It would be incorrect to characterize last week’s foreign exchange market action as a roller-coaster ride. It was just a one-way ticket to the south for most currencies in the world, against the dollar. Given the flow of news from the US, one would have expected the reverse to happen. After all, the number of workers filing for unemployment insurance compensation surged and those who claim this benefit for more than two weeks total more than 3.3 million now. With statistical models creating more jobs than the real economy does in the US, retail spending sagged in July. It is, therefore, bizarre that the financial market now expects the US Federal Reserve to raise the federal funds rate to around 3% in the next 12 months.
This is an environment for all currencies to weaken against something common. One would have expected that commodity to be gold. Instead, the price of gold has dropped more than $100 from its recent high of $965 per ounce. Gold has fallen along with crude oil and industrial metals as the market is hooked on to the idea of a global economic slowdown. Have commodities reached the end of the road? The short answer is NO; financial liquidation has exaggerated recent moves. The real story remains intact.
If we try to sort out the influence of macroeconomic factors on commodities as distinct from short-run demand and supply influences, then three things stand out. They are: (1) cost of capital; (2) outlook for inflation; and (3) demand for real assets Vs. financial assets. At first glance, (3) and (2) appear similar. They are not. In present times, (3) can also arise out of concerns over financial system stability.
Since March, with slightly different starting points, these three factors have turned less favourable for commodities. Now, they are simultaneously negatively disposed towards commodities. To assess the outlook on commodities, it is important to ask whether these factors would reverse.
The answer for (1) is that it is not just in the case of the US, but in the case of euro zone, too; interest rate expectations have become tighter. Over the last five months, rate expectations have moved towards anticipating a tight or no-move stance on the part of the European Central Bank, Bank of England and the Federal Reserve. This is remarkable considering the dramatic drop in retail sales in Europe, the collapse in construction activity in the UK and consumer confidence in the US and UK. In the fullness of time, these interest rate expectations should unwind in favour of easing.
To divine the outlook for inflation, one cannot turn to commodities for we are trying to guess the outlook for commodities in the first place. The logic would become circular. To get a grip on inflation, one has to turn to the stance of monetary policy. Financial markets now perceive that central banks in the developed world are determined to resist inflation. This has come about even without them undertaking much tightening. The perception would not last. Given the outlook for aggregate demand in these countries/regions, monetary policy would be compelled to become sufficiently inflationary in the next year. So, not only would cost of capital (at least at the policy level) become lower, but policy stance would also change sufficiently to begin to stoke inflation expectations. The likely onset of severe contraction in demand would force policymakers to shed their ambivalence and keep the punchbowl overflowing.
On (3), it is clear that, fears about financial system stability have not returned since the collapse of Bear Stearns Companies Inc. Credit default swap premiums in the case of most American financial institutions have not reached the March highs. However, with the price decline in residential properties likely to shift to non-residential properties (hotels, office buildings and shopping malls), a fresh wave of write-offs is likely in the financial sector. As investors eventually give up on expectations of a turnaround in the sector, panic would make its appearance again. That would complete the third prerequisite for a return to boom of commodities.
Until then, investors should be prepared to tolerate mark-to-market fluctuations/losses in commodities holdings. Indeed, they must even have the courage to accumulate. Needless to add, this advice would not be applicable to base metals. They would bottom out only when global economic growth bottoms out in 2010.
A counter-argument is possible but is easily dismissed. That is, if the US consumer does not save but continues to spend, then financial asset prices may not drop as much? Well, if the US consumer does not begin to save, there is no need to invoke macroeconomic arguments for commodities. Standard demand-supply framework would do to justify the return to boom of commodities.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org