By Data Diary:
Just occasionally the mist clears and the trend shows itself – in this case all shiny and smooth with a yellowish lustre. Following yesterday’s reflections, the clarity around the world’s debt problems is only too vivid. The conclusion was to take a good long hard look at commodities. The question today is which ones? We noted in an earlier article (here) that based on history – base metals are trading relatively cheap to gold.
Not even in the darkest days of the Asia crisis did base metals trade below 15% of the USD Gold price (memorable days they were – we were struggling away on the base metals desk as various customers imploded while our gold options desk was quietly vaporizing all on its own).
So are base metals a buy here or is gold a better alternative? To get a sense of the answer we turn to Kipling’s six honest serving men…
Why will commodity prices respond to monetary inflation?
Gold is a store of value – base metals are more closely tied to the industrial cycle.
We may not use gold to make things other than a bit of bling and the occasional circuit board, but it remains an ultimate store of value. And if anything is abundantly clear in the evolving sovereign debt seraglio, it’s that paper money is losing it’s attraction on this score. This was eloquently summed up by the guys at The Daily Reckoning here.
This is the single biggest reason to buy gold and more broadly commodities.
What are the supply and demand dynamics?
Supply and demand dynamics (possibly) favour gold over base metals.
It’s been a few years since I kept an eagle eye on inventory levels in metals markets but a quick glance at copper inventories as a bellweather suggests that at the very least, there isn’t likely to be a China inspired squeeze anytime soon. A summary of current LME inventory levels illustrates why (courtesy of Standard Bank’s Commodities Research):
The China buying spree of in the first half of calender 2009 stripped the LME’s Asian warehouses – but stocks are now back to their 2009 highs. With the recovery in industrial production looking suspiciously like it has peaked (see latest OECD leading indicators here), hard to see where the new buying is going to come from to drive down supplies – at least this calender year.
Conversely, the gold market may well be short of physical gold – read the Thunder Road Report (here) it’s long but crammed full of good ideas.
When will the trends play out?
Monetary inflation is a long term outcome but the tipping point is close.
The reasoning for buying commodities is political – governments around the globe will seek to forestall deflationary deleveraging by (literally) papering over the cracks. Governments will continue along the path of monetising their debt problems – a competitive devaluation cycle in drag – until market forces stop them. The most obvious market signal will be a loss of confidence in the purchasing power of money itself.
So why go long now then?
Ludwig von Mises – “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond bounds”. Ben Bernanke clearly believes he can run the gauntlet on this. We are getting some worrying signs that he will be proven wrong.
The murmuring of the investor class is getting louder – Dubai, Greece, PIIGS, STUPIDS, the acronym gets longer by the day – and can be seen directly in the widening of CDS spreads on sovereign debt and credit margins generally. The point is the commune of investors is awakening to the realisation that the government debt problem is global and that the response from our elected primates is uniformly the same. Yields are being ratcheted higher – unless that indirect bid is there to mop up all the supply. The risk that sentiment turns, and the tide of money runs from the places it is most needed, is palpable.
Who are the major participants in the metals markets and how will they respond?
It’s central bank versus central bank in the gold markets, while China is single biggest driver of base metal prices.
As we noted yesterday, China is the single largest purchaser of base metals. Risks to the sustainability of its demand swirl around the overcapacity in some of its heavy industries and in its real estate sectors. With the global consumer entering into a prolonged deleveraging phase, the risks from a demand and supply perspective are principally to the downside for base metals.
In the gold market, demand and supply is more finely balanced. Leaving aside The Thunder Reports suspicions about a global imbalance in the actual physical stuff, we have had conflicting signals from central banks (the IMF is selling, China is buying, and the emerging countries want a metallic standard to replaced USD in the SDR to name a few).
From a speculation stand-point, it does not look like the market is all a one way bet on the gold price just yet.
Against this are the various hedge funds that have reportedly built large positions in the stuff. However, if you accept that this money printing scenario has all the Sisphyean hallmarks of rolling a progressively bigger snowball up a hill, then you can get comfortable around the fact that these funds are looking at a point that is way off on the horizon. They expect gold prices to match the volume of money that is coming off the printing presses – and we have only just got started.
How to choose between base metals, gold-miners and the physical stuff?
Buy gold first, base metals second – and add to positions if we get further weakness in the equities market.
One question to ask in respect of gold is do you get yourself a stamped bar or buy a mining company? It’s a question that the Humble Student of the Markets has explored on various occasions (click here for a recent missive).
If it is mining stocks, then some conclusions to consider:
- Going back to our earlier chart, if gold is heading higher it will take base metals with it.
- Base metal and gold producers will fall in sympathy with any market weakness – but expect them both to outperform in any subsequent money printing inspired bounce.
And finally Where?
Gold looks good on yer teeth, copper doesn’t, while lead is so 70’s.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.