U store it

We were subject to congressional hearings this week on the appropriateness of bank owned physical commodity infrastructure. We have spoken of the criticism by industry regarding the holding of captive physical stocks of metal in LME warehouses. Industrial end users have complained loudly at the cash premiums they must pay in order to get prompt metal, a premium they say is inflated due to the persistent steep contango in metals such as aluminum and zinc. Congress is seeking to crack down on ownership of LME warehouses by banks such as JP Morgan and Goldman Sachs,  just as these very firms seek to divest themselves of their ownership interests. We suspect that this divestiture has less to do with congressional oversight, and more to do with the eventual narrowing of the contango. Owning a warehouse is only lucrative to the extent that physical holders are paid to store the metal. What made these hearings interesting was what was not discussed, namely the involvement of ETF’s into these commodity markets. While there was much discussion of the role of banks in the skewing of fundamental pricing, there was not much talk of the involvement of the public (via ETF’s) into what has heretofore been the purview of traditional producers/consumers. The influence of these ETF’s was seen throughout the year in the gold market where massive liquidation by the gold ETF has exacerbated any and every selloff.

While we understand that the growth of ETF’s and the financialization of commodities is something we all must live with, we do question the introduction of these products into markets which are very thin and highly fragmented. Much like congress however, we fully expect that regulatory scrutiny of “inappropriate” ETF’s will appear only after some kind unforeseen market event.


An article in the FT highlighted a recent complaint by the Beer Institute regarding the premiums currently being demanded in the aluminum market. Their complaint lies with the LME and the artificially high contango that exists, driven primarily by LME rules which effectively lock up metal in financing deals for overly extended periods. This complaint should not be taken lightly by the LME, as well as other exchanges whose rules regarding position size and nuances of delivery, favor non-commercial users. It is easy to envision a world in which commercial end users contract directly with producers (several most likely) within some contract pricing mechanism derived off- exchange. This should be of upmost concern to the exchanges as they desperately need the underlying producer output as it is critical to the entire pricing/delivery process.It will be interesting to see how these disputes between commercial and non-commercial commodity participants play out, particularly within the context of a rising rate environment.

Pay no attention to the man behind the curtain

This title really says it all when it comes to the recent action in capital markets. Market excess is not hard to find in any part of the capital markets as they exist today: high yield, government bonds, equities, leveraged loans, etc.. But, when it comes to Central Banks, the phrase ” ask and yee shall receive” has never been more true. However, just like the great and wonderful Oz, it is important that markets not delve too deeply behind the curtain because such exploration would suggest that the benefits of Central Bank actions have mostly been psychological in nature, with very little proven outcomes to date. We understand the talking points quite well, nearly 5 years into this grand experiment, Low rates: boost corporate profits, equity prices, perceived consumer wealth, spur hiring, etc.. However, this experiment in yield curve support, has morphed into a feeling by all investors in all disparate parts of the capital markets that the man behind the curtain has things covered. We were blown away by a recent article in the NYT in which Bernanke (remarking on the possible bubbles in todays environment) stated ” Microsoft ‘s stock is worth well more than it was some time ago, and it could still prove to be a bubble” He chooses Microsoft as an example? It is interesting to note that he did not use the high yield market as an example, particularly since spreads over treasuries are below where we were pre-2008. The Fed is de-facto encouraging not only a reach for yield, but a completely reckless reach for yield. No doubt, this type of behavior always ends badly, however in this latest episode the blame (as it should be) will be placed squarely on the Fed. Their ability to, once again, “save the day”  will be severely hampered under such a scenario. Forget the short term oriented deflationary chatter: BUY STUFF, SELL PAPER.

Nationalization Lite Revisited

The decision by Anglo American Platinum to revise the restructuring plan they had set out originally in January sets a bad precedent for all of industry operating in South Africa. We have mentioned in past blogs that private companies must be allowed to rationalize their cost structures, even if that rationalization means job cuts. While we understand that employers must be sensitive to local employment conditions, governments must reciprocate with a sensitivity to the reality that companies must operate at a profit. The president of Anglo stated that the shift reflected a commitment to our role in ” addressing the social economic challenges facing the country, while recognizing that we need to take actions to return the company to profitability”.  The markets were paying attention to this governmental meddling, with the yields on corporate bonds in the platinum sector skyrocketing over 80 basis points in a single day ( The Rand sold off sharply after this announcement as well).  While nationalization has always been a concern when dealing with foreign governments, companies must now deal with what we call nationalization lite. This type of intrusive behavior however, does not involve overt takeover of private assets, but rather involves a governmental co-opting of private decision making. The swift response on the part of investors  has sent a message to the governments of South Africa and others, that such heavy handed political moves will have immediate real world consequences.

Unconventional becomes Unbelievable

We read with astonishment a recent Bloomberg article which pointed out that in a recent survey of 60 Central Bankers, “23% said they own shares or plan to buy them”. Combine this with the recent comments by Mario Draghi in which he commented that policy makers had ” an open mind on negative deposit rates”.  Is it just me, or are Central Bank actions starting to strain any level of credulity at all. In our minds, both are very targeted attempts on all forms of stranded liquidity. These actions are being taken against a backdrop of perceived dis-inflation, which is driving short term asset allocation decisions away from commodities/hard assets and towards fixed income and quasi fixed income. However, we re-emphasize that the seemingly contradictory behavior between global central bank actions and the price movements in various commodity sectors is laying the groundwork for the long term outperformance of said sectors. In short, actions speak louder than words, thus pay more attention to what Central Bankers are attempting to do, than what they are expressly stating they are attempting to do.

Prognostication follows Price

Perhaps its just the explosion in the different venues available to various prognosticators, but it seems like we are being inundated with big picture forecasts based solely on the most recent price action. Witness the following: The end of the commodity Supercycle, The end of peak oil, The end of the gold bull market, The great rotation.The common thread in all of these myopic forecasts is that the fundamental basis for their viewpoints is driven solely by the most recent action in price. We very rarely see these kinds of viewpoints at real market inflection points, because standing apart from the crowd is often initially unprofitable and unpopular. Our point in this missive is not to dispute whether any one forecast is particularly correct or incorrect, but rather we question the basic tenets behind many forecasts which assume some basic amount of stasis in supply and demand which, in the real world rarely exists. Prices send signals to market participants, which then precipitates some action on the part of those participants.  The problem that  capital markets have is that they behave as if the real drivers of supply and demand act in real time. It is this disconnect which often creates opportunities, but one must keep in mind that these “opportunities” may lay dormant for some time.  In a week where commodities markets, metals in particular, experienced a significant selloff we heard increased chatter about deflation. However, juxtapose this same chatter against a backdrop of aggressive Central Bank activity, namely the BOJ.  Our own prognostication: You will not hear a discussion of the great rotation into hard assets until it is well underway.

Mothra meets Deflation

Central Banking has recently moved into the new stage of one-upmanship with the BOJ announcement that it would double the monetary base over the next 2 years in an effort to push inflation towards a 2% target. “Whatever it takes”, just became “Really whatever it takes”. This new brand of monetary machismo brings to mind that other great Japanese battle: Mothra versus Godzilla.  As you can remember, Mothra was the mutant monster who battled Godzilla, these battles often taking place in downtown Japanese locales. One can think of the BOJ as Mothra, and the specter of deflation or dis-inflation as Godzilla with the screaming and fleeing civilians desperately trying to save themselves from the collateral damage being inflicted by this battle.  The collateral damage in our modern day battle, would be a plummeting Japanese Yen, and the real risk of creating a bubble in some unforeseen asset class. This latest Central Bank effort further reinforces our inclination towards hard assets.

Pull Out the Atlas Again

As we all well know, the most recent casualty country involving a seemingly irrelevant economy with highly relevant euro linkages is of course Cyprus. The restructuring of Cypriot banks involves a tax on deposits above a certain threshold and has far reaching consequences, not only for the enraged citizenry, but also for the future of Central Bank strategy. While others in the Euro bloc might find it unfathomable that such an onerous bail out package could ever be imposed on them, the fact is that this weapon has been employed and one wonders whether this tactic was a trial balloon to see how severely markets might react. If this type of tactic seems so far fetched when applied to major economies, we would point out that such a tax is currently imposed on savers in this country given the steep negative real rates of interest that exist at the front end of the curve. Through its ZIRP this  Government is confiscating your money, albeit in a manner that appears slightly less heavy handed. While we do not want to draw spurious analogies with a country whose economy is a paltry $29 Bln in size, it should give investors some pause as they begin to think through the possible resolutions to our own fiscal crisis. We would maintain that system wide taxes such as this are now clearly in the quiver of politicians worldwide, and that proactive investors should begin to position themselves in assets outside the purview of such taxes; namely hard assets.

Noise has a name: Endogeneity

A recent Swiss study conducted on a number of commodity futures markets has concluded that (no surprise)  price moves are driven by the preceding price moves. The study concluded that since early 2000,” more than out of two price changes in a number of commodity markets followed from an earlier price move”.  The study also surmised that these “price dynamics are partly driven by self-reinforcing mechanisms … which partly reflect the development of algorithmic trading and high frequency trading”. This computer driven, herd mentality has led to a greater degree of endogeneity, which is the movement in price not generated by external information. Thus the trend is your friend, however what the trend is not a friend of is the price discovery process.  Ultimately price is driven by fundamentals, and not by hyperactive computer driven momentum trading activity.

While this study does not bring forth any new information, it does underscore what we have been railing on for years; namely the explosion in speed of execution combined with an explosion in real time “news”.  Endogeneity is out there and it is acted on more quickly and with greater volume than ever before. While this noise may ultimately affect the true price only in the very short run, the fact that a significant number of real world contracts are priced off these noisy prices is somewhat problematic.  We understand that it is not possible to slow the pace of technology ( and thus noise volume),  therefore we have instead chosen to focus our efforts on those specific commodities whose price discovery is driven by real commercial transactions, rather than some code that exists on a server sitting next to one of the exchanges.

Transmission Problems

The recent melt up in global equity markets, courtesy of global Central Banks, has shown the limitations of Central Banks in a de-leveraging post credit bubble economy. Traditionally, Central Bank policy was relatively effective in a normal recovery with slight adjustments in the discount rate and fed funds rate adequate enough to tweak growth at the margin.  However, as this recovery has been anything but normal, Central Bank policy can hardly be characterized as normal with policy tools moving way off the reservation. The continued promise to do more of the same, seems to have empowered those under-invested in equities to suddenly cast off their concerns (4 years into the meagre recovery) and take part in the “great rotation”. While it is difficult to be critical of those that are unhappy with a 180 basis point ten year note yield, it is interesting to see the underpinning for this sudden change of heart. A quick review of what sectors have outperformed during this most recent equity run reveals a great deal about what investors feel regarding the efficacy of Fed policy.  Consumer staples, utilities and healthcare have outperformed while materials and deep cyclicals have woefully underperformed. What this says to us is that investors know that Fed policy cannot affect any lasting change on real economic growth and that belief is evidenced by what they are buying. Investors have shown that they fully understand that there is a breakdown in the transmission of the Fed’s ZIRP into consistently higher levels of real economic growth.  If this were not the case, we would not be seeing such a complete avoidance on the part of investors towards anything tied to sustained real global growth (base metals, deep cyclicals, miners,etc..).