The Case against Commodities and Emerging Markets

Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.

Hang on. If the backdrop is improving growth expectations and continued, if not increased, global central bank base money expansion, why have they underperformed and why should it continue? Here’s my answer.

Misunderstanding Monetary Policy

This is going to sound bad so I’m just going to say it: Most investors and commentators have a deeply flawed understanding of monetary policy. Very few have any direct experience in this complex issue area. Many equate printing money with the money supply. They think changes in base money drive currencies. Most haven’t internalized that the money supply in a modern monetary system is endogenous (i.e. created by banks and risk appetite, not the central bank).

It is for these reasons people feared inflation, higher Treasury yields and a collapse in the dollar in response to the Fed’s exceptional measures. Remember stagflation? Me neither. None of these things happened.

People are now catching on to this. The percentage of investors who now think the Fed balance sheet will provoke a new crisis or that the ONLY possible solution to the US debt is inflating it away has shrunk considerably. This reduces the demand for hard assets.

Pavlov’s Oil

Many may have forgotten by now that the first massive wave in commodities was in 2007-2008, back before we knew what QE was. The story then was China and the Emerging Markets were rapidly plugging into the grid, set to consume our finite reserves with their vertiginous growth trajectories.

Subsequent boomlets in commodity prices, the ones that came post-crisis, were linked mainly to monetary stimuli and the flight into hard assets.

Together, this imprinting led us to reach for emerging markets and commodities any time we had a risk-on phase. In this last phase people have again reached for commodities and emerging markets to express their bullishness, but I’m suggesting this time they are setting themselves up for disappointment.

The first reason is that the emerging markets have downshifted their rate of growth. Some even have their own processes of credit digestion to contend with. Moreover, before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on “how high is high”.

Second, we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer.

These developments will, eventually, reprogram our reaction function. The days where we’d say, as someone else recently put it, “it’s going to be a risk-on day, let’s buy 200m AUD”, are likely to fade further and further into the recesses of our memories.

Beware the Hype Machine

When the sell-side makes “a thing” out of an asset class, there is usually considerable downside and unwind at some point ahead. The length and depth of the downside is typically a pretty clean function of the length and breadth of the hype. And in 2011 commodities became a thing.

Sell-side firms were sending team after team of analysts and strategists to explain exotic commodity trades, often to hedge fund managers who had no experience in them. Buy-side firms started to scramble to build their own teams and launch new strategies. John Paulson was still in hero mode and he was buying gold, thus giving cover to others’ hubris. And, of course, the gold ads on television were busy shifting into a higher gear. I could just close my eyes at night and hear the sound of central banks printing money.

The apex came in the spring 2011, a month or two before the final parabolic burst in silver. The Morgan Stanley commodity specialist came in to visit with his 8-man team. When he recommended, as his best idea, a pairs trade “long rhodium and short molybdenum” (really, I’m not kidding), I knew that the time for shorting precious metals would be soon upon us.

The bottom line: the speculative demand for commodities is likely to become less robust over time, and the growth rate of emerging markets more modest and definable. We are in the midst of the process of pricing these factors in. And the good news is the decline in commodity prices need not presage a collapse in global growth if it is mostly a function of a slow unwind of past excesses and the market’s previous monetary miscalibration.