Category Archives: Commodities

Out of Favor, Into the Portfolio

Posted on October 23, 2006 | Leave a comment

[Download this article in PDF format, with charts and better formatting]

The Dow Jones Industrial Average is hitting new all-time highs while crude oil is making new lows for the year. Moving in opposite directions is normal for these markets, but recent movements may come as somewhat of a surprise against a backdrop in which core inflation has risen to levels not seen in a decade and the yield curve is inverted.

China and India seem to be in a race to secure energy reserves in anticipation that within three years, Asia’s oil consumption will surpass North America’s. Global economic production is expanding by about 4%, about double the average rate of the last 50 years. Growth rates are highest in the countries with the largest populations, and consumption is being subsidized by growing global debt markets.

Stock valuations anticipate strong growth while commodity prices anticipate adequate supplies. This is an intellectual error.

Only fools and economists believe in infinitely compounding growth

For major world markets to continue recent growth rates, many major supply-related hurdles would have to be overcome. Current capacity for energy supplies are insufficient to support more than a few years of continued growth at this rate; additional capacity will have to be created. However, whether or not one believes in the “peak oil” theory or not, it is indisputable that known oil reserves are shrinking while discoveries are taking longer and yielding less.

While the pendulum of stocks and commodities has swung toward stocks, the fundamentals seem set up to push the pendulum back the other way.

Stocks and Commodities; Owning Both

Commodities often move in the opposite direction from stocks over periods of three months or longer. Over longer periods, this negative correlation becomes quite strong; as much as -42% for five-year periods. The result is that these two asset classes have provided strong diversification benefits when combined in a portfolio. Their risks offset each other to a high degree, resulting in more consistent wealth accumulation.

The fundamental basis for this behavior is easy to understand: stocks do well when the resources they need are cheap. Similarly, profits are diminished as the prices of natural resources go up. In addition, as commodity prices rise central banks tend to raise lending rates and slow down corporate growth rates. For this reason, commodity prices tend to be a better hedge against unanticipated inflation than
stocks, and much better than bonds.

Combinations of these two asset classes can be represented along an efficient frontier. This chart makes clear that risk was dramatically reduced by the
introduction of commodity futures while having a very small impact on returns.

Risk-averse investors who are sensitive to maintaining their purchasing power should consider commodity futures as a component of their portfolios.

Ignored Risks

The risk to the value of the U.S. dollar should not be overlooked. Many countries own substantial foreign reserves in U.S. dollar denominated debt. If these countries decided to diversify into a broader basket of currencies or assets, the outflow of capital would put pressure on the value of the U.S dollar. Commodities provide a hedge against volatility in the value of the dollar by maintaining purchasing power.

Global Growth implies Unprecedented Demand

World population is rising at a rate of about 1.3% per annum, or about 10,000 new people every hour. At the same time, productivity in the U.S. is rising at about 2.6% annually. The U.S. has very high productivity relative to other countries, and it is growing. At the same time, the vast majority of the world population lives in countries where productivity is much lower – but catching up.

The process of productivity convergence has been dramatically accelerated by the opening of trade, reforms toward capitalism, and the growth of the internet to share information. The long-term trajectory is for developing countries to grow toward U.S. productivity levels. This simple dynamic has some profound implications: we’re not ready.

If Chinese productivity rises to even half of U.S. levels, that economy’s GDP will expand from less than one fifth that of the U.S. to more than double that of the U.S.

Consider 2 scenarios:

1) An unrealistically pessimistic scenario:

Assumptions:

a. World population suddenly stops growing.

b. The U.S. never innovates, and simply maintains existing productivity levels.

c. Other countries catch up to U.S. productivity levels in 50 years.

Implications:

a. China would average 6.6% growth for 50 years, raising its production by more than 24 times to more than four times the size of the U.S.

b. India would average 8.5% growth for 50 years, raising its production by almost 60 times to more than three times the size of the U.S.

c. Global production would rise by more than 5 times.

2) Constant population and productivity growth:

Assumptions:

a. World population continues to grow at 1.3%.

b. U.S. productivity continues to grow at 2.6%.

c. Other countries catch up to U.S. productivity levels in 50 years.

Implications:

a. China would average 10.8% growth for 50 years, raising its production by more than 169 times, to more than 30 times the current output of the U.S.

b. India would average 12.8% growth for 50 years, raising its production by more than 410 times, to more than 25 times the current output of the U.S.

c. Global production would rise by more than 41 times.

These long-standing and slow-moving global economic trends will almost certainly be interrupted by commodity shortages during this period. Even the most optimistic forecasts for natural resource capacity do not anticipate supporting even the conservative scenario for growth.

Something has got to give.

We expect that as population and productivity trends push demand higher, commodity prices will rise to keep demand lower. Equilibrium prices are likely to be driven increasingly by production capacity as shortages develop. Over time, this will likely slow global growth rates and provide advantages to companies and countries that are net suppliers.

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Posted in Bonds, Commodities, Economics, Investment, Psychology, Stocks

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Freakonomics – Own land

Posted on July 14, 2006 | Leave a comment

[The following article is part of a larger commentary, available here.]

The key investment in the “green revolution” may be land. Wind farms require land, solar panels require land, bio-fuels grow on land, etc. Let’s inspect one specific use: using solar panels to generate hydrogen for fuel-cell cars:

As of last year, 700 sqft of Honda’s roadside solar generators produce enough hydrogen in one week to fuel one car for 175 miles. Clearly this is not enough, but it could be if you use more land.

(700 sqft of solar arrays) x (7 days) = 175 miles

equivalent to

(1 acre of solar arrays) x (1 day) = 1556 miles

If we assume that cars get about 25 mi/gallon of gas, then each acre produces the equivalent of about 62 gallons of gas per day. If gas costs $3/gallon, and hydrogen is priced to drive the same distance for the same cost, then each acre produces about $187/day in sales. That’s $68,140/year. Maintaining solar arrays is pretty cheap, let’s assume $5000/year/acre. If we discount the implied cash flow using a real rate of 5%, the value is $1.26m/acre. Obviously, an acre of solar arrays is expensive. Today, the cost would be about $1.5m, and exceed the net present value. But not for long!

Technology is progressing at a rapid rate. Today’s 6% efficiency may improve to 30% within 10 years. If the efficiency rises to 30%, the negative net present value of producing hydrogen turns positive. Very positive: $5 million per acre.

And don’t forget, for added upside you can install a wind farm over your solar arrays, and produce with both. Own some land.

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Posted in Commodities, Economics, Freakonomics, Investment, The Future

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Global Risks, Global Opportunities, Investment Commentary, Q3 2006

Posted on July 14, 2006 | Leave a comment

The following article is also available with charts, graphics, and additional information here.

The global population participating in world markets has risen from about 500 million to about 5 billion since the end of the cold war. This 10-fold increase in the number of workers and consumers is the dominant force in the world economy, underlying many major trends such as:

  • The boom in outsourcing and world trade
  • The falling “real” cost of low-skilled labor
  • Deflationary pressure
  • The de-industrialization of the United States
  • Overwhelming demand for natural resources

The political response from developed nations has been to embrace free trade, promote global growth, and fight deflation by increasing the money supply.

As the world adjusts to the new labor force and production capacity, we expect these trends will evolve naturally. Outsourcing will continue and broaden as technology continues to make distance and language less of an impediment. The real (inflation adjusted) wages of low-skilled labor will continue to lag. Deflationary pressure from expanding trade and improving productivity will be offset by an expanding capital base. The de-industrialization of the United States will slow as energy and commodity prices rise because U.S. industry is more energy-efficient than most competitors. The overwhelming demand for natural resources will continue to drive up prices, as demand continues to grow faster than supply.

There are still major unanswered questions that will guide global growth. For example:

  • How quickly will emerging markets raise their consumption toward levels that are common in the developed world?
  • Will the deflationary pressures of trade and productivity be offset by rising asset prices and an expanding monetary base, such that inflation can remain low and stable?
  • As limited natural resources are bid up by new global demand, will market forces be able to restrain governments from nationalizing resources?
  • Will developed nations be able to retain labor standards and a social safety net while competing freely with nations that do not?

Investors might consider the following strategies against this backdrop of trends and risks.

Overweight U.S. Stocks

We believe U.S. equities are generally cheap, with prices already anticipating a broad economic slowdown coupled with higher interest rates. While earnings have been growing very well, prices have lagged, leading to an earnings yield premium that looks more like the average of the 70s than any period in the 80s or 90s.

If the economic slowdown is less than expected, prices may rise substantially from these levels. If the slowdown is greater than expected, clearly there is risk to the downside, but the equity markets appear more attractive, on balance, than fixed income securities.

Within the U.S. equity markets, macroeconomic trends point us toward nimble multinationals and commodity producers. It might be wise to avoid owning companies that depend on the U.S. middle-class consumer. U.S. consumer spending has some structural disadvantages because of rising mortgage rates and an interruption of the rising real estate market, so is unlikely to continue growing in line with recent history. The deceleration in consumer spending may be gradual or dramatic, but it is very likely.

Underweight U.S. Bonds

The U.S. bond market may not be attractive at this time compared with equities. After a prolonged bull market in long-term bonds, the risk/reward balance, compared with stocks, appears unfavorable.

Foreign governments are buying U.S. bonds to stabilize the value of their currencies. Insurance companies and pension funds are buying bonds to offset predictable liabilities. These sources of demand are driving up bond prices independently from other investments, making bonds less attractive.

Demand from foreign governments may diminish because they may decide that holding a global portfolio of bonds is better than concentrating in U.S. bonds. Demand from insurance and pension funds may diminish because managers are migrating toward efficient asset allocation, as opposed to strictly offsetting their liabilities.

Any one of these changes could cause a drop in the price of U.S. bonds. For example, if Japan privatizes its postal saving system as planned, it would mean that more than ¥224 trillion ($2.1 trillion) in savings and ¥126 trillion ($1.2 trillion) in life insurance would no longer be invested by the Japanese government. Japanese citizens may be less eager to buy US bonds than the Japanese government has been. Indeed, they may redirect some of those assets into Japanese equities.

Investors who must hold bonds should restrict ownership to only the highest quality, short-term bonds. Even investors seeking tax-advantaged municipal bonds are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding taxes on mere income.

Lock in Your Mortgage

For the same reasons that long-term bonds are in a bubble, long-term mortgages are artificially cheap. The boom in adjustable rate mortgages was the result of a very accommodating Federal Reserve, and that time is past. Now that the yield curve is flat, locking in long-term financing within 1.25% of the overnight lending rate is a rare opportunity.

Diversify U.S. Dollar Exposure

Conservative investors should hold some investments that are linked to assets or are diversified among a variety of currencies.

The stability of the U.S. dollar is tenuous. The large trade deficit and large foreign ownership of U.S. debt and investments are a tribute to the strength of the US economy; however, they also represent a risk to the U.S. dollar. Interest payments to service these debts already exceed the budgets for the U.S. Department of Homeland Security, Department of Education, Department of Justice, Department of Transportation, the entire Legislative Branch, and NASA, combined. Then, at some point, foreign debts will have to be repaid. A more immediate risk is that foreign investors will sell their U.S. investments if they believe they can achieve better returns elsewhere.

A similar dynamic came to crisis in dozens of countries in Asia and Latin America in the last 20 years. The increased risk of U.S. dollar weakness justifies diversification. Even a gradual long-term resolution to this imbalance would richly reward asset-based and foreign currency investments.

Heavily Overweight Commodities

The risk to the value of the U.S. dollar is enough to justify an overweight position in commodities. The additional trends in global demand growth also suggest an overweight position. Also, many individual and institutional investors have long ignored this asset class, so increased interest from the investor community may provide additional upside potential.

For fundamental reasons, commodity prices may trend higher for a long time. Previously, there had been a sustained stagnation in real commodity spot prices from 1972 through the turn of the millennium. This stagnation was partly due to the collapse of the Soviet economy, and led to a slowdown in investment in new commodity production capacity. Global demand growth was widely overlooked as producers concentrated on meeting U.S. consumption patterns. This oversight was largely because emerging market commodity consumption had historically represented such a small fraction of the total market demand.

The 4.5 billion new members of the global economy are, on average, increasing consumption at a rate far exceeding that in the U.S. Per-capita demand for commodities in emerging markets is only about 10% that in the U.S., so total commodity demand could grow at an accelerated rate until they catch up. If emerging market demand rises to 20% of the per-capita consumption in the U.S., even while the U.S. does not grow at all, total commodity demand would increase by 47%. There is simply not enough production capacity to meet that demand.
How long will it take global per-capita commodity demand to rise to half that of the U.S.? If that happens, global commodity demand will have almost tripled (even assuming the U.S. does not grow at all). Commodity producers (and investors), take notice.

Overweight Select Foreign Stocks

In many cases foreign stock valuations are low, yields are high, and prospects for growth are favorable. In addition, they are less dependent on U.S. consumer spending, and can be a good way to diversify currency exposure.

Neutral Position in Foreign Bonds

Foreign bonds offer the benefit of currency diversification, and may benefit from global central banks moving away from strictly using U.S. Treasuries. Long-term bonds issued in major currencies such as the Euro, Yen, and British Pound may benefit from flattening yield curves. However with rising global interest rates and inflation, shorter maturities may be preferable for bonds in other currencies.

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America’s addiction to oil

Posted on April 6, 2006 | Leave a comment

PDF VERSION WITH GRAPHICS

Every time oil prices pull back, the financial press repeats the misguided mantra that crude inventories are too high. The fact is, inventories are far from excessive. Rather, they reflect the strategic importance of oil and America’s increasing dependence on foreign sources. Indeed, we believe that investors should expect crude oil inventories to continue rising along with prices. The higher inventories shield the economy from unexpected and uncontrollable disruptions in crude oil supply.

Oil inventories are strategic

As the chart below indicates, following the 1973 oil embargo, US crude oil inventories began rising steadily. Companies and the US Government correctly understood that maintaining larger inventories would help to avoid risks from further supply disruptions caused by OPEC. The increase in inventories continued for more than 16 years before stabilizing.

The attacks on September 11, 2001, triggered a similar change in perception – this time, the widespread recognition that inventories should be maintained to protect against supply disruptions resulting from terrorism or other political volatility. It is impossible to predict whether the current increasing trend of inventories will last as long or push as high as the previous one, but the increase appears ongoing.

CHART

Crude inventories in terms of months of supply

The slow-moving trends shown above may give false confidence in US crude oil inventory management. A more important measure of inventories is how long inventories would last during a supply disruption. Inventories would provide about two months’ supply at the current pace of consumption. This two-month period is up only slightly since September 11, 2001.

CHART

The US is increasingly dependent on foreign sources of oil

US oil production peaked in 1971. Since that time, growing demand for crude oil in the US has been satisfied by rapidly increasing imports. In 1991, imports surpassed domestic production, and since that time imports have grown to two-thirds of the total US crude oil supply.

CHART

In today’s world, the disruption of imports is a distinct risk. In the event of a war, embargo, or terrorist act, imports could be interrupted while domestic production might continue. Current US crude oil inventories would replace about 100 days of imports. This 100-day period has essentially remained the same since September 11, 2001.

If inventories do not grow in pace with demand, the period of protection against import disruptions will decline. As inventories shrink relative to imports, the US becomes increasingly vulnerable to import disruptions that could adversely affect the labor and lifestyles of Americans. By this measure, inventories have rarely been lower.

CHART

It is probably no coincidence that the|1973 oil embargo was triggered by OPEC when US inventories had fallen to less than three months of imports. A period of low inventories causes prices to respond dramatically to disruption. The oil crisis of 1979 resulted in long lines for scarce gasoline. Solar panels were actually installed on the roof of the White House.

In order to provide for the equivalent of six months of imports, inventories would have to rise by 79% over their current level.

Almost every aspect of modern living is tied to consumption of crude oil, directly or indirectly. The economy relies on the oil industry for gasoline, diesel, jet fuel, heating oil, natural gas, propane, asphalt, lubricants, fertilizers, antifreeze, pesticides, synthetic rubber, pharmaceuticals, and plastics. It is hard to imagine a functioning economy without these products.

Even the most optimistic experts anticipate that world crude oil production can only grow for a few more decades. After that time, production would decline as remaining sources became more difficult to recover from depleting reserves. Most prominent experts anticipate that global production will peak sooner; some even believe it peaked in 2005.

Already, energy efficiency is on the rise. We are increasingly using crude oil for applications that are best served specifically by crude oil. Other sources of energy are being exploited whenever possible and whenever the cost can be justified. The US economy has been growing faster than its rate of consumption of oil, but it is still highly dependent on crude.

CHART

In sum, America began coping with its dangerous dependency on oil after the Arab oil embargo of 1973. But management of this dependency is ongoing. War and terrorism, increasingly scarce supplies, and changing standards in the transportation industries are likely to lead to rising energy prices as America continues to struggle with its addiction to oil.

PDF VERSION WITH GRAPHICS

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2006 Investment Outlook

Posted on January 10, 2006 | Leave a comment


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Stable US growth

GDP and industrial production during the 3rd quarter grew at about 4% and 3%, respectively, with a relatively stable outlook, and consistent with long-term averages.

Innovation, trade, and competition are driving economic growth, while rising interest rates and commodity prices have hampered growth.

Strong earnings

Earnings-per-share (“EPS”) for the S&P 500 through June stood 30% above the peak reached in 2000.

Earnings have risen more rapidly than share prices, raising the earnings yield of stocks. Comparing the earnings yield of the S&P 500 with the yield of the 10-year bond (“earnings yield premium”), stocks look the most attractive in 25 years. From this perspective, the odds appear to favor equity outperformance.

We expect corporate profits in the United States to rise again in 2006, at a slower pace than in 2005 but better than consensus expectations. We expect that energy, other commodity stocks, and selected technology shares will provide particularly good gains.

Cheaper US equity valuations relative to earnings and to bonds have been driven in part by reduced overseas demand. Foreign investors moved aggressively into US stocks starting in 1997, but they have been reducing their purchases of stocks since 2002, focusing instead on bonds.

Bond bubble?

Foreign governments are buying US bonds to stabilize the value of their currencies. Insurance companies and pension funds are buying bonds to offset predictable liabilities. These sources of demand are driving up bond prices independently from other investments, making bonds less attractive.

Demand from foreign governments may diminish because they may decide that holding a global portfolio of bonds is better than concentrating in US bonds. Demand from insurance and pension funds may diminish because managers are migrating toward efficient asset allocation – as opposed to strictly offsetting their liabilities.

Any one of these changes could cause a drop in the price of US bonds. For example, if Japan privatizes its postal saving system as planned, it would mean that more than ¥224 trillion ($2.1 trillion) in savings and ¥126 trillion ($1.2 trillion) in life insurance would no longer be invested by the Japanese Government. Japanese citizens may be less eager to buy US bonds than the Japanese Government has been. Indeed, they may redirect some of those assets into Japanese equities.

Global growth is on fire

Worldwide political reforms since 1989 have brought more than 4 billion people (almost 2/3 of the world population) into market-driven global economies, and productivity per person continues to grow rapidly. The result of these two trends is a very rapid rise in global production. Developing nations with low wages and taxes continue to gain access to capital and skilled labor enabling them to grow faster than their domestic competitors. Many international stock markets have been outperforming US markets, and international diversification will be even more important going forward than it has been in the past. The oversupply of global labor is not likely to be fully utilized in this decade. As global production grows, the voracious demand for commodities to fuel this expansion is driving up prices, particularly for energy and industrial metals where supply is tightly constrained (3rd Quarter ’05 commentary).

Digital Revolution

Rapidly changing technology is forcing many industries to evolve. The convergence of media and communications toward a common internet protocol means that phone, cable, and radio companies will suffer falling prices in a new competitive landscape. Wider accessibility of broadband connections should also spur the growth of internet services. This same trend is making information available across borders, accelerating learning and research, improving productivity growth, and accelerating political reforms. The fragmentation and expansion of the device market is opening up the semiconductor market to more competition. Intel is likely to maintain large market share in the PC and laptop markets, but handhelds, gaming, smart HDTV, and other new markets will allow more segmentation of semiconductor companies.

Fed tightening

In June 2004, the Federal Reserve began raising rates from 1% in 0.25% increments to a current rate of 4.25%. This pattern is widely expected to continue at least through Chairman Greenspan’s last meeting on January 31st.

Prices, as measured by the Consumer Price Index (CPI), rose by 3.4% in the year ending November, still within the low range in place since 1983. The inflation adjusted (or “real”) Fed target rate is still below average. Observing the historical average, a neutral real rate of about 1.9% might be expected (implying about 4 more rate hikes like the last 13).

Our expectation is that the Fed will stop raising rates before returning to a 1.9% real rate. Productivity gains, cheap imports, and outsourcing will continue to restrain inflation, suggesting the Fed can afford to keep rates low (4th Quarter ’05 commentary).

Housing boom or housing bubble?

Housing prices have been rising rapidly for several years, leading to predictions of a housing bubble. Irresponsible speculation and use of interest-only loans have been widely reported. The value of homes purchased has almost quadrupled since 1991 .

Speculation and rising prices are addressed in part by the Fed tightening because higher rates make mortgages more expensive. However, if the Fed remains concerned about housing prices when inflation is well controlled, tighter regulation of lending standards would be a better tool than continuing to raise the target rate.

But are housing prices a problem? There may be a regulatory problem with low-credit lending, but we don’t see evidence of overextended homebuyers or excess housing supply. Housing prices are rising in line with the general trend in other commodities and assets. Everything that goes into building a home, from cement and copper to lumber and land, is rising in price.

Alan Greenspan and James Kennedy recently published a study including historical loan-to-price ratios. Mortgages represent a smaller percentage of the value of the home than the average of the past 15 years.

What about all that new construction? The number of housing starts is near all-time highs. This headline is true, but misleading. When the number of housing starts is divided by the non-institutional population over the age of 20 in the US, it is far from all-time highs; instead it is below average, and recovering from a prolonged low period.

If mortgage rates rise rapidly, there will almost certainly be more mortgage defaults and foreclosures because of the current popularity of floating-rate mortgages. In that scenario, prices might stagnate on a national scale and could fall in some markets where negatively amortizing loans are popular.

The broader risk to the economy risk is that consumer spending could slow when housing prices return to a more normal rate of growth. Consumer spending is linked to housing prices because homeowners are extracting equity from their homes as the value rises. Equity is being extracted from homes at an annual rate of hundreds of billions of dollars – recently averaging more than 6% of disposable income. A drop in equity extraction has the potential to reduce disposable income by 6%. Offsetting this, consumer net worth is rising rapidly and is at an all-time high.

Fragile stability of the US dollar

World trade is rapidly expanding, and the US is importing far more than it is exporting, resulting in a trade deficit. The historically large trade deficit is a risk to the strength of the US dollar because at some point, all those foreign debts have to be repaid by buying foreign currencies. The magnitude of the risk grows with the magnitude of the debt.

The federal budget deficit is also historically large, but not relative to the size of the economy, and it has been improving since August 2004. In addition, Americans own much of the federal debt, so paying it back will have less effect on the currency. At the end of 2004, foreign holdings of US Treasury debt were $1.886 billion, 44% of the total public debt .

In aggregate, the dual deficits and foreign purchases of US investments create foreign demand for US dollars of about 14% of GDP. Having supported strength in the US dollar, this foreign demand also represents a substantial risk if it slows down or stops.

Exposure to a basket of global currencies, particularly those from countries that are net exporters of commodities, is probably a safer position than being concentrated 100% in US dollar-denominated assets.

Long-term outlook

We are optimistic about global economics and financial investments over the long term. Skilled labor is widely available, and international trade is increasingly cost-effective. Thoughtful diversification across sectors, asset classes, and countries remains a sound investment approach, although US bonds appear unattractive. Global tax and regulatory reforms are increasingly favorable to investors and the economy. The financial markets are increasingly capable of supporting production, distributing risks, and creating resilience against shocks like war and natural disaster. These trends point to higher asset values, lower downside risk, and higher returns on investments.

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