Five years into the biggest money-printing exercise of all time, and commodities are (incredibly) approaching the status of being universally loathed. On Friday, gold provided a great illustration of one reason I always say that investors should have a position in diversified commodity indices. A Goldman Sachs report released a couple of days ago (with gold 20% off the highs) suggested that prices may have further to fall; more important to Friday’s rout, though, was the increase in the European assessment of how much more money Cyprus will have to raise for itself (€6bln, or about 35-40% of annual Cypriot GDP) to complete the bailout, and the speculation that Cypriot gold reserves will have to be sold.
Add to this the fact that Friday’s economic data was weak with ex-Auto Retail Sales -0.4% and the Michigan Confidence figure showing a surprising drop. Clearly, investors believe this to be a death knell for inflation (as opposed to the “death bell” – I’m not sure what that is – that Citigroup says has been sounded for the commodity supercycle).
But all of the data, and the European sovereign crisis, apparently does support rapidly rising home prices and equities at disturbing multiples of 10-year earnings!
Considering that commodities have been around far longer than equities, bonds, or even money itself, it is incredible how little understanding there is about them.
One misunderstanding, and key to understanding the current situation, is not peculiar to commodities. It is simply the common confusion of nominal and real quantities. In a nutshell, the change in any good’s nominal price over time consists of two things: a real price change, and a change in the price that recognizes that the value of the currency unit measuring stick has changed – that is, inflation. We’re familiar with this construction in the form of the Fisher equation, which tells us that nominal yields represent the combination of a real return that is the cost of money plus a premium (or, less frequently, a discount) for the expected change in the price level over the holding period. But that construction applies to all price changes.
So if the price of your ham sandwich rises 3% this year, is there a bull market in ham sandwiches? Well, in all likelihood not – it’s just that the overall price level is rising by roughly that amount. What about if the price of the ham sandwich rises by only 1%, because ham is becoming cheaper? Then we would say that there was a 2% decline in the real price of the ham sandwich, plus 3% inflation.
Now, if prices instead rose 15%, the ham sandwich in this latter scenario would not still be only rising in price by 1%. It would likely rise by 13% or so: the 15% inflation, minus the 2% decline in the real price of a ham sandwich. Even if a ham sandwich glut was forcing a 10% decline in real prices, the nominal price of a ham sandwich would still be rising in that case.
So, when groups trumpet the “end of the commodity cycle,” they seem to be confused. It is possible that they are saying that real commodity prices should decline over time, but I wonder whether their clients would be awed by that prediction since it has been the norm for hundreds of years. Moreover, if they were referring to real prices, then if CPI goes up 10% and commodity prices go up 5%, they will be right – but clients might not see it the same way.
But I don’t think that’s what they are saying. If it is, then those groups are also a bit late to the party – commodity indices, which include additional sources of return, have underperformed inflation by 28% since 2004 and are down about half from the 2008 highs. Frankly, in the chart below (Source: Bloomberg), which shows the DJ-UBS commodity index divided by the NSA CPI, I don’t see anything which looks like an up-leg of a supercycle, except perhaps the doubling from 2003-2008. Is a 100% gain over five years a “supercycle”?
Now, in the SP-GSCI, which has a much greater weight in energy, it looks plausibly like a “supercycle,” as prices tripled in real terms off the lows in 1999 (see Chart, source Bloomberg), and admittedly the chart looks a little feeble at the moment. But that difference is, as I just suggested, mostly due to energy. And if you think the energy supercycle has ended…just short energy, don’t paint all commodities with the ugly brush!
And, by the way, it seems like a pretty wimpy supercycle if the peak in real terms doesn’t even approach the earlier peak.
In nominal terms, all of these charts look different, with the downswings being dampened and the upswings accentuated, because of inflation. But that’s certainly not the right way to look at commodities (or any asset) over time. We don’t care about the nominal return. We care about the real return. And viewed through a real return lens, commodities are much closer to being really cheap than to being really rich!
Obviously, I disagree with all of these groups when it comes to commodities generally. About gold I have no firmly-held opinion about its valuation at the moment, but commodities generally we see as cheap – in fact, we expect triple the real returns from investing in commodities indices over the next ten years compared to equity investing. This is a function of both the very rich absolute valuations of equities and the very cheap absolute valuations of commodities indices.
Moreover, if inflation does in fact accelerate – something which has nothing to do with the weak Michigan or Retail Sales numbers – then commodities will also have terrific nominal returns while equities might well have negative nominal returns.
I like unloved assets. I can be a patient investor when I find an asset or an asset class that is unloved, but not truly loathed. When an asset class is loathed, it can take an enormous amount of time to realize value from it although if one’s horizon is long enough and one’s patience deep enough, this is where the best risk-adjusted returns are hiding. But for most of us, finding unloved assets where value is realized over a handful of years is the best we can hope for.
One of the reasons is that asset managers (ahem) tend to be a very impatient lot, and most of their clients even more so. I heard it said once that “the patience of the client is three point zero zero years,” meaning that assets whose value may take more than three years to unlock are potential poison to the asset manager’s business. This is, therefore, where investors with longer time horizons, such as family offices, foundations, and pension funds, ought to focus. The problem is that most of these institutional investors lack the expertise to analyze deep-value propositions in all of the different possible fields, so they tend to rely on sell-side analysts and buy-side firms that clearly have a vested interest in persuading them that, say, farmland is still undervalued after years of being hot, or high-tech stocks are still worth buying back in 1999 because new metrics apply.
I am continually surprised in this context by how few people “get” something as simple as commodity indices. Perhaps it’s because most people think they understand the basic idea: a commodity is something that you can feel, like corn or cattle or copper. Seems simple enough, and since these assets have no cash flows associated with them, our discounted-cash-flow-trained brains tend to view them suspiciously. “If I can’t value tech stocks, because they don’t pay a dividend,” the thought seems to run, “then how can I value commodities? If I rely on another buyer coming along to purchase it from me, isn’t this the same as holding Pets.com and hoping another buyer comes along?” Deceptive similarities like this make investors treat commodities as much riskier than at root they are. The difference, of course, is that there may be value ascribed to Pets.com solely because someone else will pay for it, whereas the commodity item itself has value-in-use. That is, you can grind the corn into meal, you can slaughter the cow to make hamburgers, or you can draw the copper into industrial cabling. If you’re the last buyer of Pets.com, you may have nothing at all; but you will never be the last buyer of corn because there will always be Orville Redenbacher standing behind you.
Pets.com is much more like a dollar bill, when you think about it – it’s only worth something because someone else accepts it as being worth something. You can’t use it, per se, if you don’t like the price.
But commodities – and even worse, commodity futures – seem more ephemeral than stocks. You feel like you own something concrete when you own MF Global stock, or Lehman, or Enron, or General Motors… well, you get the point. What you own is a small part of a business that may or may not be there tomorrow, as the result of management decisions, government action, or a global financial crisis.
Now, all of this doesn’t mean that commodities are automatically undervalued. Some commodities are actually well-liked, such as gold. You either have to look at an independent measure, such as the ones we have developed that relate commodities to currency in circulation, or compare returns to some other asset class that we think we understand better.
And it is here that it becomes really obvious that commodities are really disliked. As of today, the S&P in real terms is just about exactly where it was at the end of the month Bear Stearns collapsed. Yet the DJ-UBS commodity index is still down 34% in real terms. (See chart, source Bloomberg, with 3/31/2008=100).
Equity bulls will tell you this is because stocks got cheap in 2009, and earnings rebounded with the economy. But these same people will tell you that commodities are languishing because of the risk of weak global growth. And commodities, too, were beaten up in 2009 (in fact, the DJ-UBS fell further than stocks). Where is their bounce?
The chart below shows a slightly longer time-frame, dating from roughly the lows of the post-equity-bubble bear market. You can see in this picture that these two markets move together much better, especially in the days since early 2009. The brief (oil induced) commodity bubble shows up in early 2008, but then the current period can only be called a negative commodity bubble (or, perhaps, the beginning of an equity bubble).
So I like commodities, and I like people telling me why they’re dead money. Those people are wrong, or they’re too impatient and that’s the same as wrong. By our measures, commodity indices are between 15% and 25% cheap to fair value while stocks are somewhat rich.
To know that you’re standing before a cherry tree, you needn’t have cherries; cherry blossoms suffice. The seasons are long, so if you want to be able to harvest the fruit you need to look early for the signs.
So it is with inflation, and some would say it is with markets in general. We look for the early hints (a less-poetic scribe might call them ‘green shoots’) that signal when the season has turned. With inflation, indeed, the season has turned long ago, when core inflation bottomed in Europe, the U.S., and Japan in 2010 (and in the UK even earlier). But as we have seen, markets have not yet internalized this turning, or in some cases (as with nominal yields) have begun the recognition and then reversed it.
Consider now the humble 7.5% gain this month in the DJ-UBS commodity index (and comparably large moves in many other indices). It isn’t the size of the move, or its consistency, that is interesting to me; rather, it is that the movement has come partnered with a break of commodities’ relationship to the dollar.
Since commodities for the most part are priced in dollars, it is natural that they tend to move in the opposite direction from the greenback. When the dollar strengthens, then commodities are more expensive to non-dollar consumers, and they demand less. Yes, of course there are other factors, but when there are no stronger underlying currents then commodity indices tend to move inversely to the dollar. The chart below (Source: Bloomberg) illustrates the strong coupling of the dollar index (here inverted) and the DJ-UBS Commodity Index in yellow, both normalized to August 1st, 2011.
But note that this recent movement in commodities has come not in conjunction with a weakening in the dollar, but in spite of a strengthening (albeit a modest one) of the unit. This, I think, may be the first blossoms of spring in commodity-land.
Some may object that the rise in commodity prices is primarily driven by grains, but this is not the source of this divergence. The chart below (Source: Bloomberg) shows the dollar index again (and again inverted) against the DJ-UBS ex-Agriculture Commodity Index.
I am not a disinterested observer of the Commodity Spring, as readers well know; our models have for some time now indicated that commodities were the only outright-cheap major asset class and our main strategy has been heavily overweight them for quite a while. So perhaps I will be accused of seeing blossoms where none have yet bloomed. But as commodity indices approach their highs of the year, they are still only 14-15% off their lows, and far below their highs of a few years back. They remain the cheap asset class.
Moving to inflation more-broadly, it seems the market is growing comfortable with the notion that core inflation may have topped since it hasn’t risen appreciably in a few months. It is certainly useful for those expecting QE3 – as am I – if that perception gains currency (no irony intended) since de-fanging the hawks on the Federal Reserve Board would seem to be a sine qua non for loosening policy appreciably. But I believe that comfort is ill-placed.
I had been expecting, based on the lagged effect of the large inventory of unsold homes last year, for the housing portion of core inflation to ebb from its recent pace. It has merely flattened out, and while inventories are coming down those declines shouldn’t begin to push shelter CPI up for another quarter or two. But long-lag relationships are inherently difficult since the lags can shift over time. So let’s look at a shorter-lag relationship.
The housing component of CPI is driven by rents, both for consumers who rent their residence (“Primary Rents”) and for the consumption value of owner-occupied housing (“Owners’ Equivalent Rent” or OER). The chart below shows the relationship between OER and the CBRE index of rents on multifamily property, lagged 2 quarters (the red dot marks the last OER point). The goodness of fit of this relationship, shown for the period 2001-present in the Chart below (Source: Bloomberg and BLS), is quite reasonable but interestingly, the recent rises in rents suggests that OER is significantly understated.
The number for the rental series ending in Q1 suggests that OER, which was last at 2.03% year-on-year in June, should be more like 3.4%. Since OER has a 23.5% weight in CPI and a 30.7% weight in core CPI, if OER were to converge it would be worth 0.4% on core inflation. And rental increases do not yet show much sign of ebbing. In short, the flattening out of core inflation over the last few months may represent the extent of what we can get out of housing at this point.
The last piece of evidence is really more corroboration of a speculation I’ve previously mentioned here. The sudden revival in apparel pricing this year has caught many analysts by surprise, and most have been expecting for the series to relapse soon (the price of cotton is often blamed, as if cotton hasn’t had any previous spikes in the last twenty years). My speculation was that the flattening and declining of apparel prices beginning in the early 1990s could plausibly be related to the opening of the U.S. textile industry to global competition, but if that is true then there must eventually come a time when the globalization has run its course and there are no more gains to be had from the declining domestic labor content in apparel. Thereafter, the rise in prices going forward should reflect rising wages in the source economies, without the dilution of changing composition.
Now Morgan Stanley has published a piece, by Joachim Fels et. al., called “Margin Call” (July 25, 2012). The authors illustrate that the U.S. margins of Chinese exporters have shrunk by 20-30% between 2004 and 2010, and argue among other things that “Price increases for Chinese imports and the spillover effects these are likely to generate may contribute to meaningful upward pressure on inflation.” This is not inconsistent with my speculation above, but adds a separate potential cause for the rise in apparel prices and other China-sourced prices (significant among them, incidentally, resin prices).
All in all, these pieces of evidence contribute to my belief that as consumers we ought to take time to smell the flowers, because the harvest of cherries is likely to follow in train. And in this case, that would be the pits.
 The R2 should be taken with a grain of salt, however, since these are overlapping observations.
All in all, January wasn’t too bad. The S&P gained 4.4%. The DJ-UBS and SP-GSCI commodity indices rose 2.5% (USCI rose 4.9%). The 10y Treasury note yield fell 8bps. The yield of the July-21 TIPS fell 30bps to -0.43% – although, thanks to the roll, the current 10-year yield fell “only” 15bps.
The 10-year inflation swap rate rose 26bps to 2.53%.
So, basically, if you were long just about anything in the U.S., you made money in January. So then why was everyone so depressed? Consumer Confidence, which had been expected to rise to 68.0, instead dropped to 61.1. The “Jobs Hard to Get” subcomponent, which tends to move coincident with the Unemployment Rate, rose to 43.5 (see Chart, source Bloomberg). While that’s a 3-month high, it’s still well below the worst levels of the last few years although it should also be said that it doesn’t help the argument that Employment is on a steadily-improving trend.
Commodities prices being up is a good thing if you own commodity indices, it isn’t such a good thing if you don’t. Gasoline futures were up 7.5% over the month, and prices at the pump were up 15 cents (see Chart, source Bloomberg). Precious metals rallied 12.7%, but Industrial Metals jumped 10.9%. And I’m not saying these things are related, but M2 is up 1.3% (22.9% annualized) in the first three weeks of 2012, while European M2 rose 1.3% in December (15.2% annualized), the last data we have available.
Alas, this rising tide isn’t yet lifting all boats. The Case-Shiller Home Price Index fell -0.70%, more than expected. This takes the index perilously close to the lows from last spring, which optimists had believed were left behind us for good by summer. (The good news is that this will help restrain the inexorable rise in core inflation, so that central bankers bent on looking for an excuse to ease will probably get one if they don’t look too hard for what’s happening besides housing).
I should point out that the 61.1 reading in consumer confidence, and the weaker-than-expected Chicago Purchasing Managers’ report (60.2 vs 63.0 expected and my expectation of slightly better than that), while not cause for celebration, are also not disastrous. Taken together, they may shake the faith of economists predicting a smooth acceleration in the economy, but are not cause to reject a null hypothesis of a choppy, gradual, improvement in the economy.
That hypothesis will also not take much water if tomorrow’s ADP figure is 182k, which prior to last month’s best-ever print of 325k would have been regarded as quite respectable. Unfortunately, I suspect that there is some payback coming, and the figure will look weak. Prior to last month’s number, the prior six months had only averaged 136k. A modest improving trend to, say, 175k would suggest 150k needs still to be ‘paid back’ through revision or a shockingly low print tomorrow. I don’t expect that, but with the preponderance of the evidence on the labor market (including the Jobs Hard to Get number) indicating stability but not strength, I would be surprised if ADP exceeds expectations counting revisions.
Also out tomorrow is the ISM survey. The consensus of Bloomberg-surveyed economists is 54.5, but there’s a caveat here. The median estimate of economists who updated their estimate today after Chicago PM and after the ISM released new seasonal factors is 54.0. And frankly, that seems high. Last month’s number, which was originally reported at 53.9, has been revised downward to 53.1 and Chicago PM showed weakness. Be careful here, because a print of, say, 53.5 would look like a weak print to those who mechanically compare it to the consensus that includes stale data, but would still represent a slight strengthening trend.
I am anything but a bull on the economy at the moment, but that’s mainly because of the impending implosion of Greece and/or Portugal and/or who knows what other country. It is fair, though, to observe that the economy in the last few months is doing passably. It’s not strong enough to shrug off bad news from the Continent or meaningfully higher gasoline prices, but it’s also not collapsing. At the moment, anyway. Unfortunately, I think stocks are priced for much better than “an economy that’s not collapsing,” and are counting on the QE3 wind in their sales. Valuation is dicey here but I am reluctant to fight the Fed until the inflation numbers tick up a few more times.
After all, it doesn’t take as much hope to move the stock market as it once did. Today’s equity volume was the heaviest of the month at almost a billion shares traded on the NYSE. Note the word “almost”: the last month during which there were no pan-billion-share days was last April, but January’s volume is weak even compared to that (15.2bln shares versus 16.9bln last April). Prior to last April, I can’t find another month with no billion-share days to at least 2005 (which is the earliest data I have), and I suspect we have to go back into the 1990s to find one. Again, this isn’t very healthy.
And that’s why investors continue to flee into Treasuries and TIPS. That’s a very crowded trade at a very high price, and not a place I want to be. Bonds are in fact priced for depression. The 30-year TIPS yield has reached an all-time low of … wait for it … 0.60%. Think about that – if the economy grows at a feeble 2.1% for the next three decades, you are giving up 1.5% real growth versus just sitting around and participating pari passu in the economy. With nominal 30-year bond yields at 2.94%, markets are also forecasting very weak long-term inflation. Both Treasury and TIPS yields are going to go higher eventually, and not only will investors be selling them but so will the Fed, and all the while the Treasury will be trying to sell still more. I want to be on the side of the angels on that one, and am willing to risk the ‘Japan outcome’ (being carried out due to your bond short) to be short here.
 This isn’t technically exactly right, since TIPS are based on CPI. Since the GDP deflator is usually about 0.25% lower than CPI over time, CPI+0.6% is like PCE+0.85%. But you get the point.
 Again, not to get too technical, but there are two offsetting effects here. One is that breakevens (Treasury yields minus TIPS yields) isn’t the best way to look at expected inflation; inflation swaps are cleaner and don’t suffer from the funding disadvantage of being short Treasuries so they are a better indicator of inflation expectations. The offsetting effect is that the 30-year breakeven or inflation swap probably includes a risk premium due to the length of the structure – that is, you’re willing to pay a bit per year more for 30-year protection than for 10-year protection.