Commodities: The New Insurance?

The shift away from assuming US debt issues are the doom of all things is now underway. Whether we are in a false bottom ahead of a second broad downturn on more bad financial news is unknowable. More negative details on the total losses from mortgage based debt are likely from the banking sector. But we do think the scale of this mess is beginning to be understood and has become an issue mainly for those who created it.

The next concern in this area is from the debt swap market that has grown exponentially as the debt issues surfaced. This large scale hedging strategy is, at close to $50 trillion, an order of magnitude larger then the un-Insurance problem. Most of these are off-market deals that should be paired as hedges, so it is possible that any damage they do will mainly be seen in reflection. That would be another round of seemingly random selling to cover the holes bad deals have made in private equity and hedge fund books.

The last in line for pain is, as usual, the proverbial “little guy”. No one expects US real estate markets to improve in the medium, much less near term. Decimation of bank balance sheets and loan securitization has flattened bank reserves. In a fractional banking system the ultimate effect of this is lowered lending capabilities. In that environment banks are going to lend less, and only to the least risky.

Where does that leave all those sub primes, jumbo and even prime borrowers? Between the proverbial rock and a hard place. Like everything relating to the credit crisis statistics are hard to come by, but loans officer surveys have displayed a steady trend of tightening standards and increased refusals to lend.

Washington is trying to arrange foreclosure holidays. That won’t mean much if owners or prospective buyers can’t finance. Foreclosure is still inevitable if new loans can’t be arranged.

Is there a quick fix for this? Well, yes, but its going to be tricky in an election year. Short of Washington bailing out banks that means more sovereign fund money and more foreign ownership of American financial institutions.

You can already hear the politician’s howls of outrage over this. Think of it as a twenty first century version of the Savings & Loan. Asians do the saving and feckless US bankers do the loaning. The Fed’s rate slashing has steepened the yield curve enough that banks can, theoretically at least, earn their way out of the current mess. The only problem is that will take many quarters to accomplish. If the US chooses this laissez faire route, don’t be looking for real estate bargains before 2009 and maybe not even then.

Every conference we have been at in the past couple of months has been dominated by speakers calling for a price collapse in most metals, and especially base metals. Metals don’t seem to be reading the script. Precious metals continue to see new highs and all base metals have had significant upward moves in the past month. What gives?

We see a couple of reasons for the price moves. The first is simply that that US centric analysis is wrong. Warehouse inventories for most metals simply are not building at the speed the bears had expected.

Commodities that mainly trade through contract sales like iron ore and coal have had stronger prices than most of their open market brethren. The nature of the markets for these materials makes them next to impossible to “speculate” on directly. We therefore find bubble arguments for more liquid metal markets very hard to believe.

In the past month market traded metals have all seen good gains. The star of the show has been copper, the metal reputed to have a PhD in economics. Copper recently traded at an all time closing high, having just exceeded the “triple top” of 2007. Apparently copper earned its PhD in Shanghai or Mumbai.

Do current metal prices imply a bubble? We don’t think so, though we won’t be surprised if there is a commodity bubble before the super cycle ends. We do not however see it now. One thing prices do imply is the renewed interest of funds in the sector.

Investment groups of all types find themselves in a tough spot and those with the longest time horizons– insurance and pension funds—face the biggest challenges. Bonds have had a great few years, but no one expects increases in yields in the foreseeable future. Current yields just are not high enough. To add insult to injury, inflation is accelerating again.

One of the best ways to counter a stagflation environment is commodity exposure. It worked in the 1970’s, and it looks like ready to do so again now. Last week brought news that CALPERS, the California teachers pension funds and the largest of its kind in the US, will allocate up to 3% of its holdings to commodities.

We expect to see many more announcements like CALPERS. Fund money in commodities of all types is increasing again. This will help support the base pricing of many commodity prices, and specifically those in metals we have recently seen. The argument could be made that this is just hot money. Some of it is, but we don’t see investment from funds like CALPERS as the equivalent of hedge fund money. These are long term investors that are looking for portfolio insurance in a time of uncertainty and rising inflation.

What goes for base metals and soft commodities goes double for precious metals. The Dollar is plumbing new depths and could still go lower. It isn’t wild eyed gold bugs who see metals and metal stocks as a refuge; it’s anyone who can add. Its no longer opinion, it’s a statistic. Going forward, more people are bound to notice this winning sector. We haven't seen the arrival of the real masses yet, but they are coming.

There has been a bit of teeth gnashing over an announcement that the International Monetary Fund has sought, and will likely get, permission from its members to sell its gold. The IMF horde was built up when the yellow metal was a fixed part of the monetary system, and is one of the larger bank-based gold reserves still on books at 103 million oz (3,217 tonnes). Is this a big deal?

The total IMF holding is a little over 10 months of current gold demand. Were it simply dumped on the market, it would obviously depress prices for while. That won’t happen, but a better context is in terms of other foreign reserve holdings. At current prices the US$100 billion IMF horde would represent about 6% of China’s foreign reserve holdings. Given China includes some gold in its official reserve, a swap of the IMF gold for China-held US treasuries (and a smidgen of CDO tossed for spice) is doable, at least on paper.

We would see this as a win-win since it fills the hole in the IMF books with Dollars while generating a gain for China in one of the few investments likely to appreciate faster then the Yuan over the next few years. If China were to spoon out the gold for say oil imports, it could lose it all in a little over 10 months based on last year’s oil intake rate.

As much as we like the symmetry of the IMF gold horde being roughly market neutral to China’s oil demand, we don’t know if this sort of trade will happen. We don’t think the IMF will be dumping gold onto the market at any rate, since it would be self defeating. Small economies with significant gold exports would get hurt, and there is no reason why the IMF would junk its own price base just as it was about to capitalise on it after 3 decades. In brief, we think the IMF gold sales will have more impact on commentary then on markets. Ω

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery; publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of mining industry and financial experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information.

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