EconoGmac Launches Commodity Commons Focusing on the Commodity Complex
We are re-launching our thought platform on EconoMonitor with a more discrete focus on the commodity complex. In so doing we hope to unpack a number of themes that we have grown to uncover over the past five years.
When we sat down to create a series of long/short investment vehicles in the commodity complex we wanted to have a number of key drivers in place. Here are the principles we established to guide our analysis going forward.
1) There is no commodity complex – there are many commodity complex(S)
2) Julian Lincoln Simon and Paul Ehrlich – we take Julian’s side in the great debate.
3) Fundamentals matter in both the short and long term – the middle term not so much
4) Duration for each part of the commodity complex is vastly different one to the other
1) There is no commodity complex
This point is at the top of the list mostly thanks to our consumption of daily business news. Whether it’s TV, internet, or buy and sell side research the propensity to make a “call on commodities” may be strong but it is wrong headed, and can cause one to misinterpret important data that affects long term outcomes and decision making.
Here’s a good recent example: S&P GSCI (broad commodity index) v. the Grain Based DBA Deutche Bank
I’d love to be in grains – the balance of commodities… not so much.
2) Julian Lincoln Simon and Paul Erlich’s now famous bet about commodity prices is a foundational macro point on which a great deal of analysis around general theories of productivity should turn. Unfortunately this part of the equation often gets overlooked and thus productivity gets over or under stated accordingly.
Simply put, we believe that on a currency adjusted basis the long term trajectory of commodities is subject to supply and demand constraints that spur productivity and cause innovation. That innovation, in turn, sees prices – generally – beaten back (again on a currency basis).
The most obvious instance of this in recent memory is Nat Gas – represented here by the ETF UNG. Ouch…. Oh, and we keep finding more and more.
3) Fundamentals matter in the Very Near term and Very Long term. The challenge is understanding pricing in commodities over two time frames – a) Calendar and b) economic cycles.
Front month pricing is the penultimate example of baseline supply and demand. Most market participants use this information for feedback on the current state of the global economy. The back month pricing is where more of the analytics and crystal ball gazing takes place.
When one looks at the price divergence across those two time frames one notes the propensity of people to equalize the two inputs. It is our long held belief that such a practice does not help clarify the current state or even the 3 – 6 month forward state of global economic affairs. Rather we see an information deficit divergence that can be a major hurdle for understanding forward price regimes and cloud additional capital deployment.
4) Time matters
Our last pillar ensures that we are taking as Peter Schwartz suggested in his seminal book from the 1990’s a “Long View.” While current prices suggest various outcomes in the current economy, they also dictate what happens in the long run. Price distortions due to drought, technological innovation and/or Central Bank policy can all turn away as quickly as they arrived.
What we’ve discovered to be important is to always allow for a notion of time in one’s analysis of near and longer term pricing in the commodity complex. This allows for a more nuanced analysis of where we are and what is likely to be next for the global economy.
On current pricing
We continue to see significant deflationary tendencies across the global economy. Of late, the stampede into this notion has been hard and fast.
This suggests to us a bit of a bottom in that data set as the media tends to be very late to this story. We know our colleague Dan Alpert has been putting the table on this for over four years.
While we are not suggesting the re-ignition of a global commodity “super cycle” we are noting that prices seem to now reflect a lower growth environment. To our mind this reflects recent follow up work from Reinhart & Rogoff.
In a recent follow up paper the authors – Reinhart & Rogoff – find that prior instances of debt levels above 90% of GDP are associated with an average growth rate of 2.3% (median 2.1%) versus 3.5% during lower debt periods. Notably, the average duration of debt overhang episodes was 23 years, implying “a massive cumulative output loss.”
On a final note this morning more data suggesting that we are bouncing along a very dangerous bottom, one in which the floor may actually fall out and there would be a fairly far way to drop.
July PMI numbers suggest a further decline through the summer although not quite as steep as the Industrial Production numbers would suggest. The question one needs to ask here is whether or not the steep decline in industrial production is lead by inventory levels of significant weakness in consumptive demand.
As we noted in the top of this post we see nothing short of massive deflationary forces as the culprit behind the complex wide – save grains – decline in commodity prices. The lack of wage stability in both the emerging economies and the developed economies suggest that further broad based economic demand will continue to remain soft.
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