A somewhat bleak period for commodities (if you only focus on the short-term)
GAVIN WENDT: It’s been a generally grim past few weeks for commodities. The Bloomberg Commodity Index declined to its lowest since July 2009, with Brent crude at its lowest level since 2012, gold slumping to a seven-month low, copper hitting a 3-month low, iron ore at a five-year low, whilst even ‘soft’ commodities like wheat, corn and soybeans have all retreated to four-year lows.
The major driver of the fall in ‘hard’ commodities has data that showed weaker growth in Europe and Japan.
The euro-area recovery stalled during the second quarter, whilst the Japanese economy contracted by its biggest margin in more than five years. (Markets really shouldn’t be too surprised, because as we’ve previously discussed there was never any real prospect of ‘Abenomics’ – the supposed creation of economic growth merely through inflation – actually working).
The US dollar has simultaneously surged, making commodities more expensive in US$ terms, further impacting their attraction to investors. And there’s a general feeling that the next movement in US interest rates will be upwards, which is providing additional strength for the US currency and a corresponding weakness in gold.
Nevertheless, I am a big believer in the medium to longer-term robustness of commodity demand and I’m not particularly interested in what is driving the short-term decisions of speculators as they relate to commodities.
As we’ve seen however over recent times, gold investors are used to volatility and I believe there are big question marks over the soundness of US economy.
Despite what many market commentators are saying, I think there is only limited scope for US interest rate increases because of their potential impact on the US economy.
The US economic recovery has been built on an Everest of debt, which means we remain positive on gold.
As John Ficenec wrote recently in The Telegraph, “Nothing has been learnt from the madness of the 1929 stock market crash, as once again traders reach for record amounts of debt to pile into rising share prices.”
The level of margin debt that traders are using to buy shares in the stock market has reached the highest levels on record, according to data from the New York stock exchange.
US traders borrowed $460 billion from banks and financial institutions to back shares, and once cash and credit balances held in margin accounts of $278 billion is subtracted, this left net margin debt of $182 billion during July.
Traders are now more exposed to a fall in share prices than at the height of the dot-com bubble at the turn of the century, and just before the financial crisis during the 2007 peak.
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The chart above is a great reflection of what we’re talking about.
For the uninitiated, buying shares on margin is often used by hedge fund traders to increase the returns on their investments.
As the stock markets have steadily risen during the past five years and the level of risk has fallen, banks have become more willing to lend money for this activity.
The practice of buying shares on margin can trace its roots back to the heady days of the ‘Roaring 20’s’ stock market boom.
Retail investors, intoxicated by the offer of ‘limitless’ gains, merely had to put down a small portion of their own money to buy shares.
In the 1920’s investors put down anywhere from 10 per cent to 20 per cent of their own money and therefore borrowed up to 80 per cent to 90 per cent of the cost of the investment.
The problem of course arises when markets begin falling and investors get the dreaded margin call.
During the 1920’s many in the stock market bought on margin, confident that they would gain from the rising market and get out before everyone else started selling.
In today’s stock market the only modification to buying on margin is that the US Federal Reserve currently has an initial margin requirement set at 50 per cent.
The margin debt must remain below specified amounts on each account and not all shares can be bought on margin.
The market participants using debt to invest has also changed. Gone are the days of retail investors using margin to boost returns; it is now largely the preserve of professional investors such as hedge funds.
More and more shares have become available to buy on margin as the perceived level of risk within markets has steadily declined.
The hope is that professional investors will not behave as irrationally, and sell shares wildly at the first sign of trouble, as happened in 1929.
However, this looks to be wishful thinking on the part of the regulator. If anything the problem of the markets being exposed to sharp falls has only been amplified by the growth in the level of debt used by hedge funds.
The logic of the professional investors also appears deeply flawed as they all believe they can steadily unwind trading positions in an orderly process to realise their gains. However, because borrowing on margin requires positions to be exited quickly to prevent losses; a steady unwinding is impossible.
The northern hemisphere autumn tends to be a volatile period for stock markets – with the stock market crashes of 1929, 1987, 2001 and 2008 all happening during September and October.
In fact the anatomy of the 1929 crash is worth reviewing. It started with the Dow Jones Industrial average hitting its peak on September 3. The stock market then started to fall two days later, there was no panic and no crash throughout the whole of September and early October just stock prices failing to make a move higher.
It was on October 24, or Black Thursday, the market finally fell apart dropping sharply before recovering strongly into the end of the day.
The seeds of doubt had been sown and over the weekend investors decided they wanted to get out.
When the markets opened on October 28, or Black Monday, there was more sustained selling and no recovery. The collapse culminated in the worst day in stock market history recorded on Black Tuesday October 29, when fear gripped the markets and the lack of any buyers resulted in share prices dropping through the floor.
The Dow Jones hit a record high of 17,154 recently and the S&P 500 has also gone above 2,000 for the first time ever.
If investors do start to sell it will be into a thin market. US stock-market volume averaged $5.3 billion a day during August, compared with a mean of $6.3 billion in the first seven months, data compiled by Bloomberg shows.
As we approach those levels it is worth keeping in mind how far we could fall.
When the dot-com bubble burst at the start of the new millennium the FTSE 100 slumped 48 per cent to fall below the 3,500 level.
As the 2008 financial crisis unfolded, the FTSE 100 index dropped 41 per cent from its peak in 2007 and once again dipped below the 3,500 level.
And it’s not just the share market that’s reflective of a bubble, it’s property too. A recent Bloomberg article that showed that only twice in the past 25 years have new US apartment buildings been going up as quickly as they are right now.
And that’s not necessarily a good omen. The first occasion during February 2000 was right before the dot-com bubble burst. The second time, January 2006, came just before the housing bubble burst.
Returning to gold, we always try and ignore the fickleness of markets. Last year the gold price crashed once it became clear that the US Federal Reserve was looking to cut back on its Quantitative Easing (QE) program, on fears that it was QE that had been supporting the gold price.
What had actually been forgotten was that the gold price had advanced strongly prior to the term QE even being coined, but the market – with its ultra short-term viewpoint – seemed to have assumed that QE and the gold price were inextricably linked, thus marking the yellow metal down.
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And to all the doubters that believe a rising US interest rate environment is bad for gold, last week we showed that the opposite is in fact true. The real driver of gold prices is negative real interest rates (defined by nominal interest rates minus inflation).
Central bank policies of inducing negative real rates to ‘incentivize’ borrowing, expand the money supply and devalue currencies – have forced investors (especially mums and dads) into real assets like gold and silver. Debt is inherently inflationary if you have the ability to print your own currency.
Gold rose with interest rates during the 1970′s and this is sufficient to prove that gold doesn’t always fall when interest rates rise. The gold bull market of the 1970s was dominated by inflation – interest rates rose steadily to keep up with it, but real interest rates were mostly negative the entire time.
I therefore remain positive on gold and am confident that the flow of gold from West to East will continue. I believe there’s robust price support around the US$1,200 mark, a situation that will continue for the foreseeable future.
Gavin Wendt is the founder of Minelife, publisher of the MineLife Weekly Resource Report
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