Tuesday, May 26, 2009

Start of the Great Commodity Bull Market?

Back in January, I speculated that Pound Sterling could be the canary in the coal mine. America’s problems parallel those of Britain, but the UK does not have the flexibility to be the issuer of a major reserve currency. With last week’s warning by S&P of the UK’s potential problems, investors started to extrapolate British problems to American ones, sending the USD, along with fixed income and equity markets, into a sell-off. Not surprisingly, commodity prices advanced in the wake of this fear.

Is it time for the Great Inflation to begin?

Nowhere to run
By my reckoning, this is a false start. Firstly, there aren’t that many alternatives to monetary reserves for central bankers. For a central bank, the alternatives of any size are the U.S. Dollar, the Euro and, to a lesser extent, the Japanese Yen.

Brad Setser’s always insightful analysis has indicated that central banks haven't abandoned Dollar assets. What’s more, is the Euro a viable long-term alternative for reserves given the Eurozone’s very public problems?

As Johm Mauldin observed, the European banking system is a mess:

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

[The analyst team at Variant Perception wrote:] “European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody’s and S&P, who couldn’t rate their way out of a paper bag, and for anything that wasn’t highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped.”

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we’ll watch their economies simply implode.
The IMF recently urged Europe to do more to tackle the recession (see story here). Yet, Europe is gripped by typical EU paralysis:

European Central Bank policy makers clashed over the bank’s asset-buying program and prospects for a recovery less than a week after President Jean-Claude Trichet engineered a truce…

“The ECB Governing Council looks like a battlefield,” said Laurent Bilke, a former ECB forecaster who now works for Nomura International in London. “It would be simply ridiculous if we weren’t already in the middle of the worst recession in postwar history. But now it has more dramatic consequences. Trichet will have to restore some order.”
Why should the Dollar fall against the Euro?

No signs of higher global inflation…yet
For U.S. based investors, the news of the UK’s potential credit disease could indeed be troubling if it migrated across the Atlantic. American commodity bulls of all stripes no doubt rejoiced last week, thinking that inflationary expectations is on the horizon.

There are a number of signs that this is a false dawn. Bespoke reports that gold analysts not expecting inflation this year. Moreover, if there was truly an outbreak of rising inflationary expectations, gold prices would be rising in other currencies, not just USD. A look at the price of gold in EUR, JPY, AUD and CAD show a very subdued rise, indicating that global inflationary expectations are well under control.

The Economist recently published a bullish view of oil prices [emphasis mine]:

As soon as the world economy starts growing again, the theory runs, demand for oil will once again outstrip the industry’s ability to supply it. The seemingly ample cushion of inventories and spare capacity will quickly be exhausted, sending prices soaring. In other words, the global recession has only interrupted the “supercycle” of which many analysts used to speak, during which the normal boom-and-bust cycle of oil and other commodities would give way to a protracted period of high prices, as ever-growing demand from emerging markets swallowed everything the extractive industries could produce. “The commodity supercycle is not over, just resting,” says Mr Blanch.
The key is economic growth. Until we get a global economic recovery, it’s too early to get excited about the inflation play.

The day for a the sustainable commodity bull and the commodity supercycle will come – but not yet. In the short term commodities may have some more upside, as Bill Luby of VIX and More points out. Moreover, investor sentiment for gold, crude oil, copper, the CRB Index, etc. show rising bullishness but readings are not excessively high indicating crowded longs.

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