U.S. President Donald Trump swept into Europe this week like a storm. With little time for traditional diplomacy, the straight-talking and non-filtered leader of the free world put his stamp on the NATO meeting at the introductory breakfast. President Trump took the members to task over low military contributions and singled out Germany for buying billions of dollars in energy from Russia. The President sat before cameras and questioned how Germany could funnel billions into Russia and then ask the United States to pay more than its fair share to protect the country with Europe’s largest economy from the Russians.
European leaders had their hands full with the leader of the free world this week. Aside from the lecture at the NATO meeting about repeated calls for contributing a larger percentage of GDP towards defense and worries over Monday’s go-it-alone summit with Vladimir Putin, U.S demands for “reciprocity and fairness” in trade has put the world on the brink of a trade war. European leaders, and particularly German leader Angela Merkel have opposed the protectionist measures from the Trump administration, but some of her constituents agree with the President. German automobile manufacturers have publicly advocated for doing away with all tariffs, which would suit the U.S. President.
Tariffs are impacting commodities prices
Tariffs stand in the way of free trade. Commodities are essential products that are consumed all over the world. Commodity production occurs in areas around the globe where the crust of the earth has abundant supplies of energy, minerals, metals, and ores as well as where soil and the climate support crop growth. Therefore, output is a localized affair with only some countries rich in these raw materials. With regional output and ubiquitous consumption, governments and individuals all over our planet depend on the flow of commodities from points of production to widespread areas of demand.
Tariffs are barriers that distort the economics of the flow of commodities. Protectionist measures between nations actively interfere with raw material prices as they make the essential products more expensive for some, and less so for other countries. Tariffs and subsidies alter the fundamental supply and demand balance in individual commodities markets. The current environment of protectionist measures between the U.S. and China has had a direct impact on many different commodities. One example is the market for soybeans. With the world’s largest population that amounts to almost 1.4 billion, China typically purchases one-quarter of the U.S. soybean crop each year. We are now in the peak growing season for the 2018 crop in the oilseed and other grain markets. Usually, the primary driver of the path of least resistance for prices at this critical time of the year is the weather which either supports or inhibits crop growth. Therefore, a dry spell could cause prices to move higher, whereas normal conditions could drive them lower. However, in 2018 with the tariffs issue between the U.S. and China, the state of international trade has trumped the weather and soybeans have moved lower because the most significant buyer of U.S. soybeans has retaliated against protectionist measures with tariffs on U.S. agricultural products.
As the daily chart of new crop November soybean futures highlights, the price dropped from $10.6050 on May 29 to lows of $8.2675 per bushel on July 13. The last time that the oilseed traded at this level was in December 2008, almost one decade ago. The trade issues have pushed soybeans down to the current level because one out of every four acres of soybean production that went to China in past years will not in 2018 and 2019 as the Asian nation has canceled purchases. Therefore, tariffs have caused the move to the downside.
Meanwhile, in another example of the impact of trade issues on commodities prices comes from the copper market. Copper is a bellwether commodity that has a long history of diagnosing the overall wellbeing of the global economy. Most economists agree that a continuation of the escalation in trade disputes that lead to an all-out trade war could thrust the world into an economic recession.
As the chart of active month September copper futures that trade on the COMEX division of the CME illustrates, the price of the red metal declined from highs of $3.3345 on June 7 to lows of $2.7170 per pound on July 11. The decline of 61.75 cents or 18.5% in a little over one month came at a time as the trade rhetoric reached new heights. The U.S. tariffs on China took effect on July 6, and the U.S. administration threatened another $200 billion in protectionist measures on the Chinese on the day that copper hit its most recent low.
Soybeans and copper are just two of many examples of how the current environment of trade disputes is distorting the prices of commodities.
China versus the U.S. in steel cage match on trade
The epicenter of the tariffs issue is between the U.S. and China. For many years, politicians in the United States, from both political parties, have complained about the imbalance in trade created by America’s open and China’s closed markets. China is free to invest in the U.S., but the Asian nation does not offer U.S. businesses the same courtesy on the same level. Consider China’s purchase of the largest hog producing, the Virginia-based company in the United States, Smithfield Foods, in 2013. No U.S. entity would be permitted to make a similar investment or outright purchase of a Chinese owned business on Chinese soil. When American companies partner with Chinese firms on the mainland of China, the hurdles are much higher, and regulations more stringent than when China decides to invest within U.S. borders. Additionally, the flow of Chinese goods into the U.S. has been a smoother and less expensive affair than when U.S. goods flow into the world’s most populous nation.
While many are concerned that President Trump’s approach is heavy-handed and could have severe consequences for the U.S. and world economies, the trade issue is not necessarily partisan as almost all issues are these days in the United States. In fact, Senate Minority Leader Chuck Schumer has expressed support for the hardline towards the Chinese.
After decades of trade imbalances between the U.S. and China, the Asian nation’s GDP has grown to be the second largest in the world. The sheer size of their population and level of economic growth puts China on a course to surpass the U.S. in coming years and sooner rather than later. The trade issues are now coming to a head in 2018. China desires a status quo approach to trade, while the U.S. wants to level the playing field. While more Chinese goods flow into the U.S. on a value basis, and the trade dispute is likely to hit China’s economy more than it will the U.S., China system of government yields a significant advantage.
President Xi became the most powerful leader of China since Chairman Mao in last October’s Party Congress. He will not stand for election, and his word is the law in Communist China. Meanwhile, to a great extent, President Trump’s power depends on his ability to proceed with his agenda to fulfill promises made on the campaign trail. The loss of the House or Senate in the mid-term elections in November would impede his ability to carry forward and could render him vulnerable in the 2020 election year. Therefore, China while the Chinese economy may suffer more than America’s, the political system in China affords it more time when it comes to a standoff over trade. At the same time, President Xi’s power over 1.4 billion citizens only goes so far if the economy tanks.
While it may appear that China and the U.S. have each dug in their heels in a steel cage economic death match over trade, it is in the best interest of both leaders to settle the current dispute with a compromise so both leaders can claim victory for their respective countries.
Europe will fold as their businesses say no tariffs
When it comes to the trade issues between the U.S. and other partners around the world, the second most significant dispute is with the European Union. One of the central issues is the flow of automobiles, and the imbalance of taxes charged by Europe compared with those charged by the U.S. While the leaders of the E.U. nations are struggling to maintain the status quo, German car manufacturers almost unanimously came out advocating do away with all tariffs on their products.
Just look around the streets of the United States to understand why German businesses are siding with President Trump over the trade issue. Increased tariffs on Mercedes, BMWs, Audis, VWs, Porsche, and other vehicles coming into the U.S. that will further raise the prices of these already expensive vehicles would decimate their businesses. The automobile manufacturers in Europe are the primary reason why the E.U. leadership will fold to U.S. demands, and the Trump Administration will come to the table with some minor concessions to get a deal in place sooner rather than later.
It is darkest before the dawn- Trade deals on the horizon
Markets have been periodically panicking over the trade issues. On days when a tweet or threat from the administration hits the news cycle, the market reaction has been increasing in its intensity. While the stock market has not fallen apart because of the threat of a global recession, $200 billion in tariffs on China and more prodding against Europe, Canada, Mexico, and others will likely hit equities like a ton of bricks over coming days and weeks.
However, the trade issues have already hit a myriad of commodities with a bearish sledgehammer. Copper fell more than 60 cents per pound in a little over one month, soybeans and platinum have declined to their lowest levels in a decade over recent sessions. The price of crude oil fell sharply on July 11. Base metals have been falling as have the prices of corn, wheat, and many other agricultural commodities. Many of the moves to the downside in the raw materials asset class have not been the result of their supply and demand fundamentals; instead, they have been on the back of fear and uncertainty over trade as the current disputes most directly impact commodities prices.
The trade issues facing markets are still in their early days. $36 billion in tariffs on China only took effect on Friday, July 6. Given the aggressive nature of the President and his focus on leveling the playing field in international trade when it comes to reciprocity and fairness, this issue has not reached its acme. The rhetoric is likely to increase, and with it, periods of fear and uncertainty will intensify. Commodities will continue to see periods of wide price variance. And, the equities market will ultimately fall victim to fears of a global recession over trade. However, the dark clouds of trade that continue to gather on the horizon will give way to a new dawn of agreements which are in the best interest of all countries, including the United States.
Huge relief rallies in commodities coming soon
President Trump is pushing trade partners to the edge to see if they will buckle under the pressure of a new aggressive U.S. stance towards international trade. I believe there will be a grand summit between President Trump and Xi where they will shake hands on a new trade agreement that may not change things all that much but will provide both leaders with the opportunity to claim victory. The European Union will come to terms with the U.S. as will Canada, Mexico, and others. The U.S. is the wealthiest nation in the world with consumers that spend more than in any other country on a per capita basis. I believe that we will see agreements no later than the month before the mid-term elections in the U.S. to give the President enough time to campaign on delivering on his promises.
If I am correct, we could see some extraordinary rallies in the stock market as even slightly more beneficial trade agreements for the U.S. will be another form of fiscal stimulus. Moreover, those assets that have suffered the most could eventually experience significant recoveries. The futures market offers the most direct route for participation in the soybean, copper, and many other commodities markets that have suffered under the weight of the trade issue. Commodities as an asset class typically reflect the overall health of the global economy. Therefore, an economic boom that results from a resolution of the current trade issues is likely to move raw material prices higher.
For those who do not venture into the leveraged and volatile world of the futures markets, the Invesco DB Commodity Tracking product (NYSE:DBC) has moved from $18.47 in May to just over $17 per share on July 13.
DBC has traded in a range from $11.70 to $46.63 since 2006. At $17.08 per share, it is a lot closer to lows than highs over the past twelve years. DBC could offer a way to participate in a rally in the commodities asset class when trade agreements ignite a rally in raw materials prices.
European car manufacturers sent a significant signal to their governments over trade, and their position will likely prevail.
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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.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.