The market continues to be torn between bearish cotton fundamentals and a somewhat supportive macro picture, spurred by the promise of additional money printing by central banks. For the past 12 sessions, the December contract has not been able to break out of a tight range that was established in a single session on August 21, with a low of 74.60 and a high of 77.49 cents. This goes to show that there is currently absolutely no momentum in the market.
From a fundamental point of view the news has turned more bearish this week. Recent weather worries have proven to be unfounded, as Hurricane Isaac did only minimal damage to cotton areas in the Mid-South and the weather has since returned to mostly sunny and hot conditions, which helps to advance harvest preparations. Early yield indications are pointing to an above average crop. In India the monsoon has come back with a vengeance, bringing heavy downpours to drought-stricken areas in Gujarat and boosting crop estimates by some 2 million local bales. This has put pressure on Indian high-grades and quotes for Shankar-6 have dropped by about 5 cents since the end of August.
China has started to auction off some of its reserve stocks, as around 760’000 statistical bales have been taken up by mills over the last four days at an average price of around 133 cents/lb. This cotton is intended for the sole use of the acquiring mill and cannot be resold, otherwise wily traders might try to buy cotton from the reserve at 133 cents/lb and then retender it at the upcoming new crop procurement auctions at 146 cents (20’400 yuan/ton support price). The fact that China is feeding reserve stocks back into the local system is a clear departure from last year’s policy, when any shortfall was met with cheap imports.
This does not bode well for cotton exports to China this season and will likely exacerbate the pressure that owners of inventory in the rest of the world are soon going to feel. It also makes it more difficult for Chinese mills to compete internationally and we will probably see a further erosion of mill use in China as a result of it. However, to some extent this drop in cotton imports will be made up by increased yarn imports, as vertically integrated mills will simply skip the first step of production and import yarn that was made with 80 cents cotton rather than spinning local cotton at 135 cents. With mill use shifting to different markets, it is becoming increasingly difficult to get an accurate read on consumption.
While last year’s bull market has led to a shift to man-made fibers, some of it permanent, and thereby depressed the use of cotton, we feel that cotton consumption at the end-user level may not be quite as bad as generally believed. Retail sales figures have been holding up relatively well and considering that global population grew by around 650 million people since 2004/05, it is hard to believe that the world should use less cotton today than it did eight years ago. While retail sales in the west have stagnated in recent years, they have been growing leaps and bounds in India, China and many other emerging markets. The current USDA consumption estimate of 108.2 million bales is still nearly a million bales below the 109.1 million the world consumed in 2004/05, which seems rather pessimistic to us. This may come from the fact that the USDA keeps lowering Chinese mill use (down 11 million bales over the last 3 seasons), while not crediting enough of it back to other markets to account for the rapidly growing yarn trade between China and the rest of the world.
While cotton fundamentals look quite negative at the moment, the market keeps getting support from outside forces. November soybeans rallied to an all-time high of 17.84 dollars/bushel this week, while corn continued to hover near 8 dollars/bushel. Gold traded above the 1700 dollar/oz level today, up 100 dollars/oz from a month ago, while the S&P 500 index has more than doubled since early 2009 and is now less than 10% from its all-time high. The reason behind this renewed strength in precious metals and stocks is the expectation of further money printing by the Fed and the ECB. More and more traders are beginning to understand the rules of this ‘new paradox’ we live in, where bad news translates into higher nominal prices.
As economic growth remains anemic, ever increasing government spending and money printing are necessary to keep a still highly leveraged financial system from collapsing. Although the system would deflate if left to its own, Mr. Draghi and Mr. Bernanke have made it quite clear that they will do whatever it takes to keep asset markets afloat, and this means that there is a lot more money printing ahead of us. In an environment in which nominal values of assets are being artificially inflated, it is dangerous to be a short seller. Just ask anyone who tried to short the government bond market over the last couple of years. While the bond market should be a lot lower given the unprecedented increase in government debt, short sellers have been outmatched by a Fed that has more than doubled its treasury holdings since 2009.
So where do we go from here? The market has no clear direction, but we still feel that the impending Northern Hemisphere harvest will put some pressure on prices over the coming weeks. Although outside influences remain positive and short sellers are far and few between at the moment, it will not be enough to stop the avalanche of cotton that is about to hit the market. We would therefore not be surprised to see prices drop back below 70 cents by October. Longer-term the outlook is more positive, because the 2013/14 soybeans/cotton ratio is now at over 17:1, which clearly favours soybeans over cotton when planting decisions are made early next year. Also, as mentioned above, cotton consumption has a lot of room for improvement, now that prices are back at their long-term average. It will take a while to turn this market around given the huge supply that currently exists, but we feel that by the first quarter the pendulum will start to swing back the other way.
Source: Plexus Cotton