The surfeit of articles and research pieces on deflation/dis-inflation and the end of the commodity supercycle does not seem to be showing any signs of slowing down, particularly as we near years end. What we find lacking in most of this research is a clear understanding of the role of price in the supply/demand dynamic. We find it laughable to hear of price projections for such diverse commodities as copper and corn not only extending out several years but to several decimal points as well. What is missing in these projections is the disruptive nature inherent in a price that does not adequately reflect reasonable economics. In short, prices send very loud signals to the market, the volume of which we maintain will only increase going forward. We understand the often long -lived nature of commodity production, but after a three year drought in capital market access, many new projects can already be discounted as scrapped. However, the linear projections involved in many of these commodity price projections still simply do not reflect this reality. We would maintain that the physical nature of commodity production exerts more mean reverting pressure on price than something like, for example, technology. Think about that when reading “research” pieces projecting the future value of a Bitcoin.
The recent announcement that the Treasury would be issuing floating rate notes in an effort to feed the appetite for those investors not satisfied by the TIPS markets makes us wonder about whether the Fed and the Treasury are still on speaking terms. We are sure that the Treasury appreciates the Fed’s help, and by help we mean taking down 70% of all new issuance. But the issuance of floaters, juxtaposed with a Central Bank that aspires to create inflation, would seem to represent a situation where the two parties are at cross purposes. While it is true that the issuance is small ($10-15 Bln), and that interest rate movements are not necessarily correlated only with inflation, the fact that the Treasury would structure part of its issuance in direct opposition to what the Fed is trying to explicitly accomplish seems odd. The fact that all Central Banks( for the most part) are currently inflation wannabes, as evidenced by the ECB rate cut today and comments by Mario Draghi, might give potential buyers of said notes cause for concern. If Central Banks do indeed get their way, floating rate notes will most likely provide some protection from the collateral damage of higher inflation, but a better bet would be a position in hard assets. Continue to sell paper and buy stuff.
From Alan Greenspan’s new book: ” It is easy to contemplate price acceleration, with today’s Federal Reserve balances unchanged, ranging from 3 percent per annum to double digits over the next five to ten years.”
One has to wonder whether we are seeing Act One in what we have termed the “flight to tangibility”. Our original thesis involving the shift towards hard assets involved a sharp decline in the dollar brought about by a crisis of confidence involving governmental finances. While we have no doubt that this latest food fight in Washington will be resolved, the ease with which lawmakers were willing to create a crisis of their own making gives us pause as to their ability to make the truly hard choices should a real crisis occur. I am absolutely staggered by the ignorance displayed on both sides regarding the real world implications of a default( soft or not). While large scale holders such as the Chinese and Japanese sit in amazement at our inability to exhibit any kind of fiscal restraint, they should both hold their fire to some extent as they have both been willing participants (Japan especially) in this world wide game of print and spend.
I recently sat on a panel with Marc Chandler of BBH in which he gave an excellent talk where he mentioned “bumps and grinds”. In this talk, Mr. Chandler talked of the events of 9/11 as a bump in the growth road as opposed to the events of 2008 which has given way to a grinding environment in which growth is challenged anywhere above 2%. This got us thinking about the transitional period between deflation/dis-inflation towards something much, much different. One might think of the events of 2008 as a bump in the long road back towards reflation/inflation. During this period, the synchronized global growth that we had experienced since 2004 gave way to a bifurcation between developed and developing economies. This bifurcation would have serious ramifications for the duration and shape of that transition. Eventually this bifurcation has subsided leaving us with the “grind” towards higher levels of inflation. This grind is reinforced by generally slack global production and oversupply across many input markets. Markets, by their very nature, are short term oriented and not prone to have much appetite for “grinding” environments. This is evidenced by their almost universal disavowal of any potential for a resurgence in inflation. In our estimation, therein lies the opportunity, given that the prices of assets that would benefit from such a transition are currently severely under-priced. While some might claim that being early is the same as being wrong, we would vehemently disagree, particularly during such large secular shifts. Sell Paper Buy Stuff (early)
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.
Back in the ridiculous days of the late 90’s there was a product called split alert. This pager device would receive a message when a stock was splitting, which would then cause a pavlovian buy response on the part of the user. The premise was, at the time, that stocks splits were bullish because as we all know a pizza sliced into 24 slices instead of 12 is inherently worth more. We look back on all of the ridiculous behaviors and attitudes that existed during this time and we shake our head as to how this mentality was allowed to take hold. For some reason, I was thinking about split alert as I listened to Chairman Bernanke’s comments post FOMC. I wondered if we will look back years from now in amazement as to the gullibility of a market so fixated on monetary stimulus that it failed to see the flaws in thinking that a $15 Trillion Economy could be micro-managed using untested, unconventional and, to date, unsuccessful monetary policies. A question was asked during the Q&A about the recent backup in rates and Chairman Bernanke went to great lengths to explain that the market simply was misinterpreting the Fed’s intent. They did not understand that, while at some time their pace of asset purchases may slow, the stocks of assets that the Fed holds will remain unchanged. This, he stated, should be sufficient to hold down rates. We would suggest to the Chairman that bond market participants are not hard of hearing. What they are hearing quite clearly is a Central Bank intent on pursuing a policy of reflation/inflation and they are voting with their feet. Buy stuff, sell paper.
The most recent backup in rates across the long end of the U.S. Treasury curve has prompted much speculation as to the exact cause. The general group -think credits the strength in the U.S. economy, particularly the housing market, as the most likely culprit. However, we would argue that the sharp rise in yields that we have experienced over the past several weeks have really been driven more by the Fed’s ambiguous comments as to the ultimate disposition of their burdensome balance sheet. Chairman Bernanke’s May 22nd testimony was particularly troublesome to the Treasury Market, as it introduced the possibility that the Fed reserves the right to resurrect QE at any time should conditions warrant, even in the event that near term tapering might be soon forthcoming. The subtle message to the market was ‘ we may take away the punch bowl, but at the slightest hint of market DT’s, that punch bowl will be right back’. While the stock market enjoyed such overt support for market “calm”, the Treasury Market seemed to convulse at the message sent by a Central Bank so seemingly obsessed with healthy ( a.k.a. rising) capital markets. We recently spoke to the burgeoning credibility gap that the Fed is creating with such comments, and we believe that the rise in rates substantiates the Treasury Markets increasing distrust. Some in the gold market have commented that the movements in gold reflect an increasing/decreasing trust in fiat currencies. We would maintain that, much like Gold, interest rates are now becoming a barometer for the Treasury Markets view on the soundness/saneness of Central Bank policy.
In 2006, we wrote of the impending credit crisis, when we commented that ” The combination of an overly willing lender combined with an overly aggressive borrower can only lead to the types of credit events which instantaneously transform the capital markets’ appetite for risk”. However prescient that statement may have been, the similarities in todays current credit environment might suggest that the near death experience in 2008/2009 was simply a bump in the road. One might think that until one realizes that this “bump” was significant enough for global central banks to enact 503 global rate cuts creating $11.6 trillion in Central Bank liquidity over the past 6 years. This suppression of the yield curve, across all bond markets globally has made the reach for yield a dying grasp for anything other than zero. While it is easy to see this stampede towards yield in the public markets, we have seen this spillover into the agricultural markets as well. We have followed the ag markets for years, having managed a farmland partnership years ago, and we have rarely heard the term ” Cap Rate” applied to agriculture until very recently. There is a feeding frenzy going on in many markets such as tree nuts and wine grapes, based in some part on this incessant demand for yield. In fact, the Fed advisory panel itself stated that ” Members believe the run-up in agriculture land prices is a bubble resulting from persistently low interest rates”. We disagree with the use of the term bubble, as we define a bubble as a market in which there is an inordinate level of demand being driven by some flawed premise ( i.e. housing prices only go up, etc..). We do however feel that agricultural prices are being somewhat skewed by the ultra-low level of rates, however we can’t help but wonder whether this aggressive demand is also being driven by investors need to allocate more capital towards hard assets.
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.
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.