Sustainable assets: are they a trap in the making?
Trading in durable assets, commodities, has come alive in the past two months. This is proportional and logical to the skyrocketing of . However, is the trade in durable assets sustainable? Or is it a trap that will disappoint investors for years to come?
When it comes to trading in commodities or durable assets, it is usually shunned by the mainstream media. They prefer to focus on anything “hot broth” or investment meme is leading the market at the time. However, from “golden insects” at “oil merchants” commodity trading is a source of ups and downs along the way.
For our analysis, we will focus on the CRB Commodity Index as a proxy for commodities. From the index, we can then explore how the , interest rates, economic growth and inflation drive commodity prices.
Is commodity trading here to stay, or is it another “boom” waiting for “screw up.”
A long history of booms and busts
Since 1980, the start of my data feed for the CRB index, there have been 4 distinct cycles in commodities.
From 1980 to 2000, the trend in commodity prices declined as the economy shifted from manufacturing to financialization. Beginning in 2001, as the dot.com era drew to a close, investment flows shifted to commodities and emerging markets in anticipation of a global resurgence. Housing demand soared as mortgage rates fell and demand for energy rose on fears of “peak oil production”.
However, as quickly as it came, demand for commodities faded as the financial crisis crippled the entire global economy. This deflationary trend continued until March 2020. As the Covid pandemic brought economies to a standstill, governments injected billions of dollars to stimulate demand. Unsurprisingly, inflation has surged and demand for inflation protection in the form of commodities has increased.
Since the demand side of the equation was driven by artificial liquidity, the question now is the sustainability of the price rise?
To answer this question, we need to understand that commodities, and sustainable assets in general, do not live in a vacuum. On the contrary, they are very subject to the supply-demand equation which ultimately sets their price. Therefore, and not surprisingly, economic growth, interest rates, the dollar and money supply weigh heavily on this equation.
A review of these factors, which are directly related to inflation, is useful in determining the current upward trend in commodity prices. Or, if deflation is a bigger threat.
All Indicators Suggest Commodity Production Is Limited
While commodities and durable assets are demand-driven, particularly in the manufacturing sector, several indicators point to continued demand for these assets.
Interest rates are important because they reflect the strength of economic growth, inflation, wages and aggregate demand. There is a good correlation between the annual change in interest rates (reflecting economic strength or weakness) and commodity prices.
Unsurprisingly, the recent surge in commodity prices from 2020 lows matches the rate hike. This corresponds to the flow of fiscal policies allowing demand to exceed economic production capacity. However, with liquidity now reversed, rates are returning to levels consistent with lower economic growth rates.
A consequence of this inversion of liquidity, as measured by M2, is the inversion of inflation over the next 9 months. Again, as commodities are highly correlated to inflation, this suggests that the spike in “hard trump” trade as the economy normalizes.
Finally, commodities and durable assets in general trade globally in US dollars, and the trend and direction of the currency is important. As the dollar strengthens, it makes commodities more expensive for our foreign partners. A weaker dollar allows US consumers to buy more as demand grows. This explains why there is an inverse correlation between the dollar and commodities.
The dollar’s next move will largely depend on the relative strength of the US economy against the rest of the world. We suspect that if the US economy weakens in the coming months, the rest of the world will be worse off. The United States has, and will likely remain, the “the cleanest shirt in the dirty laundry.”
It’s the economy, stupid
While interest rates, inflation, money supply and the dollar can give us clues about trading commodities and durable assets, in the end it really is “the economy, stupid.”
As stated above, all prices for commodities and durable assets are ultimately set by supply and demand. If the economy is strong, demand for finished goods, real estate, housing, automobiles, etc. will be strong. The strength of this demand will increase production by increasing the demand for raw materials. If the economy weakens, this demand drops, leading to a glut of inventory and lower prices. Unsurprisingly, commodities follow nominal growth.
The surge in economic growth following the pandemic-driven shutdown was, as noted, an artificial liquidity flooding the system. This caused a massive increase in the money supply, leading to inflation given the lack of productive capacity. However, as is already the case, economic activity is returning to its most normal level.
“As the budget deficit increases over the next few years, interest payments alone will eat up more tax revenue. This comes at a time when that same dollar of tax revenue only covers the entitlement expenses of the 75 million baby boomers who migrate to the social safety net.
Incidentally, the only other time government income support exceeded taxes paid was during the “Great Depression” of 1931-1936.
The debt problem remains a massive risk for monetary and fiscal policy. If rates rise, the negative impact on an indebted economy quickly depresses activity. More importantly, the decline in monetary velocity clearly shows that deflation is a lingering threat.
The last sentence is the most important when it comes to durable assets.
Trading in hard assets tends to end badly
When it comes to commodities and sustainable assets in general, they can be an exhilarating and profitable ride to the upside. However, as the long-term chart above shows, this trade tends to end badly.
Will this time be different? This is unlikely to be the case.
As the country continues to evolve towards a more socialist profile, economic growth will remain limited to 2% or less, with deflation remaining a constant long-term threat. Dr. Lacy Hunt has already suggested the same thing.
CoContrary to popular belief, disinflation is more likely than an acceleration in inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will temporarily increase. Once these base effects are exhausted, cyclical, structural and monetary considerations suggest that the inflation rate will decline by the end of the year and be below the Fed Reserve’s 2% target. The inflationary psychosis that has gripped the bond market will fade in the face of such persistent disinflation.
As he concludes:
The two main structural impediments to traditional US and global economic growth are massive over-indebtedness and deteriorating demographics, both of which worsened following 2020.
This last point is crucial for the long-term dynamics of inflation and commodities. As cash is withdrawn from the system, over-indebtedness will weigh on consumption, as income is diverted from productive activity to servicing debt. Thus, the demand for raw materials will weaken.
Let me conclude with this point from Michael Lebowitz:
The myriad of dynamics that drive commodity prices means there are no quick and easy answers to determining an effective strategy.
While commodity trading is certainly “in bloom” with the surge in liquidity, watch out for its possible reversal.
For investors, deflation remains a “trap in the making” for durable assets.