Materials Risk

Commodity markets are typically interpreted through the lens of changes in supply and demand and the impact on inventories in any particular year. This model works for most commodities that are ‘consumed’ (crude oil, wheat, etc.), but is useless to understand the value of those commodities used for investment purposes. I think this distinction is so important for investors to appreciate that I’ve shared how wealth management company Incrementum outlines it (highlights my own).

While the economic utility of a consumable good is created when it is destroyed or used up, the utility of investment assets lies in their possession and later resale. Industrial commodities therefore have low stock-to-flow ratios, this is to say, inventories usually only cover consumption demand for a few months. If there were no inventories at all, supply would have to correspond exactly to production and demand exactly to consumption. However, if there are inventories, consumption can temporarily exceed production. Since inventories of consumable commodities are as a rule very low, prices will rise quickly in anticipation of a future supply shortage and bring consumption into balance with production.

Unlike consumable commodities, gold and silver exhibit a large discrepancy between annual production and the total available supply which is a high stock-to-flow ratio. It is our premise that the high stock-to-flow ratio represents the most important characteristic of gold (and silver).

While the entire amount of gold ever mined totals approximately 190,000 tonnes (the stock), annual production is about 2,900 tonnes (the flow). If you divide the stock by the flow you get a stock-to-flow ratio of 66 years. Silver meanwhile has a stock-to-flow ratio of ~22.

Platinum and palladium have a ratio of 1.1 and 0.4 respectively. Although typically lumped together with gold and silver as precious metals, annual production is a much more significant factor. If either of these metals start being hoarded prices will rise leading to higher supply and falling prices.

Gold isn’t as valuable because it is so rare, but quite the opposite: Gold is valued so highly because annual production relative to the existing stock is so small. Putting it differently: not only scarcity, but primarily the relative constancy of the available stock is what makes gold unique. This characteristic was attained over centuries and can no longer be altered. This stability and security is a crucial precondition for creating confidence.

Apart from gold’s unique stock-to-flow ratio its high marketability is another important feature. The easier it is to exchange a commodity, the more pronounced its ‘moneyness’ is. Carl Menger developed the theory of marketability in the 19th century. According to this theory, gold has established itself in a long term evolutionary process, because its marketability was higher than that of any other good. According to Menger, the marginal utility of gold therefore declines more slowly than that of other goods. Gold and silver therefore enjoy their monetary status not due to their alleged scarcity, but rather due to their superior marketability. 

In this respect there is a crucial difference between gold and other stores of value such as expensive real estate, diamonds or art objects. A Picasso painting, an expensive Bordeaux or a unique piece of real estate are all difficult to liquidate at an acceptable price in a liquidity emergency during a crisis situation. Furthermore, the specific features of art objects or real estate are only ascertainable after extensive due diligence. The fungibility of gold is therefore a crucial differentiation. This seems to be an additional reason why central banks are hoarding gold and not real estate, art objects or commodities as their main currency reserve.

As regular subscribers will know, I recently recommended reading Ray Dalio’s book, “Principles For Navigating Big Debt Crisis“. Dalio outlines Bridgewater’s research on more than 50 debt crisis that have occurred over the past 100 years, drawing together the remarkable similarities. It provides a consistent playbook for how crisis play out, how policymakers respond (who often make the same mistakes) and what it means for investors. This article pulls together some of the main insights I took away from the book (emboldened text mine).

Dalio notes that debt crisis typically occur “because debt and debt service costs rise faster than the incomes that are needed to service them, causing a deleveraging.”

Important to note that debt cycles are not limited to the business cycle. Debt can gradually build up so that, “each short-term cyclical high and each short-term cyclical low is higher in its debt-to-income ratio than the one before it.” According to Dalio this is just human nature. People have a natural inclination to borrow and spend more instead of paying debt back. “As a result, over long periods of time, debts rise faster than incomes. This creates the long-term debt cycle.”

Debt cycles are nothing new.

“It has existed for as long as there has been credit, going back to before Roman times. Even the Old Testament described the need to wipe out debt once very 50 years, which was called the Year of Jubilee.”

Central banks help inflate the bubble rather than constrain it by focusing on inflation and growth, not debt.

“In my opinion it’s very important for central banks to target debt growth with an eye towards keeping it at a sustainable level-i.e., at a level where the growth in income is likely to be large enough to service the debts regardless of what credit is used to buy.”

Forecasting a recession has become a regular thing in the financial media. Most predictions of a recession on a horizon rest on standard metrics: yield curve inversions, the length of the business cycle and other forward looking indicators of business activity. However, this misses the point that recent recessions have been caused by crisis rather than an overheating economy.

The long-term debt cycle creates an economy that gradually becomes more and more vulnerable to collapse through every subsequent business cycle. The lesson from the financial crisis is that debt, especially corporate debt has continued to grow. Spotting the signs that a debt crisis is about to boil over will become increasingly important.

How to identify a debt crisis before it occurs? According to Dalio the most defining characteristics of bubbles that can be measured are:

1. Prices are high relative to traditional measures.
2. Prices are discounting future rapid price appreciation from these high levels.
3. There is broad bullish sentiment.
4. Purchases are being financed by high leverage.
5. Buyers have made exceptionally extended forward purchases to speculate or to protect against future price gains.
6. New buyers have entered the market.
7. Stimulative monetary policy threatens to inflate the bubble even more.

As with a lot of economic indicators it pays to look at the distribution, not just the average. According to Dalio in order to “anticipate a debt crisis well, one has to look at the specific debt service abilities of the individual entities, which are lost in these averages. More specifically, a high level of debt or debt service to income is less problematic if the average is well distributed across the economy than if it is concentrated-especially if it is concentrated in key entities.”

So what happens at the top of the cycle?

“The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce. Unemployment is normally at cyclical lows and inflation is rising.”

The more leverage that exists in the economy and the higher the prices, the less tightening it takes to prick the debt bubble and the bigger the bust that follows. According to Dalio investors overestimate the power of monetary policy to respond once the bubble starts to burst:

“In the immediate postbubble period, the wealth effect of asset price movements has a bigger impact on economic growth than monetary policy…people mistakenly judge the decline to be a buying opportunity and find stocks cheap in relation to past earnings and expected earnings, failing to account for the decline in earnings that is likely to result from what’s to come.”

Things start to get really ugly when people begin to worry about cash flow. Lack of cash flow is an immediate and severe problem-and as a result, the trigger and main issue in most debt crisis according to the author. Dalio makes the case that even well capitilised business may suffer cash flow problems if the equity is in illiquid assets:

“With investors unwilling to continue lending and borrowers scrambling to find cash to cover their debt payments, liquidity-i.e., the ability to sell investments for money-becomes a major concern.”

A major part of the deleveraging process is people discovering that what they thought of as their wealth was merely people’s promises to give them money. As Dalio explains, “most of what people think is money is really credit, and credit does appear out of thin air during good times and then disappear at bad times.” As the deleveraging takes hold, those promises are no longer kept and that perception of their wealth also vanishes.

Authorities rarely learn the lessons of past debt crisis, but investors place too much faith in them to make things right again. A repeated pattern through all debt crisis is that actions to stimulate the economy have far less impact than investors believe (or hope) they will at the time.

“During the Great Depression there were six big rallies in the stock market (of between 16 percent and 48 percent) in a bear market that declined a total of 89 percent. All of these rallies were triggered by government actions that were intended to reduce the fundamental imbalance.

In order to counteract the deflationary forces of the debt cycle aggressive stimulation is required. Based on the debt crisis Dalio has studied there is a pattern to how authorities respond with action normally coming, “two to three years into the depression, after stocks have fallen more than 50 percent, economic activity has fallen about 10 percent, and unemployment has risen to around 10 to 15 percent.”

A beautiful deleveraging?

“People ask if printing money will raise inflation. It won’t if it offsets falling credit and the deflationary forces are balanced with this reflationary force…Remember, spending is what matters. A dollar of spending paid for with money has the same effect on prices as a dollar of spending paid for with credit. By “printing money”, the central bank can make up for the disappearance of credit with an increase in the amount of money.”

After cutting interest rates and undertaking quantitative easing central banks are left “pushing on a string”. It’s here Dalio notes that the previous deflationary debt crisis have resulted in a, “coordination of monetary and fiscal policy in a way that creates incentives for people to spend on goods and services.” Arguably, this is where the US, Europe and Japan find themselves now.

Debt crisis are usually deflationary, except in economies heavily reliant on foreign debt and investment:

Getting this balance right is much more difficult in countries that have a large percentage of debt denominated in foreign currency and owned by foreign investors because the debt can’t be monetised or restructured so easily. This is why debt crisis in emerging economies tend to spill over into high inflation, hitting neighbouring countries and forcing authorities to adopt much more extreme measures to get their economies under control.

These inflationary depressions are far more likely to occur in countries that:

1. Don’t have a reserve currency.
2. Have low foreign exchange reserves and so the cushion to protect against capital outflows is small.
3. Have a large foreign debt.
4. Have a large and increasing budget and/or current account deficit.
5. Have negative real interest rates which means that lenders are not adequately compensated for holding the currency.
6. Have a history of high inflation and negative total returns resulting in low trust in the governments control over the economy.

Some countries are more susceptible to debt fueled binges and busts than others.

“Economies whose growth is significantly supported by debt-financed building of fixed investments, real estate, and infrastructure are particularly susceptible to large cyclical swings because the fast rates of building those long lived assets are not sustainable.”

It’s no wonder that the countries that have suffered the most spectacular inflationary debt crisis have been those where lots of debt fueled infrastructure spending has taken place.

“This type of cycle-where a strong growth upswing driven by debt-financed real estate, fixed investment, and infrastructure spending is followed by a downswing driven by a debt-challenged slowdown in demand-is very typical of emerging economies because they have so much building to do.”

Investors can be so invested in an emerging economies growth story that even a minor event (a sharp reversal in commodity prices) can trigger a slowdown in capital inflow growth and even a net reversal.

It’s almost school holiday’s here in the UK. It that time of the year when families typically drive to the airport, to their next Airbnb, to the campsite. Anything to get away from the typical British summertime (this year has been especially dreary). Almost always it involves spending more time than you have done all year with your family, in a confined space for hours, being distracted by “How much further?”, complaints about your driving all the while having to focus on the road ahead of you for several hours I’m lucky(!) enough to be counting myself among that group over the next few weeks.

In preparing for my journey I happened across an article about being a better driver during the holidays. Two suggestions in particular struck me as important lessons; to always look further ahead, and to always think about your own journey as personal to you.

Being able to anticipate the speed of other cars further down the road, the actions of pedestrians and the conditions of the road should help you be a better driver. In essence its about being able to give yourself enough time to react to events. The more you practice, the greater your experience, the more likely (at least in theory) that you will avoid any trouble.

Meanwhile, always thinking about your own journey as personal to you means that you don’t react negatively to the behaviour of others on the road, while also becoming more proactive and compassionate in how you interact with other road users.

What does this all have to do with investing and trading commodity markets? First its about looking ahead, looking for the signs that things may be about to turn, that sentiment is too extreme and that investors may be about to run for the exits. In commodity markets this can take the form of extreme market positioning in futures markets, commodity producer sentiment (supply discipline for example) and seasonal demand and supply trends.

Second, whatever your outlook, whatever your trading or investing style its important to always consider that your own journey. That goes for your own level of risk, the instruments you trade, what time period you are considering, what your hopes and dreams are. Its your commodity market play book, no one else’s.

It’s always been challenging balancing your own objectives versus the fear of missing out, comparing yourself to others and then overly reacting. It’s now much harder to sift through what is important to your journey, and what is not. Someone’s tweet about their view on gold may run counter to your own, but they may have a completely different time frame to yours. Their concerns may just represent a mere footnote in years to come on your investment journey.

The danger (to return to the driving analogy) is that you get caught up in someones else’s race, someone who has a completely different destination to you, an alternative set of time constraints with completely contrasting priorities to you. We’re all on the same road, but we’re all on very different journeys. As it is with our highways and byways, as it is in the markets, keep a watchful eye on others but never let them dictate how you should respond to events. As with driving, as it is with investing always have your end destination in mind.