Global Economic Slack to End Commodity Rally

This year began with a bang. Our forecasting models accurately predicted many of 2016’s early commodity rallies in metals, energies and grains. Our models also expressed the notion that while these rallies would be sharp, there was little evidence to suggest that this was anything more than a temporary spike in a deflating global economy. Therefore, the persistence of these rallies has been the biggest surprise of the year. However, the same factors that have led us to believe that these rallies would be temporary have only increased their alarm. This week, we’ll examine the primary component of our deflationary argument while also shedding some light on an inspired tweak to an existing measure of global economic activity.

We’re going to examine a few macroeconomic points to set the table. First, let’s define economic activity as the pace at which goods, services and money exchange hands. We’ll look at a series of charts from the St. Louis Fed regarding money supply and velocity. We’ll also take a detailed look at the Baltic Dry Freight Index as it is frequently used as a benchmark for global economic activity. We’ll also show an alternative index that we feel better defines the correlation between global shipping and economic activity. Finally, we’ll discuss the use of commodity futures to not only protect but profit from proper portfolio creation.

Let’s begin with a macro look at the growth of U.S. debt levels.

historical u.s. total money supply
This shows the dramatic growth in total debt here in the U.S. The shaded portions represent recessions.

Debt levels were fairly constant until the 1980’s. Modern financing techniques combined with the evolution of the hostile takeover began to fuel the notion of borrowing at a discount to projected revenue rather than basing it on past growth and collateral. However, this is also what led to the .com bust and early 2000’s recession as well as the real estate bubble and economic collapse of 2009. More importantly, the Federal Reserve Board’s response to borrowing, now based on potential future profits, was to ease interest rates even further. Remember this point when come back to it to discuss productivity.

COT column bannerSticking to money supply growth, the Fed’s response at each and every economic downturn has been the easing of interest rates by raising total debt levels through the selling of new Treasuries on the open market. The dramatic rise in debt levels led many to believe that not just inflation but hyperinflation was right around the corner. This led to the massive commodity rallies in 2008 in energies and metals. We said at the time that there was no economic justification for owning these commodities other than following an existing trend for as long as it lasted. Therefore, when the energy market collapsed and the metals markets never received the inflationary support they’d anticipated, they collapsed as well. Now, look at the dramatic growth in money supply and you’ll see why so many people logically bought into this argument.

historical federal reserve money supply chart
This chart shows the growth in M1 money supply over the last 10 years. Obviously, the world is now awash in Dollars.

However, the inflation never came because the economy never really improved. Inflation is measured partly by the velocity of money. It’s not how much money is in circulation but rather how quickly that money is changing hands. This measure of economic activity has been in a persistent downward trend. Note that the economic upswing of the mid-2000’s never came close to breaching the economic activity high of the mid 1990’s.

Historical velocity of money chart
The velocity of money or, how quickly money is changing hands is a primary indicator of inflation and deflation.

Returning to productivity, you’ll notice that the rapid growth made through technological gains has stalled in the last four years. While gains in productivity are linear, the rise of debt has been exponential. Each point gained becomes exponentially more expensive creating a drag on GDP.

historical gains in productivity chart
The pace of productivity gains has slowed substantially and has grown linearly as compared to debt, which has grown exponentially.

 

 

Now that we’ve discussed the background points, let’s look at the Baltic Dry Freight Index. The Baltic Dry Freight index measures the cost of shipping. This external indicator has received lots of press since its creation but we’ve found a better alternative.

From, The Economist:

THE Baltic Dry Index (BDI), which measures the rates for chartering the giant ships that transport iron ore, coal and grain, has long attracted the attention of commentators hoping to take the pulse of world trade. The cost of shifting the basic raw materials that are the ingredients of steel, energy and food supposedly provides a leading indicator of the state of the world economy.

Here is the Quandl chart.

The Baltic Dry Freight Index has managed to climb off its lows but still suggest an extended period of slow economic conditions.
The Baltic Dry Freight Index has managed to climb off its lows but still suggest an extended period of slow economic conditions.

The problem with this data set is that it tracks the cost of shipping rather than the value of the goods being shipped. A wonderful counterpoint in Forbes by Tim Worstall, notes that the primary reason for the decline in this index is not lack of global demand for base raw materials but rather a calculated and rapid expansion in the number of ships available. It is therefore, the doubling of the cargo ship supply between 2010 – 2013, rather than the lack of demand that caused the index to fall. However, the notion of tracking the cargo activity is a valid point in today’s global economy.

To this point, The Netherlands Bureau for Economic Policy Analysis developed an index entitled, “CPB World Trade Monitor.” Their index divides world trade in volume by prices received in Dollars. This allows us to calculate the total value of goods being shipped thus tying the index to global demand. Unfortunately, their chart may be even uglier.

historic value of goods shipped chart
This chart by, CPB Netherland’s Bureau for Economic Policy Analysis isolates the total value of goods being shipped to determine global economic demand.

I think we’ve made the case for a generally slowing economy that has primarily been supported by the growth of money supply both here in the U.S. as well as abroad.  This is reflected in the continuing move to negative interest rates in first world countries attempting to stimulate their own economies. The fact that this pool is growing at an increasing pace bodes poorly for any type of economic normalization.

negative interest rate by country chart
The scope and severity of the negative rate interest rate pool of funds is growing both in pace and total size.

The sole purpose behind governments moving to negative interest rates is to get money out of the banks and into the hands of people, small companies and corporations who can leverage low interest rates into a positive rate of return. Unfortunately, this isn’t working and it’s showing up in declining corporate profits as well as a corresponding decline in demand for new debt. We can see this in the S&P 500 corporate profit chart below.

The combination of already low interest rates plus declining corporate profits offers little hope for economic growth.
The combination of already low interest rates plus declining corporate profits offers little hope for economic growth.

So, what’s an investor to do? Well, we make our living tracking the behavior of the commercial traders. These are the companies that have an economic tie to the market they’re trading. Whether they’re producers or consumers, they’re attempting to maximize their bottom line through the proper forward pricing of their inputs or output. Based so many of the above factors, is it any wonder they’re EXTREMELY bearish on the current commodity rally? We’ve seen tremendous selling in then energy markets as crude traded over $45 per barrel. Many energy producers can at least begin to breakeven and service their debt costs at these prices and their actions in the futures market are a direct reflection of this. Furthermore, we’ve seen RECORD selling in both the soybean and silver markets. Once again, commodity producers, farmers and miners in this case, are fervently locking in their year’s prices.

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We believe one of the best ways to take advantage of the coming commodity decline is through the selection of a mechanical strategy based on the supply and demand expectations of the commercial traders and tuned to the deflationary environment in which it is being deployed. Our analysis has proven that markets have different personalities on rallies than they do on declines. This makes our equity curve generator a tremendous tool. It allows a user to choose which markets and sides to trade. Using some prevalent selection methodologies, a trader can choose the short side of the stock indices, or a combination of short stock indexes and long interest rates. The versatility of being able to employ supply and demand based trading programs based on your own economic outlook is invaluable. While there are many ways to protect one’s finances in an economic downturn, a small allocation to the short side of the stock index futures or, the construction of a deflation fighting commodity portfolio could be a prudent move if the economic turbulence appears as expected.


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