Commodity Invesments are Dangerous

Executive Summary

1. The current commodity bull market has arisen from underinvestment in commodities in the 1990's and booming demand in China amidst a subdued global economic recovery.
   
2. The takeoff in commodity prices since late 2003 has another basis: speculation.
   
3. Hedge funds and proprietary traders are far larger now and they are pouring funds into commodities.
   
4. Staid investors like pension funds and private bankers have found in commodities a new fad and fashion.
   
5. With access to zero cost credit, speculation in commodities in China is rife.
   
6. The combination of these three factors constitutes awesome fuel for speculative overshooting in commodities.
   
7. The macro economic environment is supportive of firm but not booming commodity prices.
   
8. The Chinese economy had a record out of control credit expansion in 2002-2003 which has led to grave misallocations of resources. Measures to slow the Chinese economy were put in place last year and are being strengthened. When the slowdown occurs it will be negative for commodity prices.
   
9. JapanEurope's dead in the water. The U.S. economy has been booming but a reduction in fiscal and financial stimulus could lead to a slow down.
   
10. Commodity prices will fall hard when the current global speculation crests.
    
11. The Japanese MOF/BOJ were squeezing speculators in dollar yen, threatening a cascade of reversals in reflation trades including commodities. The U.S. authorities have pressured the Japanese authorities to change their policy, thereby allowing speculation to persist.
    
12. Today's parabolic rise in commodity prices might peak and reverse without a precipitating event. But in all probability some such event will be required.
    
13. A perceived slowdown in China or in the global economy could be such an event.
    
14. The most obvious would be a Fed rise in interest rates. Given Easy Al's commitment to moral hazard and rampant speculation, that probably will not happen this year.
    
15. But, if any aspect of the multifaceted Great Reflation Trade unwinds, it could precipitate a sell off in commodities that would feed on itself. So would a steep stock market decline which would sound a change in market theme from reflation to deflation.
    
16. At this juncture, commodity investments are dangerous.
    

Introduction

In December I put out a warning signal on commodities. Clearly I was far too early. The CRB index of commodity prices has risen a full 20% more since my cautionary call and the rate of ascent of prices has accelerated.

For years I had been a commodity bull. I was a staunch gold bull on the price lows of 1998-2001. I took up energy strategy at $23 oil in early 2002 as a secular bull when all of Wall Street was bearish. I endorsed a broad secular bull case on commodities based on insufficient supply: years of misallocation of resources from traditional old economy sectors to new era tech sectors had resulted in underinvestment in commodities and higher commodity prices had to materialize when global aggregate demand eventually rose. So, when I turned cautionary on commodities in December, it was a real change in thinking. I had to have real reasons. What were they?

Why The Caution On Commodities?

First, the U.S. economy had recovered strongly, but only by way of huge private debt expansion. That was not sustainable. It was especially questionable after the collapse in bond prices and rise in mortgage rates in the summer of 2003.

Second, China was the other locomotive of global growth and the world's leading consumer of commodities. However, its 2002-2003 credit and investment booms were unsustainably high. The authorities in China understood this and moved to curb credit expansion and excessive investment. Excess credit had encouraged considerable speculation in commodities in China. In several ways a slow down in China would be negative for commodity prices.

Third, the easy money policy of the Fed was encouraging speculation in all asset markets. Unlike the 1990's, in this cycle it had spread to commodities. This was apparent from record net speculator long positions in several commodity futures markets. When such speculative positions were reached in the past, commodity prices corrected.

What Went Wrong With The Forecast?

First, the U.S. bond market rallied despite a growth surprise. Why? To my mind because speculation by hedge funds and proprietary traders (unleashed by Easy Al) against the dollar forced Asian central banks to buy U.S. bonds and thereby reduce long term rates. In any case, whatever the reason for the bond rally, it took the brake off the U.S. expansion.

Second, China has tightened credit, but Chinese industrial production has had more momentum than I expected.

Third, owing to years of underinvestment, supply interruptions in some key commodities like soybeans and copper propelled commodity prices higher.

Fourth, the speculative craze to purchase commodities has reached proportions I never imagined.

Why? In part because hedge funds and proprietary traders, whose funds are now several times what they were years ago, have focused on commodities. These speculators have embraced what I have characterized as a multifaceted Great Reflation Trade. Because the Japanese MOF challenged them on one aspect of this trade - short dollar yen - these speculators took losses (until the U.S. authorities forced the Japanese authorities to stop squeezing the speculators). A weak employment report in the U.S. inflicted losses on their shorts in dollar bonds. And, according to an ISI survey of hedge fund positions, these speculators subsequently trimmed their U.S. equity exposures. I expected losses on one part of their portfolio to lead to reductions in other positions. This was probably underway until the U.S. authorities came to the rescue of the speculators on dollar/yen two weeks ago. Since their rescue, and now emboldened, they have poured funds into commodities. Just look at the charts - once the yen reversed and rose for eight days in a row, the CRB went parabolic with a similar sequence of daily advances.

There is one other important aspect to the current commodity speculation. Apparently, many staid institutions like pension funds and private banks have decided they should invest in commodities as a hedge against a deliberate debt confiscating inflation that might be engineered by the Fed. I hear from the investment banks that the phones are ringing off the hooks because of calls by such investors trying to get into commodities. Traders tell me about customers trying to buy into small markets like rhodium or palladium in sizes that make no sense give the scale of these markets. This has provided an investment bid that has supported trend following speculation.

Taken together, these speculative flows may now be larger (relative to the scale of commodity markets) than they were in the inflationary 1970's. Though there were early signs of such a development, I did not expect it in an environment where the dollar had formed a bottom and global stock markets were forming tops.

Where Do We Go From Here?

First, the micro fundamentals do not support the current strength in commodity prices. Energy is a case in point. The long run secular bull case for oil remains intact, but the shorter run outlook is not especially bullish. There are no current supply disruptions. Iraq is coming back on stream. There have been some significant increases in non OPEC production. Saudi Arabia, Kuwait, and UAE have idle production capacity and don't want prices this high. There is now a near record speculator long position on Nymex and that probably explains today's high oil price.

From a macro point of view, the fundamentals probably do not support the current blow off in commodity prices either. Typically, commodity prices boom after a full three or four year cycle of global boom during which demand growth outpaces increases in supply. This two year G-3 expansion is the weakest on record. Despite the current rabid investor enthusiasm for Japan, its economy is only beginning an expansion. Core Europe's economy remains dead in the water. Yes, the Chinese economy is booming, but it is still only a fraction of the global economy and accounts at most for perhaps 10%-15% of global commodity demand. Past underinvestment warrants rising commodity prices but not a parabolic take off in commodity prices.

With the end of U.S. fiscal stimulus demand growth in the U.S. may taper off. Should the Chinese authorities succeed in their efforts, Chinese aggregate demand growth may fall from an 11% - 13% rate in 2003 to a 7% rate going forward. Targeted reallocations of resources will lead to an outright decline in some important commodity consuming sectors. Unless core Europe and Japan catch fire, the global macro environment will not be supportive of today's high commodity prices.

Conclusion

The uptrend in commodity prices since 2001 was justified by underinvestment, a boom in China, and the emergence of the G-3 from recession. But the recent take off in commodity prices is due to a degree of speculation with no precedent. The hedge funds and proprietary traders have never been so dominant. Never have staid institutions like pension funds and private bankers embraced commodities as their new fad and fashion. And never was a speculatively inclined people given access to zero interest rate loans to speculate in commodities, as has happened in China.

The current speculation in commodities may crest without a precipitating event. As long as Japan's MOF/BOJ was intent on squeezing the speculators in dollar/yen I thought I saw a trigger that would unwind the speculation. But the U.S. authorities have dissuaded Japan from doing damage to the speculative community. The odds are that another precipitating event will be required.

In a recent note, Stephen Roach of Morgan Stanley explains why China will slow down, and two notes by Andy Xie of Morgan Stanley list the possible precipitating events. Andy's scenarios are a bit too wild and far fetched for me. But I agree with him that a Fed rate hike is the obvious precipitating event and it won't happen soon. Andy focuses on a possible collapse in a real estate market somewhere. I would argue that the recent decline in stock prices, if it goes further, is a more probable precipitating event.

In any case, I believe there is currently great vulnerability in commodity prices today. Unprecedented speculative and investment interest could keep kiting these prices higher, but the subsequent collapse would only be larger. In today's bubblized world, everyone wants to ride bubbles and wants to know the precise timing of a trend reversal. But the important point is to recognize the true market dynamic. I recognized the dynamic behind a coming bull market in commodities years ago, but no one wanted to listen. The relevant dynamic in today's market is unbridled and unsustainable speculation created by a desperate Fed hell bent on propagating moral hazard. And that has created a dynamic which will lead to bursting bubbles and probably a rendezvous with deflation. Today's parabolic rise in commodity prices will be one of the many casualties.

By : Frank Veneroso

venerosoassociates.net

Frank Veneroso is the managing partner of Veneroso Associates, which provides global research to institutional investors.

From 1991 to 1994 Frank Veneroso was the partner responsible for global investment policy formulation at hedge fund Omega Advisors. From 1995 to 2000 and prior to 1991, through his own firm, Mr. Veneroso was an investment strategy advisor to global money managers and an economic adviser to institutions and governments around the world in the areas of money and banking, financial instability and crisis, privatization, and development and globalization of securities markets. His clients have included the World Bank, the International Finance Corporation, and The Organization of American States. He has advised the Governments of Bahrain, Brazil, Chile, Ecuador, Korea, Mexico, Peru, Portugal, Thailand, Venezuela and the United Arab Emerates. Frank is a graduate from Harvard and has authored many articles on the subjects of international finance.

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