Commodities: An Inversely Correlated Asset Or A Symptom Of The Credit Bubble?

International Perspective, by Marshall Auerback

Commodities: An Inversely Correlated Asset Or A Symptom Of The Credit Bubble?

October 28, 2003

"China Saps Commodity Supplies. From steak to iron ore to cotton to diamonds, China's rising urban incomes, exports are reshaping the world's commodity markets. The country's emergence as a major importer of raw materials is driving global prices higher and catching some suppliers flat-footed."- WSJ, Oct. 24, 2003

Commodities have become the latest investment darlings. Copper, long seen as a harbinger of future economic prospects, is trading at 30-month highs. Nickel is at a 3-year high. Soy futures are close to a 6-year high. The price of platinum is at a 20-year high. Gold fetches more than it has for almost a decade. The CRB index has surged over 20% this year. And, as quote at the top of this page suggests, China is a big driving factor in the rise of these commodities, despite most of the G-7 economies being characterised by economic stagnation. Such is China's appetite for large volumes of raw materials, energy, fabrics and food that the cost of shipping has also been pushed out to uncharted waters.

A decade ago, circumstances were eerily similar, with surging commodity prices, a weaker dollar and much talk of a jobless recovery and "profitless prosperity" making much of the running amongst market commentators. But ultimately, the 1993/94 rally in commodities proved to be ephemeral. In retrospect, it is clear that much of the rise was driven by speculation, as opposed to underlying physical supply/demand trends.

There are many interesting parallels today. With the collapse of the high tech bubble in March 2000, financial institutions, pension funds, endowments have all begun to look for assets inversely correlated to equities. This has encouraged an explosion into such "alternative assets". This search for "reflationary" plays has intensified against a backdrop of in which the prevailing disinflationary orthodoxy of the worlds' leading central banks has been comprehensively jettisoned, most notably in the now famous Ben Bernanke speech last November, in which he extolled the virtues of the electronic printing press. The bets have also been made easier by the recently constructed indices in steel and gold, and the effective securitisation of bullion itself promoted by organisations such as the World Gold Council.

To be sure, it is superficially attractive to make the case for commodities on classic global recovery lines today alone. The US stock market has been very strong since March, bolstered by an anticipated strong recovery in GDP for Q3 on Oct. 30^th. Regional surveys also point to a sharp rise in the manufacturing component in the ISM survey.

But as we have noted earlier, an important sub-component of the ISM also points to a huge surge in import growth ahead, which means less domestic ramp up of future production, which in turns translates into less domestic growth. Indeed, the overall constellation of data that has come out recently makes it hard to ignore the possibility that the US growth has been sustained by a one off surge in consumer demand on the mortgage refi wave and tax rebates, much of which has largely leaked abroad to a degree unlike anything the US economy has experienced in the past. If imports do catch up in the fourth quarter, as the ISM data now implies, it may well turn out that a substantial part of the economic growth (and corresponding rise in commodity prices) was indeed a transitory phenomenon.

Indeed, the recent rise in mortgage rates could well put a further dampener on US household expenditures, which are still largely crimped by huge debt burdens. For much of last year and this, the Fed has been expecting households to hand the baton of economic growth to corporations, but these households continue to gamely hold on to the baton through the expedient of further debt accumulation. The double effect of these phenomena could well short-circuit cumulative recovery dynamics and render current US economic strength short-lived, which could well also impact on the bullish case for commodities.

Equally important, the recent rise in the mortgage rate may well dampen US household expenditures. If a surge in imports begins to short circuit positive recursive growth dynamics in the US, then income support to household expenditure will falter and with it, another potential source of buoyant commodities demand.

Outside of the US, China has become the big buzzword in the commodities world, just as it was in 1993. True, the country has already become the world's single largest consumer of copper, and a large importer of iron, steel, building materials, and non-ferrous metals. But for all of the China-driven euphoria, such excitement ignores important adverse monetary developments, which threaten to short-circuit this underlying demand. As long time China observer Simon Hunt has noted, the Central Bank has issued instructions to all commercial banks to be very careful in opening fresh lines of credit for the importation of alumina and iron ore. This is in line with what Ma Kai, Minister for the State Development and Reform Commission, stated when he identified these commodities as one of the key sectors of the economy where signs of overheating were most apparent and, hence, most worthy of further monetary control. Chinese monetary authorities appear to have begun what will be a concerted effort to unwind the excesses of a bank lending cycle that pose the very real risk of a new wave of nonperforming loans in China. As Andy Xie of Morgan Stanley has argued, a reduction in bank lending will have the unmistakable effect of slowing Chinese capital formation and Chinese commodity demand -- factors that have been central in driving these hard assets higher this year.

Investors who express scepticism about China's ability to prick its capital expenditure bubble forget the experience of the early 1990s, during which authorities also announced to great fanfare (and concomitant widespread Western scepticism) that they would be tightening credit demand to avoid a future crash. Not only did China do so, but the successful post bubble transition largely enabled the country to weather the adverse external shocks brought about by the 1997/98 Asian financial crisis. As China is now a huge marginal commodity consumer, any such slowdown is bound to have a deleterious effect at the margin, and may very well catch speculators on the wrong side of the trade.

Commodities strike us today, not as an alternative asset play, but simply another symptom of a massive credit bubble. The drivers of demand are not Western businesses or end users, but managed futures funds and hedge fund managers who have been thematically investing in "reflation" plays, as well as being driven by short run price momentum. If it trades well, these funds get on the bandwagon. One can see this trend vividly in the record long speculative positions now being recorded in the copper and gold market futures.

If an adverse growth inflexion point is reached, as we suspect it might imminently, global growth will invariably falter and speculators will exit these long positions en masse (which is precisely what happened in 1993). That spells considerable price vulnerability in the absence of further physical demand. It will also undermine investment and speculative demand for commodities. Indeed, false economic pricing engendered by speculative purchases may actually have the ultimate effect of triggering gluts and thereby reverse recent gains made in the commodities complex. Already BHP has announced a significant expansion of copper production in its Escondida property in Chile based on an anticipated increase in underlying demand next year. Were this demand fail to materialise just as copper production was reaching full peak, it is not too difficult to envisage what would happen to underlying prices.

In a sense, the price rise in commodities, reflect not so much the emergence of robust global demand for "stuff" as it provides yet another manifestation of what the Fed's extraordinary credit bubble has wrought. The main players in these trades are the same kinds of players heavily involved in European bonds in 1993/94, (despite knowing nothing about the underlying liquidity of such instruments), the yen/dollar "carry trade", and the Russian GKO market in the late 1990s (during which foreigners at one stage held more than three-quarters of the debt traded). We all know what happens when such trades get uncomfortably crowded. The rush for the exits creates very unpleasant price action and invariably does nothing more than illustrate the dangers of rampant speculation run amok. The commodities complex has that unfortunate feel about it today.

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