April 23rd, 2013 | By Nick Sargen
The steep drop in the price of gold this month caught most observers by surprise and left many wondering what's behind it. In my view, it represents the culmination of several developments.
The prevailing view among investors is that the world economy is expanding at a sluggish pace, which, in turn, has caused demand for commodities to soften. Following a strong start at the beginning of this year, the U.S. economy slowed in March, and Europe remains mired in recession. Meanwhile, the Chinese economy disappointed investors who expected growth in the first quarter to exceed 8%. While the miss was small (7.7%), there is a growing perception that the days of double-digit economic growth for China are probably over. If so, the trajectory for raw material demand is likely to be lower in the future.
At the same time, worries about inflation are ratcheting downward, as reflected in a decline in inflation expectations derived from the TIPS market. When the Federal Reserve and other leading central banks implemented quantitative easing following the 2008 financial crisis, gold and commodity prices surged, as many investors believed these actions would boost inflation. Instead, global inflation has decelerated by a full percentage point over the past 12 months to 2.5%. One reason is that banks have been willing to sit on substantial excess reserves; consequently, the increase in bank reserves has not resulted in faster money supply growth.
A third factor that has affected gold and commodity prices is the resilience of the U.S. dollar. When the Federal Reserve embarked on the latest round of quantitative easing last autumn, many investors thought it would weaken the dollar. However, this has not happened, partly because Fed officials subsequently have discussed the possibility of scaling back purchases of treasury and agency paper in the event the economy improves. Another reason is that the Bank of Japan has embarked on a more aggressive program of quantitative easing that has caused the yen to depreciate by 25% against the dollar.
Finally, there has undoubtedly been a speculative element contributing to the six-fold surge in the price of gold since the early part of the last decade. While this resulted in the price of gold reaching levels that were not sustainable, there was no way of knowing when the bubble would burst. (My own assessment was that it would probably require a tightening in central bank policies to alter expectations.) However, now that the price of gold has fallen decisively, many are wondering what the longer-term implications are.
According to Edward Morse, Citi's Global Head of Commodities Research, the sell-off in gold and other commodity prices this year marks the death knell for the commodity super-cycle that has been in place for a decade. (See "From Commodities Supercycle to Unicycles", Citi Research, April 12, 2013.) He views gold as the linchpin for understanding underlying trends for commodities, and believes gold lost its luster as a safe haven as equity markets gained momentum in the first quarter.
This does not mean Morse is bearish on commodities as a whole. Rather, he believes there will be greater differentiation in the performance of individual commodities than was the case in the past decade, during which commodities tended to move in tandem with one another:
"For the next few years, each commodity looks more likely to be sitting on its individual supply/demand fundamentals than on more general factors affecting all of them. This means that…for some prices will rise while for others they will decline, and investors across commodities will be able to take advantage of alpha return strategies focusing on long versus short positions, other relative value relations across the commodity space…"
One implication is that investors will need to have a greater understanding of demand conditions for individual commodities. On this score, Morse cites shifts in investment patterns in China and other emerging markets from commodity-intensive fixed asset investments and industrial growth to household-based and service sector growth. He also sees increased production of natural gas in the United States posing a real challenge to oil's dominance of the transportation fuel market. His bottom line is that the coming decade will be one in which there will be greater focus on individual commodity "unicycles" and less emphasis on a broad-based trend in commodity prices.
If the super-cycle in commodities is indeed over, I believe there are several implications for the global economy and financial markets: