracted in small quantities found when mining other metals. It is kind of roundabout to mine more nickel in the hope that palladium will show up. There is no simple, quick way to get supply on the market.  

Higher prices have not seemed to deter buyers either. Palladium is not a large part of the cost of a car, so manufacturers, consumers and sellers can absorb the costs. There is a lack of substitutes. Even if you assume that all the cost is passed to the consumer, it would take a much bigger move to push a significant number of people back into diesel cars. Manufacturers could possibly construct gasoline catalytic converters with platinum instead of palladium, but this would require expensive investments in technology, and the switchover would not necessarily go smoothly. Some analysts have questioned the long-term viability of any such investment as many car manufacturers are looking to pivot to electrical cars which don’t require catalytic converters.

While electrical cars may be helping palladium prices temporarily, they represent a big threat. Electrical cars do not require palladium, so demand may plummet as they become a larger chunk of new car sales. Electrical cars aren’t the only threat to prices. One often forgotten source of palladium is increasing: scrap. Palladium is being recycled from out of service cars. It is getting to the point where thieves remove catalytic converters from parked cars to sell it on the black market. 8 8 Close We are not trying to give you any ideas.   This is probably a signal that palladium is overvalued. 9 9 Close WSJ, “Thieves Mine Catalytic Converters for Metal More Valuable Than Gold,” 2/10/2019. In addition, any slowdown in activity caused by the coronavirus could reduce demand for cars and palladium. Traders seem to think these factors will bring palladium prices back down. Palladium futures are in backwardation meaning that prices for delivery further out in time are lower than the current ones. This is consistent with a temporary shortage.

This recent move in palladium is instructive for investors even if they don’t normally trade the metal. It gives some important clues about how commodity markets work. The reason that commodity markets can have unusually large moves is that when supply and demand get out of balance, stabilizing forces can be slow to come into play. Supply and demand can be quite rigid in the short run. Change takes time, whereas shortages are immediate. It takes enormous price moves to get a reaction. That is why commodities have such large trends in the short and medium term. But eventually the changes are made, and the trends end. In the long run there is that famed mean reversion. Even the most precious of metals experience it. 

What We Are Watching

Iowa Caucuses (Monday Evening)

The first contest of the U.S. Presidential Primary will take place this week, kicking off a months-long process of deciding which Democrat will challenge President Trump in November. While former Vice President Joe Biden has held a fairly consistent lead in national polls, his support is somewhat weaker in Iowa and New Hampshire, the first states to vote. In both states, Senator Bernie Sanders has led in recent polls, with Senator Elizabeth Warren and Mayor Pete Buttigieg not too far behind. Strong performances in Iowa have provided a boost to some candidates in past elections, and the outcome of this week’s caucuses could impact future states. If Biden were to win in Iowa, it would put him in a strong position as the race turns towards more favorable states such as South Carolina. A victory by Sanders or Warren, who appear to be splitting the support of more left-wing party members, might cause those voters to consolidate around one candidate. A victory by centrist Buttigieg, whose national polling has remained subdued, would leave the race wide open. U.S. equities may respond favorably to a win by a centrist candidate, i.e., Biden or Buttigieg, and negatively to a win by Sanders or Warren, who have advocated policies that might be problematic for large corporations. 

China Manufacturing PMI (Monday)

China’s Caixin PMI showed signs of improvement in the fourth quarter of 2019, extending a gradual rebound from its June trough. Stimulus from Chinese authorities likely supported business sentiment in the second half of 2019 and the Phase 1 trade deal between the U.S. and China could further bolster confidence. However, with the coronavirus outbreak disrupting transportation and retail activities in China, sentiment may take a blow in January. Given the collection period for the Caixin survey (“mid-month”), the January release may only show partial impact from the outbreak, but the market will pay close attention to any early signs of softening business sentiment on the back of this public health crisis. Weaker-than-expected data may prompt declines in global equity markets, particularly in Asia, as well as safe-haven flows into developed market bonds.

U.S. Employment Report (Friday)

Data releases in recent months have pointed to continued health in the U.S. labor market, even as other measures of economic growth have slowed somewhat. However, employment data was a bit softer than expected in December, and another disappointing result might generate concern among policymakers and investors that job growth is decelerating. Wage gains have also moderated over the last year, and a continuation of this trend would underscore that inflationary pressure remains subdued despite the low level of the unemployment rate. While the Fed has signaled an on-hold stance at recent meetings, sustained deterioration in labor market data would likely be enough to prompt renewed discussion of rate cuts. 

 

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.

 

Past performance is not a guarantee of future performance.

 

This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

 

The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.

 

The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.