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1 COMMOO DITIES : STAY ING LO NG SH ORT-TE RM, EX IT POINT DRAWS NEAR June 14, 2013 Northern Trust Global Investments 50 South La Salle Street Chicago, Illinois northerntrust.com Edward Trafford, CFA Basic Materials and Industrials Analyst et44@ntrs..com While reaffirming our tactical allocation to commodities near-term, we cast a cautious eye toward the sector s long-term prospects. We do not base our recommendedd position onn the oft-cited secular supercycle; instead, we prefer a tactical stance. Demand for commodities in early 2013 was optically weak as inventories were drawn down, a movement wee anticipate will reverse in the latter half of 2013 as stockpiles are replenished and China ss State Reserve Bureau (SRB) engages in opportunistic purchases. We continue to expect the major metals including copper and iron ore will move toward surplus in Therefore, we recommend a more nuanced approach, focusing on commodities where we expect demand growth will outstrip supply and the marginal cost of production will help support price. We see the shorter-term risk-reward for commodities as compelling, based on several factors: continued accommodative policy from China s new administration early indications of a rise in China s construction activity evidence of improving physical demand rotation into global cyclicals as investors seek cheaper sourcess of yield To assess the commodity sector s prospects, we examine a number of sources, including: heavy machinery order trends within China global warehouse data non-fundamental speculative positionss unbiased micro-indicators such as Chinese cementt demand analysis of government-provided economic statistics COMMODITY COMPLEX HEADWINDS IN EARLY 2013 Commodities faced headwinds in early 2013 tied to a number of factors, the most notable being lower global growth prospects in the commodity-intensive emerging markets. Commodity markets were rattled as economists reduced forecasts for China s gross domestic product (GDP) and analysts loweredd their expectations for intensity of demand. This negative sentimen is evident in several global purchasing managers indexes (PMIs) in addition to the Citigroup Economic Surprise Index for the commodity intensive Asia-Pacific PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH ACCOUNTS OF QUALIFIED ELIGIBLE PERSONS, THIS BROCHURE IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COMMISSION. THE COMMODITY FUTURES TRADING COMMISSION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN ANY INVESTMENT PROGRAM OR UPON THE ADEQUACY OR ACCURACY OF COMMODITY TRADING ADVISOR DISCLOSURE. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS PROGRAM OR THIS BROCHURE.

2 region* (Chart 1). In addition, concern about speculation in the Chinese real estatee market unnerved investors, raising questions about thee sustainability of commodity demand. We saw asset flows out of the emerging markets and commodity complex into the relative safety of U.S. equities. This was driven in partt by the United States being viewed as the proverbial best house on the block, offering investors above-global-trend economic growth and relative safety. The strong dollar has also acted as a meaningful headwind, given its inverse relationship to commodities. Finally, we flag the U..S. 5-year forward 5-year breakeven rate, 1 a proxy for inflation expectations that has trended downward and created a backdrop against which investors require less protection afforded by hard assets. Chart 1* Chart 2 (*Citigroup Economic Surprise Index is a weighted historical standard deviations of data surprises, with a positive reading indicating that economic releases have on balance been beating consensus.) OPTIMISTIC SHORT-TERM ON COMMODITIES Given the consensus long-u.s. dollar/short-emerging market investor positioning, we see the risk-reward as favorable for commodities should China s economy re-accelerate as we expect in the latter half of We would argue from a contrarian perspective that the weak PMIs, most notably for China and its export partners, are a positive that provides support for continued accommodative policy in China. Net short speculative positions in copper (Chart 3) reached a new highh in early May (30,700 contracts), which we believe indicates a very crowded and consensus trade that may drive copper prices higher as positions unwind. Global fund managers (Chart 4) are underweight materials to an extent not seen since January We would note that the Standard & Poor s (S&P) 500 Materials Index provided a total return of 51.7% in the 12 months after the January 2009 extreme underweight versus a total return of 36.4% for the general market represented by the S& &P 500 Index during the same period. 1 The 5-year forward 5-year breakeven rate is the Federal Reserve s preferredd gauge of inflation expectations, starting five years from now and continuing for the five subsequent years. 2

3 Chart 3 Chart 4 Supply Growth Impeded Mining companies have rightly been viewed as poor allocators of capital, as evidenced by their declining return on invested capital (ROIC) during a period when commodity prices marched higher. As mining companies boardss of directors install new management teams embracing the mantra of capital discipline, wee believe a meaningful shift in philosophy is underway. We argue that this focus to improvee shareholder returns will impede further capacity expansions and thereby provide support to commodity prices. In addition, as credit spreads reflect, access to capital by small-cap mining companies ( junior miners ) is increasingly challenged. Choking off capital too the marginal producer will not only impede expansion plans but also help eliminate less-disciplined market participants. Of note, Chinese banks are already cutting off loans to steel companies, and we anticipate this will support pricing as excess capacity is removed from the markets. China Continued Accommodative Policy Expected We expect China s accommodative monetary policy to persist, given its low levels of inflation, weak export and domestic manufacturing market and its less-than-robust consumer and retail data. Notable is the recently reported HSBC Manufacturing PMI, which shifted into contractionary territory in May with a reading of (PMI readings exceeding 50 indicate expansion, and readings lower thann 50 connote contraction.) China s exports deceleratedd sharply in May, up 1.0% year overr year compared to 14.7% growth in April 2013, with exports to the United States and Europe down 1.6% and down 9.7% year over year, respectively. Imports in May demonstrated a similar r trend, down 0.3% year over year versus growth of 16.8% in April versus a yearr earlier. China s May 2013 Consumer Price Index came in 40 basis points (bps) lower than expectations and 140 bps below the government s 2013 target of 3.5% %. We believe this meaningfully reduces the risk of tightening and likely provides the government the latitude to cut the Reserve Requirement Ratio. China ss Producer Price Index also was 40 bps lower than expected, dropping 2.9% year over year. Looking at historic trends (Chart 5), we 3

4 estimate that inflation at the 2.1% level provides the People s Bank of China the leeway to cut rates by approximately 50 bps. We see accommodative monetary policy continuing, as evidenced by the 31.0% trailing four-month growth rate in the total social financing (TSF Chart 6), which is a measure of liquidity in the economy. While we have concern about the increasing proportion of the seemingly opaque wealth management products embeddedd within TSF, we believe the government will take a tactical approach to address offerings deemed risky. We also note that while new loan growth slowed in May, wee attribute this to banks and regulators taking a more cautious stance over loan quality and the related collateral rather than it indicating a tightening bias. Despite the deceleration in bank loans and TSF, money supply growth (M2) remains solid, ncreasing 15..8% year over year in May, up from the 13.2% reported last year and ahead of the administration s 2013 target of 13.0%. This suggests that the Chinese government is likely more focused onn growth versus countering inflation. We believe this accommodative monetary backdrop, coupled with a need to compensate for the slowing manufacturing and export sectors, paints a compelling shorter-term backdrop for the commodity complex. Chart 5 Chart 6 While China s May PMI improved modestly from April up 20 bps to 50.8 we see the composition as more relevant. The New Export Orders sub-index remained in contractionary territory for the second consecutive month due in large part to the European Union s sustained recession. Given China s export-reliant economy, such weakness may increase the likelihood of expansionary policyy to counteract the impact on China s manufacturing sector. The Chinesee government also facess consumer activity that appears to be weakening: the HSBC Services PMI was essentially flat month over month up just 10 bps and is approaching levels not seen since the third quarter of China s May retail sales growth slowed by 90 bps versus a year earlier, highlighting the headwinds the government faces in developingg a consumer-based economy. The retail sales data was disappointing in light of falling gold prices that bolstered jewelry sales by 38.4% 4

5 year over year. Similarly, restaurant revenues,, in addition to food and beverage sales, have softened, with much of this trend attributable to a crackdown on lavish spending by government officials. While we don t dispute the government s intentt to transitionn the economy toward a consumer-led model, weakening consumer-related data points including a disappointing employment component of the PMI coupled with a softening export market increase the likelihood of extended accommodative policy. China Seeing Strength Where It Matters With the seating of a new Chinesee administration complete, we believe concerns surrounding the government transition are largely behind us. We anticipate that re- housing urbanization, environmental-related construction (water/effluent treatment), social development and the build out of transportatio on infrastructure will emerge as key drivers for the commodity complex as already announcedd projects break ground in the second half of Cement demand (Chart 7), a reliable indicatorr of construction activity, increased approximately 9% year over year in both April and May, accelerating from the 4% growth rate seen in March. Planned investment in newly started projects, a leading indicator of commodity-intensive fixed asset investment (FAI), surged in April to up 41.3% year over year in April 2012 and from the 15.8% growthh rate in March. Indicative of the broader construction market, industry-wide excavator sales in China were up 6.2% year over year in May following 5.8% growth in April (Chart 8) ), marking the first yearly increase since April A major Chinese manufacturer of construction-related equipment noted similar positive trends in pile-driving equipment, concrete truck mixers and truck cranes. Chart 7 Chart 8 Physical Market for Commodities Improving We believe that May s 100.9% year-over-yearr increase in the aluminum premium, the incremental cost above the quoted London Metal Exchange (LME) price to receive the actual metal, is indicative of improving demand for the metal. We noted a similar trend with 5

6 copper cancelled warrants (metal booked for removal from the LME), which increased to 35.4% in May 2013 from 9.4% of LME inventory in May As highlighted in Chart 9, we anticipate a lift in the price of copper, given its historical relationship with the percentagee of LME cancelled warrants. The absolute tonnage of cancelled copper warrants hit a new high (Chart 10) in May 2013, drivenn primarily by strong physical demand. It also was aided by LME/Shanghai Futures Exchange (SHFE) arbitrage and a shortage of copper scrap. Copper inventories on the SHFE hit an eight-monthh low, while copper in China s bonded warehouses recently reached a seven-month low and Chinese copper imports increased 21.3% from the low hit in April. Imports of iron ore, a key steel-making ingredient, rose in both April and May by 16.4% and 7.4% %, respectively, So far this year, Chinese apparent steel consumption is up 9% compared to a 2% increase during the same period in Chart 9 Chart 10 No Supercycle: Shorter-Term Catalystss Evident Despite our tactically positive shorter-term stance, we see challenges to the commodity complex as we move into This is due largely to the peak in China s propensity to consume hard commodities (per unit of GDP) coupled with mining companies leveraging sunk capital to bring on new capacity. We expect this to result in a backdrop where supply may exceed demand for many commodities. Commentary from China s new leaders regarding the quality and efficiency of growthh indicates their intent to prevent asset bubbles, rampant inflation and escalating levels of non-performing much of the move in hard commodities over the last loans all of which occurred under the prior administration. From a demand perspective, we believe decade resulted from the misallocation of capital in China following rapid credit expansion as well as the government s pull-forward of infrastructure spend and its accelerated urbanization plan. A seemingly perfect storm ensued as years of underinvestment by mining companies, coupled with labor- and weather-related supply disruptions, resulted in an environment where supply failed to meet the seemingly insatiable demand from China. We would expect that the new administration s stated intention to lift the service sector s share 6

7 of GDP by four percentage points, will provide headwindss to the hard-asset complex in the coming years. We believe further industry rationalization, along with high-single-digicommodity pricing. growth in global demand, is required to maintain the upward trend in Given this supply/demand backdrop in the commodities sector, we remain committed to a shorter-term, tactical allocation rather than a strategic overweight. FOR MORE INFORMATION To learn more, please visit northerntrust.com or contact your Northern Trust relationship manager. Important Information There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal. This material is directed too eligible counterparties and professional clients only and should not be relied upon by retail investors. The informationn in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation off any security orr product described herein. Indexes and trademarks are the property of their respectivee owners. All rights reserved. Information intended for use with institutional investors only. Not to be distributed to or relied upon by retail investors. Pastt performance iss not necessarily a guide to the future. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Index performance is based upon information providedd by the index providers. Indexes and trademarks are the property of their respective owners, all rights reserved. There are risks involved with investing, including possible loss of principal. For Asia Pacific markets, this material is directed too institutional investors, expert investors and professional investors only and should not be relied upon by retail investors. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy orr product described herein. This information is not intendedd as investment advice and does not take into account an investor s individual circumstances. Opinions expressed herein are subject to change at any time without notice. Informationn has been obtained from sources believed to be reliable, but its accuracy and interpretationn are not guaranteed. Asset management at Northern Trust comprises Northern Trust Investments, Inc., Northern Trust Global Investments Ltd., Northern Trust Global Investments Japan, K.K., The Northernn Trust Company of Connecticut and its subsidiaries, including NT Global Advisors, Inc., and investment personnel of The Northern Trust Company. Northern Trust Global Investments Japan, K.K. is regulated by the Japan Financial Services Agency. The Northern Trust Company has a branch in China mainly regulated by the China Banking Regulatory Commission, People s Bank of China and State Administration of Foreign Exchange. The Northern Trust Company of Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission. In Singapore, Northern Trust Global Investments Limited (NTGIL), Northern Trust Investments, Inc. and The Northern Trust Company of Connecticut (NTCC) are exempt from the requirement to hold a Financial Adviser s License under the Financial Advisers Actt and a Capital Markets Services License under the Securities and Futures Act with respect to the provision of certain financial advisory services, and fund management activities. In Australia, NTGIL is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 in respect to the provision of financial services. Issued by NTGIL. NTGIL is authorised and regulated by the Financial Services Authority under UK laws, which may differ from Australian laws. 7

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