Poor Commodities: Assets Without a Central Bank

Commodity investors stung by the four-year bear market made one simple mistake: investing in an asset class not backed by a central bank.

Whereas equities and bonds have benefited from very meaningful support, direct and indirect, from central bank asset-purchase programs, commodities have not.

That may or may not be good policy; certainly you can argue that the current downdraft in commodities prices reflects a singular lack of inflation risk in the global economy. That might argue for more quantitative easing, but given that what we've had so far has neither generated much inflation or kindled demand for raw materials, it would be hard to be too sure that more central bank buying of financial assets would help commodities prices.

What the situation does underscore is the tremendous extent to which official policy, rather than performing analysis and bearing risks, makes or breaks investment strategy in the post-crisis world.

Commodities are in the midst of a four-year bear market which has only intensified in recent months. The Thomson Reuters/CoreCommodity CRB index, down 46 percent since April 2011, has fallen more than 30 percent in the past year alone.

The causes for the fall, are of course, complex. Not only have energy prices fallen sharply, in part due to weak demand, in part due to improved efficiency and in part due to a strategic decision by crude producers to make life difficult for emerging producers of shale and other energy sources.

As well, China's economy, which has been the dominant marginal buyer for most commodities for more than a decade, is both slowing rapidly and undergoing an historic shift away from investment and towards consumption, a change which implies less intensive demand for raw materials.

Commodities are thus a bit of an unloved step-child in a world in which everyone's new dad is a central bank. The Federal Reserve, European Central Bank, Bank of Japan and Bank of England have found it useful to buy government bonds, and sometimes other assets, at least in part because of the impact this has on other financial assets, making investors wealthier and financing easier to get and cheaper.

LUCKY IS THE TOOL
China has gone beyond this, stepping in to rescue its plunging equity market with an unparalleled intervention including financing lenders which in turn lend money for stock purchases. And official policy in China has been calibrated to ease and support the transition to a more consumption-oriented economy, thus hastening the arguably inevitable dampening effect this has on commodities prices.

In this way financial assets, as opposed to commodities, have simply been lucky in that they are one of the few levers central banks have left to attempt to kindle demand and inflation. None of this is to say that policy should have supported commodities prices, though it is superficially attractive to put money into the pockets of the less well off who produce commodities, as opposed to the better off who own securities.

At least in developed economies the fall in commodities, especially energy prices, is a bit of a break for policy makers, putting money in the pockets of consumers who might spend more or pay down debt.

It may be too that central banks in supporting asset prices are fighting a battle they cannot ultimately win, both with inflation and with the very inflated expectations investors have about how much they should earn.

Investor William Bernstein has argued that as economies grow they naturally give rise to lower returns. Not only is there simply more capital, but technological innovation speeds up, making huge new investments obligatory. Society ends up wealthier but returns drop, though speculative bubbles tend to rise.

As in tech companies, so is something similar seen in commodities, where new technology makes the use of commodities more efficient, and the sourcing of new supplies easier. The coming wave of high-yield bond defaults among energy producers may well be an excellent example of this phenomenon. We've got access to more energy but returns are not what investors hoped.

We all end up with much more of what we want, be it energy, steel or mobile phones, but outside small niches like Apple it becomes much harder to both pay for new investment and make good returns.

Much of this is self-reinforcing. So long as central banks see asset markets as useful tools for other ends the performance gap between financial assets and real ones may persist. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

By James Saft