“He came to town like a midwinter storm… but all he had come for was having some fun.”
Conclusion: While the global cotton situation can be characterized by tight supply relative to demand, we would advise you not to buy this soft commodity at this time. Production is rebounding, consumption is decreasing, and historical analysis lend credence to our view that aggressive forecasts for stockpile rebuilding are actually not that aggressive after all. Thus, we do not see current prices as a buying opportunity.
“Stay long of The Bernank’s Inflation,” has been one of our more successful themes over the past 3-6 months, and with the USD setting up for may be an expedited move to the downside over the next 8-10 weeks, we’re been looking to increase our exposure to certain commodity markets. Cotton, in particular, has been one of the commodities we’ve been bullish on for the last couple of quarters, so we put our up-and-coming intern Freddy Masotta to the test with the following question – “should we be buying the dip in the cotton market?”
With cotton futures trading slightly above $166.00, cotton has made a nice run over the past twelve months while riding an inverse correlation of -0.80 to a sinking US Dollar. In total, the numbers are staggering: cotton is up +29.2% YTD and +114.4% over the last twelve months while the US Dollar Index is down -5.9% and -8.3%, respectively.Over the past three weeks, however, the correlations have changed. Cotton is down -11.8% over the past month and currently has a three-week positive correlation of 0.64 with the greenback. Though not what we’d consider statistically significant, we would be remiss not to remind you that the US Dollar remains quantitatively bearish across all three of our key investment durations: TRADE, TREND, and TAIL. As the inverse correlation between the two is firmly broken, we viewed this as a unique opportunity to delve into cotton’s supply and demand fundamentals.
On the supply front, production is expected to pick up for five out of the world’s seven largest cotton producers in the 2010/11 season. India, the United States, Brazil, Central Asia, and Australia should all make significant rebounds and see their cotton production increase by double-digit percentages over their disappointing 2009/10 levels; as a whole, global production is estimated to increase by 13.6% during this season. However, China and India, the world’s largest and fourth largest cotton producer, respectively, are likely to face production declines. This will mark the third time in as many years that China’s cotton production has declined.
One concern on the supply front is the -27.8% drop off in the world 2010/11 beginning stock, but production this year seems to be sufficient enough to make up for the majority of this decrease. It is also important for investors to keep in mind that it typically doesn’t take more than a couple of years for ending inventories to refill. And given the severe weather incidents that plagued the last planting season (flooding in Australia, drought in China, freezing in Latin America, etc.), the “comps” for this projected rebound in supply are easy to say the least.
The main driver on the demand side has been China. The surging demand in China presents a legitimate concern in regards to the global cotton market and supply and demand fundamentals. China faces restricted supplies from all sources in 2010/11 and will likely be constrained by a lack of foreign exports. Further, declining area and weather problems in China are likely to reduce production to a five year low. This, coupled with tight beginning stocks, probably has bulls everywhere licking their chops. We argue, however, that this is likely priced in at current levels – especially given cotton’s massive run-up YTD. In addition, China’s cotton consumption is forecast to decline by 6% in the 2010/2011 season, while, globally, cotton consumption is expected to decrease between -1% to -2% as global clothing brands delay purchases into the latter half of the calendar year (courtesy of the Hedgeye Retail team).
We believe cotton could continue to correct from here, as the aggressive production and consumption numbers presented in the 2011 USDA Cotton Outlook appear quite feasible when analyzed with a historical lens. While total supply is expected to decrease by -0.4% this season, consumption is expected to decrease by a greater amount in the 2010/11 season, falling -1.6%. Needless to say, we urge caution to any investor thinking about buying the dip in the cotton market.