Materials Risk

A number of people have asked me what they should invest in if inflation suddenly starts to increase over the next few years. A return to inflation as a major and negative part of economic life would be a generational change. The last time we saw inflation in the double-digits in the developed world wasn’t since since 1990, while most of the past decade has been spent in a desperate effort to raise inflation, not control it. Yet there are emerging signs that inflation could return, perhaps more swiftly than many expect.

To understand how to guard against it, investors first need to be aware of the difference between expected and unexpected inflation. Expected inflation is essentially the market’s consensus view on the future path of inflation. Since financial markets are forward-looking, they presumably incorporate this view into current asset prices. In contrast inflation risk relates to unexpected inflation.

Based on analysis from PIMCO the following assets have performed well during periods of high and unexpected inflation – Treasury Inflation-Protected Securities (TIPS), non-dollar currencies, commodities and gold.

Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds whose value is contractually linked to CPI. As T-bills are frequently considered a “risk-free” asset, inflation expectations are often gauged using T-bill yields. Meanwhile, non-dollar currencies meanwhile may help combat inflation driven by higher prices for imported goods which are brought about by a weaker U.S. dollar.

But by far the most effective assets have been in commodities and gold in particular. Commodities may help hedge against rising food and energy prices and are its most volatile components. Commodity investments can therefore act as a shock absorber for inflation surprises. Gold has characteristics of both a commodity that is easily stored for a long period of time and a currency. It may help provide value in the event of competitive currency devaluations.

Bonds on the other hand, have historically responded negatively to surprises in inflation. Bond prices tend to fall because inflation erodes the value of investments with a fixed income, or yield; it is also associated with rising interest rates.

Equities have traditionally been viewed as an inflation hedge asset class. The theory is simple: a company’s revenues and earnings would also rise with inflation over the course of time. From a long-term perspective, equities may therefore be considered an inflation hedge.

However, the proposition does not always hold over shorter periods of time. Since equities can be thought of as a discounted stream of future cash flows, higher inflation means that the discount rate applied to those cash flows rises, which lowers their current value. Higher interest rates also increase the cost of capital to corporations, and higher inflation means that earnings may be overstated since they depreciate historical cost rather than replacement cost of assets.

For investors looking to increase their exposure to commodities and gold to hedge against an inflation surprise that presents a conundrum. Short of investing in physical gold (the ideal investment if their funds allow) most investors would need to gain exposure to commodities by investing in commodity producers (gold miners and energy companies for example).

Note that the share price of commodity producers are not always correlated with the price of the underlying commodity. Factors such as capital expenditure, government policies, management, balance sheet and accounting practices, unforeseen operational issues (a miners’ strike, for example) and the general appetite among investors can all affect the share price.

Analysing an index of commodity producers (the MSCI All Country World Commodity Producers Index) against an all share index (MSCI All Country) in the 35 years to 2008 showed that producers consistently outperformed the general market when inflation rose above its historical 36 month moving average, but produced mix results when inflation was below this level. However, since the driver for inflation varies over time so the correlation between commodity producers equity values and inflation also varied over time.

In short: To hedge against unexpected inflation risks its probably best to increase your exposure to physical gold and some degree of commodity futures (always being wary of the potential for negative roll yield to erode your returns).

Bloodbath. Armageddon. Crash.

As soon as markets begin to volatile you can bet that commentators are wheeled out to explain why it happened, what you can expect to happen in the future and what individual investors should do.

TV financial media is designed to entertain you, not necessarily to enlighten you with insight that will make you better at making the right financial decisions. Like any form of entertainment, financial TV is designed as an assault on your senses, with all manner of irrelevant information in which to overwhelm our cognitive resources. Financial media caters for the majority, it doesn’t cater for you and your specific circumstances. Remember, truth is harder to sell than fear. The question then becomes, is there anything better?

The move away from an information system based around vertical axes of trust (ie, conventional research and investment institutions), to one predicated on horizontal axes of trust (ie, Twitter and other forms of social media), has important implications for commodity and other financial markets. Although you could argue that social media (whether that takes the form of blogging or updates on networks like Twitter) democratises the supply of information, commentary and forecasts, it also forces the consumer of that information to swim through an ever increasing flood of viewpoints and commentary in order to weed out the gems. In turn, it leaves them open to the risk of information overload and of being overly responsive to the latest market updates.

In research published by Oxford University, entitled “Social Media, News Media and the Stock Market”, researchers found that the most talked about stocks on social media exhibited more volatility than those that did not. Although the research didn’t specifically look at commodity futures, it would not take too much of a stretch to imagine a similar impact here.

Despite the risks of information overload, maintaining a diverse set of information and views is likely to help raise returns for both traders and investors. Two academics at the MIT media lab in Boston – Sandy Pentland and Yaniv Altshuler – have been crunching vast quantities of computer data to track what happens to commodity and foreign exchange traders who are plugged into social media, such as Twitter. The MIT research suggests that investors do not perform as well when they are isolated from social groups.

The image of a brilliant, maverick trader sitting alone and shunning conversation to order to make winning individual trades is wrong. However, neither do traders outperform when they are embedded too deeply in any single market group, be that the gold bug community, oil market watchers or enthusiasts for any other commodity market. Instead, the best returns occur when investors are plugged into diverse social groups that enable them to collide with information from multiple networks. In the social media world, as in real life, it pays to hover on the edge of cliques – but not get slavishly sucked into just one.

Just as there is a danger in blindly following forecasts from renowned institutions, the MIT researchers argue that social effects are so strong that they sometimes over-ride individual’s rational assumptions. Individual traders are often prone to much riskier behaviour when following their peers, and are much more likely to overreact when their peers are doing so and market uncertainty is high. All of the commodity traders in the world (whether you are a physical buyer or seller or just speculate on the price of commodity futures) are organised into networks of friends, colleagues, contacts and others who are all sources of information and opinion and therefore influence. According to the concept of herding and imitation, commodity traders tend to imitate the opinions of their “neighbours” in their network, not contradict them. Social media may make this effect even stronger.

Oil is certainly the commodity market, perhaps along with gold, that gets the most attention from investors, but the impact of social media is far more widespread. The relatively private bulletin boards where the future of this or that commodity and the companies that produce them is still there; however, now you only need to search for a particular commodity or company and you can get a constant stream of unfiltered news and opinion. The trick is to spend enough time understanding each person’s agenda and track record in order to filter out the noise.

False hoods (ie, convincing narratives) can feed on themselves to take commodity and other asset markets well away from where the price should be. The occurrence of false trends is only likely to rise as global information and interpretation flow increases and narratives become more uniformed and accordant. Nassim Taleb put it well when he said:

The mind can be a wonderful tool for self-delusion – it was not designed to deal with complexity and nonlinear uncertainties. Counter to the common discourse, more information means more delusions: our detection of false patterns is growing faster and faster as a side effect of modernity and the information age: there is this mismatch between the messy randomness of the information-rich current world with its complex interactions and our intuitions of events, derived in a simpler ancestral habitat. Our mental architecture is at an increased mismatch with the world in which we live.

As information flows increase, it is now more important than ever to combine that with insight and knowledge. The commodity trader or investor of the future will find both on social networks. To this end, social media is something of a double-edged sword. According to Chris Berry of House Mountain Partners:

Most investors don’t have an adequate foundation of the multiple skills necessary to ask the right questions or interpret the answers. As a result, people end up in chat rooms making all sorts of claims. One of the best things investors can do is stay out of chat rooms.

So what should you do? According to Tadas Viskanta, author of “Abnormal Returns: Winning Strategies From the Frontiers of the Investment Blogosphere”, you basically have two options, “The first is to simply eliminate, or at least dramatically cut back on news consumption… The other option is to try and consume media in a smarter, more focused way.” If you as an investor, trader or producer or consumer of commodities have a time frame of more than several months, then there is a case for arguing that a media diet will help you. Nassim Taleb writes in his book, “Fooled by Randomness” that “the problem with information is not that it is diverting and generally useless, but that it is toxic.” On the other hand, as the success of most other diets testifies a media diet may not be all that successful either if it means you become less able to sift the wheat from the shaft.

And what about consuming media in a smarter, more focused way? There are two key aspects to this. The first is to focus on the best aggregators of information that are relevant to you. While this may result in you missing some bits of information, a competent aggregator of information should only highlight the information that is most relevant. Tadas Viskanta notes the value of following blogs, and here the market does a good job of working out who you should follow: “To a certain degree, the blogosphere is a meritocracy, an imperfect one for sure, but a meritocracy nonetheless. In general, the blogs that are consistently updated will find a growing readership.”

The final key aspect of consuming media more effectively is to be multi-disciplined and read widely. According to Oaktree Capital’s Howard Marks, “in order to be successful, an investor has to understand not just finance, accounting and economics, but also psychology.” That’s not just understanding the psychology of the market, but your psychology and also the psychology of the pundits and their inherent biases.

My recommendation? Do your own research. Learn from the best but rely less on the opinions of others when making investment or trading decisions. One way you can do this is by having a diary. Before you make an investment describe your reasoning in a decision diary that you can then refer back to at times like this when emotions can overpower rational thought.

This article is based on an extract from my new book, “Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino”.

According to Jan Hatzius, Goldman Sachs’ chief economist, forecasters face three fundamental challenges: first, it is very hard to determine cause and effect; second, that the economy is always changing and, third, that the data that they have to work with is pretty bad. This article looks at the last of those challenges in more detail.

Basic statistics and forecasts about oil reserves, production, consumption and stocks ought to be a matter of routine. You stick a gauge at the end of a pipe and measure the amount of liquid flowing through, right? However, it’s not that simple, and the problem isn’t limited to just oil, but to all commodities.

Doubts about the reliability of energy statistics were a major part of the “energy crisis” that erupted during the 1970s. As late as 1968, the US reportedly had four million barrels per day of spare production capacity. Meanwhile, thousands of wells across Texas and Louisiana were being operated for fewer than ten days per month. But by March 1972, spare capacity had dropped to zero; every well was at maximum production, domestic output was falling and politicians spoke of an energy crisis.

The oil embargo, announced in October 1973, intensified the sense that something had gone badly wrong, leaving the US unprepared. Politicians and the media blamed a conspiracy between domestic producers and OPEC for engineering the crisis to drive up prices and profits. Congress held hearings amid a sense the statistics and forecasts prepared by oil and gas producers and the US Department of the Interior had been inaccurate or manipulated. One outcome of the crisis was the creation of a new US Department of Energy, and within it a new Energy Information Administration (EIA), in 1977, to produce more accurate and independent data. Another was the creation of the International Energy Agency (IEA) in 1974, to gather better statistics and bring greater transparency to the international energy markets.

Improvements in data collection and forecasting in the US, led by the EIA, have by and large quelled controversy about domestic US oil production, consumption and stocks; but that doesn’t mean they are free from error or revision. According to a study by the Wall Street Journal (WSJ), annual estimates of global crude demand by the IEA in the seven years until 2016 were underestimated by an average of 880,000 barrels per day. And there is little evidence that the demand forecasts from others are any more accurate. The EIA also underestimated global demand – by an average of 2.3 million barrels a day.

Demand is much harder to estimate than supply. Unlike supply, which can be estimated from the pre-announced expansion plans of a relatively small number of companies, estimating demand involves billions of consumers worldwide and many millions of companies of all sizes.

Revisions to oil supply estimates are typically much smaller than for demand, and are often about correcting overestimates for crude production. The IEA’s supply data has been revised down 60,000 barrels a day on average over the seven years to 2016, according to the WSJ’s analysis. That means the oversupply usually ends up being smaller than initially thought. The history of data discrepancies underscores how oil markets often trade on incomplete data.

The information collected in many other parts of the world remains much less comprehensive and accurate. Two major sources of uncertainty are the deliberate secrecy of the major oil producing countries and poor data collection in emerging markets.

In late 2016, OPEC producer Iraq published an unprecedented level of detail about its oil producing activities. Instead of providing just one figure for output and one figure for how much it was exporting, the Iraqi authorities released detailed data about the crude oil output at each of its 26 oilfields and detailed export figures. This “transparency” was a calculated move to prove to outside observers, and other OPEC members in particular, that secondary source estimates of its oil production were way too high. In doing so, it was also making the case that Iraq should not be subject to output cuts.

The opaqueness of oil data from OPEC producers is nothing new. As with any oligopolistic organisation, there is an incentive for individual OPEC members to misinform. This can take the form of under-reporting the amount they are producing and the size of their reserves, but it can also result in outright disregard for pre-agreed production cuts – the higher the price of oil, the greater the incentive for an individual member to break the agreement. Remember, each OPEC member is a sovereign country, meaning that they are not legally obliged to commit to or honour any agreement.

The oil market is by far the largest, most liquid and most important commodity market in the world. If such big revisions are made in the oil market, then imagine how difficult it becomes to estimate demand and supply and then forecast prices in much smaller markets such as lead, live cattle or lithium.

Opaqueness can also be a feature of major commodity consumers too. Despite China’s undoubted influence on global commodity markets, developments in its economy continue to remain opaque and hence so too are its implications for commodity prices.

In the past week, the Financial Times published an article revealing the fake gross domestic product data routinely released from many northern Chinese regions. Although it has long been believed that authorities “smoothed” the economic growth figures, it is now clear that many provinces artificially boosted growth figures between 2012 and 2016, masking a real downturn, and last year covered up a genuine recovery.

Unreliable data makes it difficult to assess risk, which raises the probability of some internal shock. Statistics are never completely accurate, especially when trying to estimate activity in far flung parts of the world. An analyst trying to figure out where the price of copper is going next has to first look at what could happen to copper demand growth. Will it slow, increase or even fall? For this you need to look at what businesses consume lots of copper, not just in the US, Europe or China but also in emerging economies where the quality and frequency of data may leave much to be desired.

Even if there were copious amounts of statistics available in real time and covering all aspects of demand and supply, that doesn’t mean that the data is the best and the final estimate. Think about population growth for a minute, which is thought by many to be the most predictable of all variables that could affect future demand for commodities. Ignoring the uncertainty about the future, even the baseline from which you could take a forecast is uncertain and subject to frequent revisions. As Dan Gardener remarks in his book “Future Babble”:

…demographic facts like this are based on available research, and when new research suggests the established “fact” isn’t accurate, it has to be changed. Between 1951 and 1966, the official estimate of the world’s population in 1951 changed 17 times.

Uncertainty about what is happening to commodity supply and demand, and thus the overall commodity balance, is not without cost. The uncertainty is likely to increase the risk premium that commodity producers use to decide on whether to invest or not. This increases the cost of that investment, perhaps resulting in delays or cancellations. The cost of which will only be felt during the next upturn in commodity prices when, yet again, producers may be caught in the dark.

Better data on commodity demand and supply outside of the US must be the priority if policymakers want energy and other commodity markets to operate more smoothly. The activities of large commodity producers are particularly opaque. Better data on consumption in fast growing emerging economies will also help to give a more accurate assessment of demand prospects.

Some private companies and often large institutional investors deploy people to count cocoa stocks in the Ivory Coast, use infrared cameras to monitor oil levels in storage tanks in the US or set up cameras to film coal stocks at Japanese power stations. All are set to determine the inventory fluctuations and price discrepancies through which they and their clients can profit. This kind of inside edge is outside of the scope for all but the wealthiest people. Nevertheless, some participants in the commodity markets are fighting back. Using a combination of technology, crowd sourcing and social media, they are beginning to change things for the better.

Samir Madani, a consumer electronics entrepreneur, saw an opportunity to combine real time data with his passion for oil markets. Traditionally, oil researchers and forecasters would talk about their expectations for supply and demand. However, without knowing how much is being exported and how much is going into storage, the overall supply and demand estimates are of limited use. I interviewed Sam for my latest book and he explained he launched the not-for-profit website Tanker Trackers to help increase market transparency by combining crowd-sourced data on crude tanker movements and official data published by government agencies. “I love real-time data and felt that the average Joe had no insight into what’s happening out at sea,” Sam told me as he outlined his vision of how he could help disrupt the market to the benefit of “ordinary” traders:

Two-thirds of the world’s oil is transported by sea and instead of hearing what crystal-ball-polishers think the price of oil would be end of the year due to supply vs demand, I felt that I could do something about it.

It’s here where crowd-sourced information on tanker loadings can help increase market transparency, hopefully allowing traders and physical market participants to make better decisions. For example, knowing that one week there was an unusually large spike in tanker loadings in Saudi Arabia destined for the US means that a trader can deduce that in approximately 45 days time there could be a big jump in crude inventories in the US.

Whichever way, the pursuit of better and more open data is likely to reduce uncertainty in commodity markets and potentially reduce price volatility too. Robert McNally, founder and president of energy consulting firm The Rapidan Group and the author of the book “Crude Volatility”, believes that much more should be done to force or incentivise the energy industry to become more transparent (the same arguments are just as valid for other commodity markets):

The oil market is turbulent enough, patchy and incomplete data make the problem worse. Energy data reporting should be lawfully compelled, timely and comprehensive. Upstream governments should require industry to disclose and validate field-by-field production and reserve data. Doing so would reduce surprises, manic hoarding, and price volatility. Downstream, figures for production, storage, net trade, and refining stocks and flows should be comprehensively reported, enabling much better implied demand estimates.

Data may be the new oil that powers the the global economy, but the former needs to improve for investment and innovation to really power progress.