The “commodity supercycle” myth dies hard

August 1, 2017

[The following is an excerpt from a TSI commentary published about one month ago, but with updated charts.]

Some commentators on the financial markets still refer to something called the “commodity supercycle”. This is remarkable considering that the inflation-adjusted (IA) GSCI Commodity Index (GNX) made a new all-time low early last year and that relative to the Dow Industrials Index the GNX is not far from the all-time low reached in 1999. The relevant charts are displayed below. Just how badly would commodities have to perform to completely bust the supercycle myth?

IAGNX_010817

GNX_Dow_010817

We’ve been debunking the “commodity supercycle” in TSI commentaries for at least 10 years. The following lengthy excerpt from an August-2007 commentary is an example:

…when it comes to the “commodity supercycle” we are definitely sceptics. We concur with the view that commodity prices in general and metal prices in particular are in long-term upward trends, but we do not think these trends are being driven by the strong growth of “Chindia” or the global spread of capitalism or the industrialisation of Asia or the movement of billions of people to the ranks of the “middle class” or any of the other catchphrases routinely used to neatly explain the price action. In our opinion, these explanations rank alongside slogans such as “new economy” and “technology-driven productivity miracle” that were used to legitimise the price action of tech stocks during the boom of the late-1990s.

As we see it, inflation (money supply growth) is causing a rolling boom/bust cycle whereby the combination of relative valuation and scarcity determines which sectors will be the major beneficiaries of inflation during the current cycle and which sectors will be relegated to the investment ‘scrap heap’.

The analysts who concoct simple explanations based on real (non-monetary) changes in the world and repeat these explanations in mantra-like fashion will look incredibly prescient for a long time, even though they largely ignore the monetary factors that are actually at the root of the price changes. Some of these analysts will even take-on the status of prophets due to their apparent abilities to see the future. But the inflation-fueled boom will eventually turn into a bust, even if the touted fundamental bases for the boom persist. For example, the growth of the internet and technological progress in general did not ‘miss a beat’ when the NASDAQ crashed. All that happened was that the primary focus of inflation shifted, causing the “new economy” prophets to fade away and bringing to the fore a new bunch of prophets who chant “commodity supercycle”.

The above three paragraphs can be summarised as: There never has been and there is never likely to be a “commodity supercycle”. Instead, during some periods financial assets are the main beneficiaries of monetary inflation and during other periods commodities are among the main beneficiaries of monetary inflation.

It’s as simple as that.

The periods when financial assets are the main beneficiaries of monetary inflation are, on average, much longer than the periods when commodities are among the main beneficiaries of monetary inflation. This is because central bankers generally view large multi-year rises in commodity prices as evidence of an inflation problem and large multi-year rises in financial-asset prices as evidence that everything is fine. Consequently, steps are taken to curtail the monetary inflation more quickly when commodity prices are leading the charge.

The situation today presents an asset-allocation challenge because it’s far too soon for a new long-term commodity boom to get underway, but the major financial assets (stocks and bonds) are near their highest valuations ever. We are dealing with this situation by becoming more short-term-oriented in our thinking, which for us means not looking beyond the next 6-12 months when deciding what to own.

Print This Post Print This Post

The “we” fallacy

July 26, 2017

Globalisation, a term that when used in economics refers to the integration of national economies into a global marketplace, is perceived to be part of the reason for economic weakness in some countries. This is a perception that the politically-astute feed upon, often by invoking the “we” fallacy.

According to the “we” fallacy, anyone who happens to be located inside an arbitrary border is one of “us” and deserves preferential treatment at the expense of anyone who happens to be located outside the border. The “we” fallacy underpins the concerns that are routinely expressed about trade deficits, the thinking being that “we” are being hurt because “they” sell more stuff to us than we sell to them*.

To expose the flawed logic that initially leads to teeth-gnashing over trade deficits and subsequently leads to protectionist trade policies, I’ll use a hypothetical example involving two pig farmers (Bill and Bob) and a butcher (Arthur). Bill, Bob and Arthur live and work in a small US town located 1 mile south of the US-Canada border. Bill is a more efficient pig farmer than Bob and is thus able to sell his pigs at a 10% lower price. Consequently, Arthur buys twenty pigs per year from Bill and none from Bob. This arrangement continues for several years, at which point Bill decides to move his farm 2 miles to the north (to the other side of the US-Canada border).

Business-wise, nothing changes and Arthur continues to buy 20 pigs per year from Bill. However, due to the minor change in the physical location of Bill’s farm the business that Bill and Arthur have been conducting for many years now adds to the US trade deficit. In other words, a business relationship that nobody was previously concerned about suddenly becomes a problem for the collective “we”, even though nothing has really changed. Bob, sensing an opportunity, complains to the US government that he will have to fire his farmhand unless something is done to prevent his business from being undercut by cheap imports. In response, the US government slaps a 15% tariff on Canadian pigs, prompting Arthur to start using Bob as his pig supplier.

In this hypothetical example Bob has clearly benefited from the government’s interference in the pig market, but only at Arthur’s expense. Arthur is now forced to pay 10% more for his pigs, which will either cut into his profits — and, perhaps, curtail his plans to invest in the growth of his business — or cause him to raise his prices. Whatever happens, Bob’s gain will be matched by the loss incurred by other people within the US. In other words, the US “we” will not actually benefit, even in the unlikely event that the Canadian government doesn’t take counter-measures in an effort to protect its own collective “we”.

In the same way that the overall US economy failed to benefit from the pig tariff in my hypothetical example, “we” can never benefit from policies that restrict international trade. This is because from an economics perspective there is no “we”, there are just individuals trading with each other for their mutual benefit. A consequence is that when measures are taken by the government to protect the collective “we”, what actually results is the artificial creation of both winners and losers. The benefits gained by some individuals within the economy will be offset by the losses of others within the same economy.

The upshot is that protectionist measures are, at best, a zero-sum game, although in most cases they will turn out to have a net-negative effect on the ‘protected’ economy because they will interfere with price signals, keep inefficient businesses alive, and generally make both the cost of doing business and the cost of living higher than would otherwise be the case.

Protectionist measures are often popular, though, especially during hard economic times. Here’s why:

First, you generally need only a superficial understanding of economics to see the immediate and direct effects of a policy, whereas a deeper understanding of economics is often required to see the long-term and indirect effects. Very few people have this deeper understanding, so all they see are the immediate and direct effects of protectionism, which could be positive.

Second, the immediate benefits of the protectionist policy are typically concentrated, whereas the costs are widely spread. As a result, a politician can adopt a protectionist stance to gain the support of the relatively small number of people who are advantaged without losing the support of the much larger number of people who are disadvantaged. It’s an example of robbing Peter to pay Paul, where Paul notices and Peter doesn’t.

Third, when things are obviously going wrong it’s convenient to point the finger of blame outward at “them”. It certainly beats trying to identify the real source of the problem when doing so would lead to the finger of blame being pointed inward.

I guess we should be thankful that the same flawed logic that is often applied to international trade is usually not applied to interstate trade and is never applied to trade between towns, neighbourhoods and individuals within the same state, because if it were then there would be a lot less trade and a lot less wealth. The only reason the flawed logic isn’t applied at a more micro levelĀ is that the collective “we” is arbitrarily defined as everyone on a particular side of a country border.

*Refer to my 13th February blog post for an explanation of why a trade deficit is never a problem.

Print This Post Print This Post

The Fed versus the Market

July 25, 2017

The following monthly chart shows that the year-over-year (YOY) growth rate of US True Money Supply (TMS) made a multi-year peak in late-2016 and has since fallen sharply to an 8-year low. The downward trend in US monetary inflation since late last year has been driven by the commercial banks, meaning that the pace of commercial-bank credit creation has been declining. The Fed, on the other hand, hasn’t yet done anything to tighten US monetary conditions. All the Fed has done to date is edge its targeted interest rates upward in a belated reaction to rising market interest rates.

That the Fed has been tagging along behind the market is evidenced by the following chart comparison of the US 2-year T-Note yield (in blue) and the Effective Fed Funds Rate (in red). The chart shows that a) the 2-year T-Note yield bottomed and began trending upward in the second half of 2011, b) the Effective FFR bottomed and began trending upward in early-2014, and c) the Fed made its first rate hike in December-2015. The market has therefore been pushing the Fed to raise its targeted interest rates for several years.

FFR_2yr_250717

Interestingly, the Fed has caught up with and is possibly now even a little ahead of the market. This suggests scepticism on the part of the market that economic and/or financial conditions will be conducive to additional Fed rate hikes over the coming few months.

Based on the prices of Fed Funds Futures contracts we know that the market does not expect the Fed to make another rate hike until December at the earliest. This expectation is probably correct. Rather than make an additional ‘baby step’ rate hike there’s a good chance that the Fed’s next move will be to start reducing the size of its balance sheet by not reinvesting all the proceeds from maturing debt securities. Unless the stock market tanks in the meantime, this balance-sheet reduction will probably be announced on 20th September (following the FOMC Meeting) and kick off in October.

When the aforementioned balance-sheet reduction does start happening it will constitute the Fed’s first genuine attempt to tighten monetary conditions, although, as mentioned above, US monetary conditions have been tightening since late last year thanks to the actions of the commercial banks.

Print This Post Print This Post

Don’t think like a lawyer

July 21, 2017

The job of a judge or juror is to impartially weigh the evidence and arguments put forward by both sides in an effort to determine which side has the stronger case. The job of a lawyer is to argue for one side, regardless of whether that side happens to be right or wrong. As a speculator it is important to think like a judge or a juror, not a lawyer.

Unlike a lawyer, a speculator can change sides ‘mid-stream’ if necessary to keep himself on the side favoured by the current evidence. There is no need for him to stick to a position come what may. However, changing sides is easier said than done, which is why so many speculators and commentators aren’t able to do it. Rather than let the evidence determine their stance, they adopt a stance and then look for confirming evidence. If they come across conflicting evidence, they downplay it. They aren’t aware of it, but their goal is to prove a particular case rather than align themselves with the strongest case.

Sometimes the case that a speculator desperately wants to prove also happens to be the case supported by the strongest evidence, enabling him to make large gains. However, if he continues to think like a lawyer he will eventually run into the problem that the weight of evidence shifts. After the inevitable shift happens he will steadfastly maintain his earlier position and lose whatever advantage he previously gained from being on the right side of the market.

In my speculations and financial-market writings I’m sometimes guilty of thinking like a lawyer. That’s why I developed the gold model (the Gold True Fundamentals Model – GTFM) that was discussed in a blog post last month. This model prevents my own biases and opinions from getting in the way when assessing whether the fundamental backdrop is bullish or bearish for gold.

The bottom line is that there is never a requirement for a speculator to defend a position. Unlike a lawyer, he is free to change with the evidence.

Print This Post Print This Post