The Mystery of Rising Commodity Prices
The Amphora Report
IN THIS EDITION
• THE MYSTERY OF RISING COMMODITY PRICES: In recent months, global commodity prices ranging from precious metals to grains to cotton have risen dramatically, notwithstanding signs of moderating economic activity. Is this due to constrained supply or simply a weaker dollar? We find these explanations inadequate because commodity prices are rising in all currencies and relative to both stocks and bonds. This is highly unusual and suggests that investor preferences have shifted in favour of commodities for some reason. But why? We believe we know the solution to this mystery.
• THE FED’S TEENAGE TEMPER TANTRUM: When a young child is caught in a lie, they deny it. As they grow, they find ever more elaborate ways of deceiving their parents, only to be caught out time and again. Finally, as a teenager, they give up trying to deceive and begin simply to blame their parents for their transgressions, rather than take responsibility. Recent statements by Federal Reserve officials suggest that, following a long childhood, the Fed has now entered its teenage years.
THE MYSTERY OF RISING COMMODITY PRICES
In recent months, commodity prices have risen dramatically. From a low point reached in June, various broad commodity indices are up from 15-20%. Few components have not participated in this rally to at least some extent.
While commodity prices are individually quite volatile, when placed in a broad, diversified, basket, their volatility is comparable to the stock market. So this recent rally is significant. Moreover, it is occurring alongside signs that the global economy is beginning to slow, which is the opposite of what one would normally expect. Leading indicators in the United States and Japan have turned decisively lower, while those for Europe are moderating. Economic policymakers in all of these areas have expressed concern that the risk of a double-dip is rising and in several instances they have backed up rhetoric with action:
- The US Fed has openly discussed plans to add additional stimulus to the economy, most probably in the form of increased US Treasury purchases;
- Japan intervened aggressively in the foreign exchange market in September to weaken the yen
- Euro-area officials, including Eurogroup Chairman Jean-Claude Juncker, have expressed concern that euro strength is now excessive and threatens the recovery
And it is not just the developed economies that are concerned. Emerging economies, including the largest ones known as the BRICs (Brazil, Russia, India, China), have moved toward a united front in resisting further dollar weakness versus their currencies, concerned about the negative impact that this would have on growth. Last month, Brazil’s Finance Minister Mantega went so far as to declare that a currency “war” had begun, with the developed economies seeking to devalue versus the developing.
So this presents a bit of a puzzle: If growth is weakening, why are commodity prices rising sharply? After all, demand should be weakening. Stockpiles should be increasing. Producers should be cutting, not raising prices, correct? What is the explanation? Well up to now we have only concerned ourselves with the demand side. What about the supply side? Are their factors constraining supply? Let’s consider a handful of the more widely traded commodities.
First, the largest of them all, crude oil. Crude oil and distillates thereof comprise 65% of the Goldman Sachs commodity index (GSCI), reflecting their huge relative volume in the global commodities trade. Have there been supply issues with crude oil recently? No, there haven’t.1 And in fact, the price of crude oil has not risen by much over the past few months. From a low of around $75/bbl in June it has risen to $85/bbl, a 12% rise, which given the normal volatility of crude is not notable. As the most important industrial commodity, used in all manner of production across the globe, the fact that crude oil prices are not up by much suggests that global economic growth is no longer accelerating.
Second, let’s turn to the next most important industrial commodities, the base metals, of which aluminium and copper are amongst the most widely traded and are used in a broad range of industrial applications. Since June, both have risen about 20%, somewhat more than the modest rise in crude oil prices. Have there been base metals supply issues? No, there haven’t. So this price behaviour is at odds with crude oil and requires further explanation.
Now let’s turn to agricultural commodities. The prices of grains began to rise sharply in July, when it became clear that the Russian wheat crop was suffering severe damage from widespread wildfires. This past week, grain prices soared again when the US Department of Agriculture (USDA) issued a report indicating the US grain production would disappoint this year. These are clearly supply issues which could be considered mostly if not completely responsible for the rise in grain prices.
Sugar, coffee, cocoa and cotton are also widely traded agricultural commodities. In recent months, none of these has been directly affected by supply issues to the extent that grains have. However, of these four, only cocoa has not risen significantly in price. Livestock prices have been mixed, with hogs prices flat and cattle prices rising a modest 5% since June.
To summarise, nearly all commodity prices are up, at least slightly. Some are up sharply, in particular grains and precious metals. Hardly any are down, which is unusual. Supply issues certainly have affected certain commodities but not others. As such, we must conclude that, at the margin, demand for commodities generally has been rising. Once again we must ask ourselves the question, if the global economy is beginning to slow down, why are commodity prices rising?
This discussion has yet to discuss the denominator of these prices, namely, the dollar. Could it be that commodity prices are rising primarily because the dollar is falling? After all, the dollar has declined versus most currencies during the past few months and, relative to certain currencies, such as the Swiss franc, Canadian and Australian dollars, is at or near record lows. Looked at in trade weighted terms, that is, relative to other major economies with which the US trades, the dollar has weakened by about 5% since June. So does the weaker dollar explain the broad rise in commodity prices?
No, because broad indices of commodity prices are up by 15-20% over the period. And they have risen slightly even relative to even the strongest currencies in the world, including the Swiss franc and Australian dollar, by 2-3% in both cases. Dollar weakness may be a partial but certainly not complete explanation for the recent, sharp rise in commodity prices.
Having determined that industrial demand, various supply issues and the weaker dollar as providing, separately or together, a full explanation for the strong rise in commodity prices of late, is there anything left? Where might we look for clues to help us solve this mystery?
As with all prices, we can understand much more about why they are rising and falling when we place such moves in context of other, related prices. Relative prices, after all, are those that ultimately determine whether we are going to trade one thing for another. So let’s take a look at what has been happening in commodity prices relative to those for financial assets, namely stocks and bonds.
Commodities have strongly outperformed since June (% return)
DJ-UBS broad commodities index; S&P 500 equity index; US Treasury total return index Source: Bloomberg LP
What we find is that commodity prices have been rising relative to both stocks and bonds over the past few months, which is unusual. This is because, when investors are optimistic for growth, stocks tend to perform best and, when investors become more pessimistic, bonds outperform. A broad basket of commodities is normally caught somewhere between the two (although naturally one or two commodities might do much better, or much worse, for specific supply or demand reasons).
Let’s now consider our findings. First, we have eliminated industrial demand, supply issues and the weaker dollar as potentially full explanations separately or together, for the sharp rise in broad commodity prices in recent months. Second, we have demonstrated that broad commodity prices are rising relative to both stocks and bonds, an unusual development. The only conclusion that can be drawn is that demand for commodities is rising for some reason other than industrial demand.
But what possible source is there for commodity demand that is not in some way related to industrial production or consumption? Is there a solution to this mystery? Yes there is. All we need to do is look at relative commodity prices to see which have led in the outperformance. What we find is that, notwithstanding the supply issues with grains, precious metals have been leading the way.
Precious metals outperforming, even amidst grain supply shocks (% return)
DJ-UBS broad commodities index; Gold ETF; Silver ETF Source: Bloomberg LP
Demand for precious metals is not primarily industrial, although silver does have a broad and growing range of industrial uses. Historically, gold demand has been dominated by the jewellery market, although the World Gold Council reports that, over the past year, demand for bullion has risen sharply relative to that for bling2. This, we believe, is key to solving the mystery of outperforming commodity prices generally: With supply issues confined to gains, rising demand must be the factor driving prices higher. But with industrial demand not increasing and possibly slowing, as demonstrated both by the weakness in leading indicators and the relative underperformance of the stock market, rising commodity demand must be due to stockpiling–hoarding–not for production or consumption.
What possible reason would investors have for hoarding not just precious metals but commodities generally? Well, consider the topic of the "Currency Wars", discussed at length in the last edition of the Amphora Report, October 1: If, in the face of a weaker dollar, other countries are unwilling to allow their currencies to rise, and currency and trade wars thus ensue, wreaking global economic havoc, then there is no way for investors to protect their wealth other than to hoard precious metals and other commodities. These cannot be printed, devalued or defaulted on and, as such, should prove a superior store of value relative to cash, stocks and bonds, that is, financial assets generally. Commodity prices are rising because investors no longer trust the economic and monetary authorities around the world to protect the purchasing power of their currencies of issue. With the US Fed embarking on a reckless policy of quantitative easing, the Bank of Japan intervening to weaken the yen, the Chairman of the Eurogroup complaining that the euro is too strong and the BRIC countries closing ranks against the developed economies generally, who can blame them?
So where does it stop? At what point will investors have hoarded enough precious metals and other commodities to protect themselves? It is impossible to know. However, we doubt that the hoarding will cease until at least one major economy and most probably several commit to maintaining strong and stable currencies. But with sovereign debt burdens rapidly on the rise and policymakers seeking new and ever more creative ways to artificially stimulate their economies rather than to step back and allow them to restructure and grow naturally, it might be some time before investors choose to move out of commodities and return to unbacked, fiat currency cash, if ever.
THE FED’S TEENAGE TEMPER TANTRUM
Notwithstanding overwhelming evidence to the contrary, the Fed remains steadfast in its refusal to accept any blame whatsoever for the near collapse in 2008 of the financial system it regulates. That said, the Fed is quick to take credit for having saved the system from disaster and for getting the economy back on track. On track? Well, over a year ago, Chairman Bernanke was talking about how the "green shoots" of recovery were increasingly evident3. We’re not sure exactly what was green, other than the colossal amounts of freshly printed dollars being thrown at the economy, but just as young plants don’t always survive and thrive, the US economy is clearly struggling again of late, with the broad unemployment rate U6 having risen again to 17.1% in September.4
Now it is rare for US central bankers to criticise government economic policy. A quid pro quo of an independent Fed is one that leaves the President and the Congress to their political business, which includes fiscal policy. On occasion, Fed Chairmen have been asked by the President or the Congress to give their opinion on certain policies, in which case they are obliged to offer one up, although normally this is done is an apolitical way.5
Even rarer is for a US central banker to voluntarily criticise government policy, rather than as a response to an inquiry on a specific issue. Yet this is exactly what Fed Chairman Bernanke did last week, when he claimed that it would be wise for Congress to systematically exercise more budget restraint, perhaps in the form of explicit budget rules, which have been adopted by a handful of countries and also several US states.6 That's right, the Fed's latest excuse for why the US economy is not performing the way it should is that Congress has been doing a poor job and, as such, business and consumer confidence remain subdued, explaining much of why this recovery has been so weak, notwithstanding the extraordinary degree of stimulus, fiscal and monetary, that has been thrown at the economy since 2008.
While not entirely unprecedented, it is certainly rare for a Fed Chairman to exhort the Congress in this way. One could therefore surmise that Bernanke must feel quite strongly about this matter. By implication, his overt disapproval of chronically high budget deficits implies that he believes it would be better for monetary, rather than fiscal policy, to provide the stimulus necessary to get the economy back on track. While we happen to agree with Bernanke that fiscal policy is not the answer to the current set of US economic woes, we disagree that monetary policy can somehow succeed where fiscal policy fails. This is because US and to some extent global economic problems are structural rather than cyclical in nature. This structural malaise can be seen in various economic "imbalances", which is econospeak for "unsustainable developments".
Let's place the current set of imbalances in context. As we know, the US has long run a current account deficit, implying that it has been consuming and investing more than it has been producing. The net result is a large accumulated debt owed to foreigners, in particular the big savers such as China, Japan, Germany, and a handful of other, primarily manufacturing economies. Now it is one of the basic accounting identities of economics that savings = investment. Money that is saved, even if put in the bank, finds its way into investment, say in the form of a commercial loan which a business then uses to finance new equipment or to hire additional workers. Another identity is that what is not saved/invested is, naturally, consumed. So what we have is:
savings + consumption = production (GDP)
Back in the mid-2000s, as the US current account deficit grew and grew, it became fashionable to talk about a "global savings glut" which was "forcing" savings into the US, holding bond yields unusually low and, therefore, stimulating investment in housing and commercial real estate, among other areas. Bernanke himself used this argument in 2005, arguing that high rates of savings, in particular in Asian economies, were responsible for this "glut" of savings.7 This argument became, for a time, the conventional wisdom. Amongst Bernanke and his mainstream, neo-Keynesian policy and academic colleagues, this remains the explanation to this day for why US aggregate demand is so weak: The world, now including the US, is saving too much.
So when Bernanke was talking about there being too much savings, he was implying either that a) there was too little consumption; or that b) there was too much production. It must be one or the other. Now it is farcical to argue that from 2004-2007, the global economy was consuming too little. Indeed, this was one of the greatest ever consumption booms in world history, led by the US course, where the household savings rate went outright negative. So therefore it must be the case that, in those years, the global economy was producing too much. Yes, that's right, by claiming that there was a global savings glut, by implication Bernanke was claiming that the world was producing too much! That it was, in other words, overheating! So why on earth did Messrs Greenspan and Bernanke not raise interest rates more in order to slow the global economy?
The answer, we know, was that US consumer price inflation was low, so it seemed that there was no need to raise rates. But do you see the inconsistency in Bernanke's argument? YOU CAN'T MANAGE THE RISKS OF DANGEROUS IMBALANCES–SAVINGS "GLUTS", ASSET BUBBLES OR WHATEVER ONE CHOOSES TO CALL THEM–AND TARGET CONSUMER PRICE INFLATION AT THE SAME TIME! In other words, consumer price inflation targeting is a bogus policy, yet one on which Bernanke has staked his academic and profession reputation. And then, when it all blows up in arguably the greatest credit crisis in the history of the world, he has the audacity to assign blame to anywhere, anyone but the Fed itself–Wall Street, Fannie/Freddie, China, the list grows and grows–and now at the US Congress!
When a young child is caught misbehaving, sometimes they attempt to make some simple excuse to talk their way out of it, only to find the parent knows better than to believe them. As the child grows, the excuses grow ever more complex in an attempt to obfuscate, deceive, bewilder or simply exhaust the parent into retracting an accusation. However, when a teenager is caught, rather than make increasingly elaborate and frequently futile excuses, it becomes more common to simply blame the parent!
Once upon a time the Fed used to make simple excuses such as "no one could see the bubble", which was used following the dot.com crash in 2001-03. Then the Fed began to make increasingly elaborate, bewildering and, as demonstrated above, internally inconsistent excuses such as there being a "global savings glut" which the Fed could do nothing about. Now the Fed is blaming the Congress that created it and lightly oversees it for US economic woes. We're sorry, but this sounds like a teenage temper tantrum to us, not the rational voice of a sensible, competent institution ready and willing to take responsibility for its actions past, present or future.
It is a sign of a teenager maturing into an adult when they not only stop making excuses generally but, even to the extent that they feel their parents are to blame in some way for their foibles, they move on, get over it, take responsibility and make the best out of the imperfect situation known as the human condition. If the Fed is indeed on such a path, then maybe there is some hope after all. We need only be patient, as all good parents are.
The Amphora Liquid Value Index (through 8 October 2010)
Source: Bloomberg LP
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1 The BP Gulf of Mexico oil spill disaster may have dominated the oil headlines for a few months but as it did not involve a producing well, the spill had no impact on global crude production, distribution or refining.
2 Evidence for this is provided by data showing that scrap jewellery has been returning to the market and the production of new jewellery has declined, implying that gold is being re-monetised, that is, finding its way into bullion instead. The World Gold Council tracks a wide range of data related to gold mining, jewellery production, scrap supply and investment demand around the world. Their research reports can be found here.
3 Bernanke’s now infamous "green shoots" comments can be found here. More recently, US Treasury Secretary Geithner published a pep-talk on the economy, titled Welcome to the Recovery. These statements from the Fed Chairman and Treasury Secretary indicate to us that neither understands the structural issues impeding a normal, healthy US economic recovery.
4 An increasing number of observers no longer believe that the headline US unemployment figure gives a full picture of the jobs market because it excludes so-called “discouraged workers” who have given up looking for a job and, as such have left the workforce. The U6 figure includes these workers, who swelled in number in the recent recession and, notwithstanding the modest rate of positive economic growth over the past year, continue to increase.
5 A relatively recent, high-profile example of this was back in the early 2000s when Fed Chairman Greenspan testified before Congress on the desirability of converting Social Security into a system of individual accounts instead, which holders could then invest as desired. The proposal came under immediate criticism. Greenspan tried to support it in his testimony, pointing out, for example, that the Social Security Trust Fund was eventually going to run out of funds and that something had to be done. He stopped short, however, of criticizing the role Congress has played in building up the Social Security program through the years.
About John Butler
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