The answer probably is yes, but not until the financial system’s balance sheet is repaired and the global economy begins to recover. Wide-spread balance sheet de-leveraging by financial institutions will undoubtedly be deflationary and cause a recession of as yet unknown depth and length. The prospect of a deep recession, as well as a more pressing need to generate liquidity to plug up gaping balance sheet holes, is what triggered the commodity sell-off.
As was seen during Japan’s Heisei Malaise, the initial gobs of liquidity pumped into the system during financial market crises are absorbed in their entirety by the banking system. In a normally operating economy, banks function as money multipliers and conduits for monetary policy to feed into the real economy in that monetary stimulus provided by the central banks in what is known as the fractional reserve system.
The fact that banks usually keep only a fraction of their deposit base in the vault and recycle the rest of their deposits back into the economy through loans and other credit creates the so-called “money multiplier” effect, where liquidity provided by the central bank is converted into a multiple value of credit created in the real economy.
In times of financial stress, however, banks cease to perform their function as money multipliers and hoard liquidity and destroy rather than create credit and liquidity. They are too busy repairing/deleveraging their own balance sheets and tightening credit to minimize loan losses. US and European banks will not again be able to function as money multipliers until they deleverage/clean up their balance sheets. This will be a deflationary, not inflationary process.
Japanese banks and companies, however, have already cleaned up their balance sheets, and the Japanese financial system never had the kind of leverage seen in the US and European financial systems.
At some point, however, monetary and fiscal stimulus will overshoot as bank balance sheets repair and the recession plays out, resulting in too-fast growth in the money supply. Overly aggressive/accomodative monetary and fiscal stimulus will not only be inflationary, substantially exacerbated government financial deficits could well debase the currency and can lead to a currency crisis.
Financial Crisis and the Commodities Bear Market
The following table shows that commodity prices peaked roughly a year after stock prices peaked, and have now crashed just about as much as stock prices have.
Simply put, commodity prices do well in periods of economic expansion AND rising inflationary expectations, but lousy in recessions and worse during deflations.
Unlike the 1973/1974 bear market that was characterized by runaway inflation, the deleveraging cycle that was unleashed with the collapse of the mortgage-backed securities market will first and perhaps overwhelmingly be deflationary, similar to the 1930s and the 1990s in Japan.
While commodity “super cycles” have historically lasted 25~40 years, commodity prices tend to perform best in periods of strong economic growth, such as the period before the global credit crisis hit in August 2007. Until the second half of 2007, world GDP was growing at a robust 5% per annum, equaling the strongest, steadiest and longest global economic expansion since the 1960s. The major macro-economic differences between this commodities bull run and the previous in the 1970s are;
1. Monetary policy was much more accommodative during this cycle because
inflation pressures were nowhere near as high.
2. There were no supply shocks, such as the oil shocks of the 1970s.
3. There was less scope for commodity demand substitution.
4. Incremental commodity demand was being driven by high economic growth and
active construction spending in the emerging market BRICs and the Middle
East.
5. Commodities became a bona fide investment asset class for institutional
investors. The favored vehicles for this investment were not the physical
commodities, but commodities indices, trading in which was facilitated by
commodity derivative contracts which were estimated to have reached a
notational value of $9 trillion by December 2007, according to the Bank of
International Settlements, and a gross market value of $753 billion ($673
billion of which was non-gold/precious metals commodities).
A 20-year bear market in commodity prices had depressed investment in new production capacity, while growth in underlying “real” demand was accelerated by rapid growth in global demand from the BRICs/emerging economies.
For example, China’s oil consumption alone grew from 5.5 mm/bbl/day in 2003 to 7.5 mm/bb/day by 2008. They now account for 31% of global crude oil demand. China was also responsible for 64% of the increase in global demand for copper, 70% of the increase in global aluminum demand, and 82% of the increase in global demand for zinc, as the economy soared along at 10% PA+ growth rates.
In addition, institutional investor assets under management in commodities grew with increased portfolio asset allocations to commodities as an asset class “uncorrelated” with stocks and bonds. Commodity funds under management soared from an estimated (by the previous Lehman Brothers) $70 billion at the start of 2006 to $235 billion by April 2008 as pension funds tried to allocate between 3% and 5% of total assets under management in commodities. Sovereign Wealth Funds also allocated about 5% to commodities, and hedge funds were taking leveraged bets on stronger commodity prices.
That’s a lot of money sloshing around in rather small commodities markets. In 2006, McKinsey estimated global institutional assets under management to be $167 trillion, while Pension & Investments magazine estimated that the global fund management industry in 2007 had $74.3 trillion under management. Including alternative investors like sovereign wealth funds, hedge funds and private equity, the P&I figure for total assets under management was more like $110 trillion.
Allocating 5% of $110 trillion in assets under management implies buying demand of $5.5 trillion, a number much, much bigger than the entire size of the commodities market heretofore. Coversely, the value of entire physical gold demand (World Gold Council estimates) was only $78.5 billion in 2007 when gold was at $695/ounce.
Moreover, options traded by investment banks trying to accommodate these massive fund flows into commodity index products accounted for 50%~60% of trading volume in commodity markets. Given both strong “real” demand as well as soaring investment demand, it is not surprising that gold surged 4.1-fold from $252.50 in 1999 to a new high of $1,033.90 in 2008, and crude oil futures surged 12-fold from under $12/bbl to $147.90/bbl.
However, the market dynamics of the commodities market dramatically changed in 2008. Investors first piled into commodities as a means of offsetting deteriorating performance in equities, but from the middle part of 2008, investor attention rapidly shifted from concern about the inflationary impact of soaring commodities prices to the deflationary/recessionary impact of the credit crisis as credit markets remained frozen.
As the chart from the IMF clearly shows, commodity prices have declined sharply during previous downturns, and growing fears of an economic downturn following the credit crisis immediately began to be discounted in commodity prices after the peak in prices in July 2008.
Moreover, this decline was exacerbated by presence of leverage (commodity derivatives like options, forwards and swaps). Just as investors and began to realize that demand from BRICs nations centering on China was beginning to falter, they were getting margin calls on leveraged commodities positions, forcing them to sell even more.
In terms of physical demand, reports were filtering out of sharp reductions in steel production in China before GDP estimates for the country were sliced from 10%-plus to as low as 6.5%, i.e., the lowest growth since 1990. Companies like Rio Tinto for example were reporting significantly lower demand for aluminum and iron ore imports, while Japanese car makers were cutting back China production. Home sales in Shanghai and Beijing between January~August 2008 have plunged 38.5% and 55.5% respectively.
While it is unlikely that China and the emerging economies will see negative growth, growth in the developed nations will be flat-to-minus, resulting in global GDP growth of 3% or less, which the IMF defines as a global recession.
Consequently, the forced selling of commodities by leveraged hedge funds because of record redemptions and fund outflows only exacerbated the downturn, just as it had exacerbated the upside price movement.
Thus, in analyzing commodity prices both in terms of underlying demand from BRICs/emerging nations and in terms of leveraged investment demand from institution and hedge funds, it is not surprising why commodity prices have subsequently plunged almost as fast as stock prices.
Even though commodity brokers claim that price movements in “alternative asset classes” such as commodities are not correlated with price movements in stocks and bonds, that is simply not true in a financial crisis, given the unwinding of substantial securitization of commodities and the increasingly complex linkages between stocks, bonds and commodities in institutional investors and hedge fund portfolios.
Is Gold That Much Different?
Gold’s failure to make new highs amidst maximum investor fear and blood-letting in equity investments has investors piling into physical gold scratching their heads as to why gold was not already well past $1,000/ounce. While many argue that gold marches to the beat of a different drummer than other commodities, the supply-demand factors that, according to the World Gold Council, are instrumental in determining the price of gold show much of the same pressures on gold as other commodity prices.
In terms of the demand side of the equation, gold demand consists of; a) jewelry demand, b) industrial demand and c) investment demand. Jewelry is economically and price sensitive as is industrial demand. On the other hand, investment demand for gold is driven by investor demand as an inflation and USD hedge, as well as a safe haven hedge.
Newly mined gold is not the only source of supply. In fact, recycled gold and official central bank sales of gold account for over 40% of total supply.
Between Q2’07 and Q2’08, World Gold Council data show that jewelry and industrial demand in volume has been declining by 24% and 5% YoY, while identifiable investment demand for gold in volume was also declining by some 4% YoY. Yet demand in US$ terms increased 9% YoY because of a 34.4% YoY increase in the price of gold during the period.
Ostensibly, the greater risk aversion, recession and inflation fears of investors, the greater propensity to invest in gold. However, the gold market has also seen a great deal of securitization (paper gold) with derivatives and the establishment of gold ETFs, meaning that short-term liquidity needs of investors also affect the price of gold, particularly during periods of severe financial sector stress.
Moreover, gold tends to move in reverse to the USD index. A serious recession in the US is actually bullish for the US dollar because it reduces the supply of USD globally that heretofore had been provided by growing balance of payments deficits. A rising USD index in turn reduces demand for gold as a USD hedge.
What is essentially left is safe haven investment demand, i.e., to hedge against the possibility of a total collapse in the USD, a series of bank runs or other financial sector chaos, or the igniting of runaway inflation as central banks pull out all the stops to stave off a financial sector melt-down. Thus, a renewed surge in credit spreads triggered by growing despair that US and European government initiatives to free up credit markets are not working would re-ignite investment demand for gold.
On the other hand, demand for physical gold is strong. Investors in Europe are piling into gold coins as their faith in the global financial system has been tested, and the government mint of one country is reportedly working at full capacity 24/7 to meet this demand. Sales of gold coins are also on the rise in Japan, and demand is strong in the Middle East as well as the very important India, which is a major consumer of physical gold.
As a result, the price of gold has not fallen as far as other commodities from its $1,000/ounce plus high (gold futures are down 28% versus +/-50% declines for other commodities) because there is a solid base of demand for jewelry in addition to “safe haven” investment demand for physical gold.
We believe the tug-of-war between forced selling of paper gold and strong underlying demand for physical gold will eventually be won by physical gold buyers. Depending on how much forced selling the remains from hedge funds and other leveraged players, gold prices could continue to waffle downward—to the mid-$600 range—before finding more solid jewelry demand support.