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. (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.)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 aluminum 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 their been base metals supply issues? No, there haven’t. So this price behavior 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 summarize, 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 jewelery market, although the World Gold Council reports that, over the past year, demand for bullion has risen sharply relative to that for bling. 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, vol. 1/10: 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.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]