Materials Risk

Two headlines caught my eye recently that demonstrate the power of sentiment in commodity markets. If you read my post from June (What headlines are telling us about sentiment in commodity markets) you’ll recall that headlines in the media (and especially in the financial media) tend to confirm what we already know, once a trend has been firmly established and often extrapolate that trend into the future.

The two headlines are from the FT and the BBC and both relate to the market for palladium. To recap, from a low of $470 per oz in early 2016 the price of palladium has more than tripled over the past three and a half years to almost $1700 per oz.

The first article (“There’s no end in sight for soaring palladium prices” – 2nd Oct, FT) notes the fundamental factors in support of the palladium price but the headline suggests that there is no end to the palladium price boom. Just as with headlines that suggest it can only get worse this headline suggests that bullish sentiment is ripe for a reversal.

The second article (“Huge rise in catalytic converter thefts” – 20th Sep, BBC) brings it home to the average car owner that although they may feel safe driving round in their SUV, in fact they are showing off to potential thieves that they have something that has tripled in value. When the impact of high prices starts to register with the end consumer it can be a sign that demand will start to wane.

The long term palladium chart looks stretched with prices well above the 50 and 200 day moving average while there are signs of a negative divergence that could indicate a sharp correction is close.

Investment bank UBS sees further upside in the coming months but with an increased risk of sharp corrections:

“We see further price upside over the coming quarters, but performance will likely continue to be volatile with large price drops possible – as already experienced twice this year. Such corrections could be caused by renewed risk-off events and/or sales from Russia’s Nornickel Global Palladium Fund (GPF). It remains unclear how much metal the GPF still holds, however. Declining ETF holdings – which were used to cover the market deficits and are now at the lowest level since 2008 – suggest that above-ground inventories are quickly dwindling”

One of the oldest sayings in commodity markets is that the cure for high prices is high prices. It is exceedingly is rare for any commodity to remain this far above its long-term average for so long especially one where sentiment is so stretched.

Related article: Palladium prices: The top 10 most important drivers

Data covering the 45 years to 2005 from the largest global 85 economies shows a consistent pattern: people tend to consume capital (i.e. spend it) when they are young, build up capital from middle age through to retirement, and then gradually at first and then suddenly eat into that capital. This matters a lot for future investment returns. The demography of many developed and less developed countries is forecast to shift dramatically over the next few decades with the share of older people (consumers of capital) likely to increase significantly.

The chart below from Gavekal shows the global capital providers ratio (a weighted coefficient of the numbers of people in the capital providers relative to the total population) and plots it against the nominal yield on US 10 year Treasuries. Between 1960 and 1980 an increase in the share of capital consumers (both young and old) lowered the savings rate. In turn this meant that the real equilibrium interest rate increased since if capital is to be directed to where its needed and that capital is scarce its price must go up to. After 1980 this relationship reversed and resulted in the favourable tailwind of gradually declining interest rates that we’ve seen ever since.

Could the relationship just be a one-off resulting from the Baby-Boomers? It comes down to whether we are as inflationary in retirement as we are in our youth. Older people typically (but not always) spend their money on different things depending on their health; hopefully foreign holidays and a new sports car and not medical care. If pensioners are not in a position to contribute to inflation directly then another way older people can do this by passing some of their savings to their grandchildren.

In the future older people’s appetite for inflation will also depends on their investments and any income they receive. Traditionally they have reliant on fixed incomes and so have been wary of inflation eroding its value. That could change in the future if more pensioners have to manage their own investments, rather than relying on the state or final salary pension schemes.

Nevertheless, a look back at history suggests the the relationship will remain. The Bank of International Settlements (BIS) looked back over previous cycles going all the way back to 1870. It reveals the same stable relationship between age structure, the capital providers ratio and inflation. Although there are outlier’s, its also consistent across countries. 

So what to make of this? Well, inflation is very likely to make a strong return over the next 30 years. Aside from the demographic impact there are another two D’s. First deglobalisation is also likely to be inflationary as trade moves towards more regional systems and technology fails to deliver the same deflationary pressures that we’ve seen over the past two decades. Second, debt (government debt specifically) is likely to increase as central banks and governments are forced to move beyond quantitative easing to finally get their economies moving through fiscal policy.

From an investment perspective it says buy those assets that are cheap and that do well in inflationary environments. Right now, that’s commodities. We are entering a period very similar to 1890-1920 and 1950-1980. Both periods exhibited high inflation with rising commodity prices. Notwithstanding the bleak recessionary outlook in the short term, anyone with a 20-30 year time horizon could do worse than consider increasing their exposure to commodities.

I admit it. I’m a big fan of Twitter. It’s allowed me to connect with people from across the globe, people that it would be impossible to communicate with least of all know existed prior to Twitter. The people I follow have opened my mind to ideas and opportunities that I wouldn’t have heard about otherwise.

Individual investors decisions often depend on the ideas and behaviour of other investors, investors that we increasingly find on Twitter (or FinTwit). When we perceive that a high proportion of our ‘group’ are going to act in a certain way then we are more likely to also. However, as individuals we rarely have global knowledge of others, but instead must estimate them from the local observations of our social contacts.

And that’s a problem if you are relying on the latest tweets from investors in your feed to gauge the ‘markets’ opinion.

Network structure can significantly distort individual’s observations. Under some conditions, a state that is globally rare in a network may be dramatically over-represented in the individuals within your group. This effect is known as the “majority illusion” and could lead an individual investor to systematically overestimate the prevalence of the actions of other investors.

Humans have a tendency to think that what we see is all there is. Beware: the majority can sometimes be an illusion.