Are Commodity Markets Overleveraged?

By James Wellstead – Exclusive to Resource Investing News

Debt weighs heavy on the minds of investors these days. Not their own balance sheets, but those of US and the Euro Zone governments. Investors who attended the World Resource Investment Conference in Vancouver, Canada  were cautioned on the impact of continued government liquidity injections in commodity markets and offered a number of solutions to protect themselves, or profit from government spending risks.

A common theme amongst the presentations—though one could be excused for losing track of any consensus amongst the countervailing opinions—was the search for connections between the fate of US government’s monetary stimulus, mounting US and EU government debt with lagging economic growth, and the bull run of commodity markets. However, as commodities trade at record levels almost across the periodic table, disagreement prevailed as to the fate of commodities as an asset class in the coming six to twelve months, and whether the broad-based commodity demand is linked to strengthening global growth or is supported by speculative, government infused cash flows.

Danielle Parkof Venable Park Investment Counsel felt commodity markets are preparing for a large correction as “we are now looking at assets that don’t make sense”. Park pinned these assumptions upon the “margin abuse” seen in the more than US$1.2 quadrillion (1200 trillion)in derivative markets worldwide that have found their way into commodity markets and have inflated asset prices, financed in great part through government monetary stimulus. As a result, current commodity prices in this world of leverage are inflating commodities like oil and copper which then become less about supply and demand issues, and more about market manipulation through excess liquidity.

Further, Park noted, we should begin to expect deflation, not inflation, “as the velocity of money [the speed at which money passes though the economy] has been slowing,” and little of the stimulus that has made it through to ‘Main Street’ “has been completely obliterated by food and oil prices” with the rest of the stimulus caught up in the balance sheets of banks. Park continued “it is for this reason that the inflation that we’ve seen of late is not persistent…It’s not likely to stay with us because it is not actually made its way into an acceleration in demand in the economy.”

Park used the analogy of a teeter-totter to help investors understand the relation between commodity asset values and the US dollar. When US dollar is being pushed down on one end, all other prices are pushed higher, and vice versa, as the dollar acts as a safe haven [in the minds of investors] when concerns of overinflated asset prices reach a peak.

Frank Holmes of U.S. Global Investors also picked up on the importance of the US dollar to commodity price valuations, but drew different conclusions on the future of commodities, specifically gold. While asset prices like gold and silver are trading at all time highs, these prices should not be taken at face value since the assets are priced in US dollars whose value is being inflated. What is important, Holmes noted, is that paper money growth is not matching commodity growth.

As such, Holmes remains strong on continued commodity demand with multi-billion dollar infrastructure projects underway across the globe in China, Russia and Saudi Arabia. In speaking on the prospects of emerging market growth, he noted that the so-called “Love Trade” of gold emerging in Asian markets was a long term trend that would continue to push gold and other commodities higher.

In the end, disagreement seems to come down to the potential strategies investors will pursue in order to manage, or profit from, government’s debt and monetary actions. That is, will investors seek out commodities like gold, silver or others as an inflation hedge against potential continued US monetary stimulus, or will investors actually move back into the US treasury bills as a short term security move. Park says that the last ten years have shown that while the long term prospect for the US dollar is less positive, history shows that investors seem to believe that US treasury notes can provide the security in the short term. Others however, seem to think that the political incentive for continued, even “stealth” monetary expansion is more likely.

In his speech to the IMF on Wednesday, Federal Chairman Ben Bernanke eased some of those concerns when he avoided any talk of further monetary support. This may have also supported the recent opinion voiced by Reuters analyst John Kemp that “What is clear is Bernanke and other senior Fed officials believe the Fed should not overreact to temporary commodity price shocks…Recent gyrations in commodity prices and the race for safe haven investments in the U.S. Treasury bond market show investors are no longer afraid the Fed will fight rising food and fuel prices by tightening policy and choking off growth.”