The Bard and bubbles

Apologies, on behalf of Barclays Capital in London, to a certain English playwright. But this warrants repetition – especially in a week when Western publics are waking up to the implications of the biggest one-day hike in the price of oil ever seen.

That happened on Friday, when the price of light crude spiked more than $10 to trade above $139 at one stage.

The following was duly dispatched to BarCap clients the very same day:

Is this a bubble that I see before me?

"Well, no actually. It is instead a group of disparate commodities markets, with some common themes but with differing fundamentals, vastly different past price performances, and divergent price outlooks."

Has institutional investment in commodities become a charm of powerful trouble, like a hell-broth boil and bubble?

"Again, no. The amount of money involved has often been massively overestimated, flows of new money have been confused with valuation changes in existing holdings, physical and financial volumes have been confused, and some of the strongest price rises have been in commodities with no institutional holdings."

Is the rise in prices full of sound and fury but signifying nothing but speculation?

"No, speculation cannot keep prices higher than fundamental values over extended periods, and speculative flows have in many cases been falling even as prices have risen."

Does something wicked this way come?

"Probably not, in that while some markets do have balances that imply a significant downside for prices, the outlook remains positive across most of the asset class."

 

BarCap went on to say that if you want to understand why commodity prices go up and down – sometimes violently – then you need to undertake a detailed examination of the fundamental factors of commodities. Moreover, you should expect to see strong divergences across the range of commodities, since different markets in individual commodities have different fundamentals.

The investment bank adds: "Far from being a bubble, we see it as a healthy asset class in which the appropriate strategy consists of a varied selection of both shorts and longs depending on relative fundamentals."

The BarCap commodities research team, led by Kevin Norrish in London, admit to developing something of a bubble psychosis, such is the energy they have had to employ in tackling the widely-held notion the price of oil and base metals reflects a speculative craze that will crack, sometime soon.

They complain that observers repeatedly make elementary mistakes in measuring the amount of investment money that has supposedly poured into the broader commodity sector. The investment bank's own research indicates a net outflow of investor funds from commodities, especially base metals. Indeed, there is evidence of mounting short positions in energy – speculators selling oil they do not yet own in the expectation that they will be able to deliver it at a cheaper price at a later date.

Such technical analysis does not sit easily alongside headlines shouting Oil Price On Way to Moon.

And, to be sure, the whole commodity bubble argument can be looked at another way. Take Albert Edwards, the notoriously bearish strategist at Societe Generale. His latest missive to clients states, boldly: "Many believe, like us, that commodity price inflation has turned into a bubble. It is a bubble of belief based on capacity shortage and the structural nature of strong EM growth." He thinks it is going to burst, but for reasons that are rather different from those who talk rather casually about speculators, awash with liquidity, cashing the price higher and then threatening to rush for the exit at once – causing collapse.

"Too often at the height of a bubble, liquidity is used as an explanation. This is voodoo strategy. Much of the "liquidity" that supports markets at the height of a bubble is merely investors leveraging up on the back of long established price momentum trades (often in cyclical risk assets). And even as the fundamentals deteriorate, investors keep borrowing and investing. But like Wile E. Coyote in the Road Runner cartoons, reality eventually catches up and the ocean of liquidity evaporates overnight until the next cycle. Poof!" Edwards does accept, however, that the growth in global foreign exchange over recent years can be seen as a measure of sharply increased liquidity, since this is real monetary creation.

"One more soundly based analysis of liquidity centres on what central banks around the world are doing in response to the weak dollar. Normally currency movements are a zero sum gain. They cause a redistribution of global GDP as one country loses competitiveness but another gains. But when we have a situation where the central banks in a large number of emerging market (EM) economies (mainly) are intervening heavily in the foreign exchange markets to prevent their currencies from rising against the US dollar, money or "liquidity" is created."

So, to summarise Edwards, fast growth of foreign reserves amongst emerging economies is inevitably turning into domestic inflation, which has fed through into commodity prices. But once the US recession spreads beyond the sub-prime housing crash it will inevitably impact on imported goods. That will break the trend on the US current account deficit, the dollar will rally – and suddenly the growth in those emerging market surpluses will come to a halt.

The SocGen man is convinced that, one way or another, the consumer spending splurge in the US has been the "global liquidity pump" pushing commodities higher. If and when that pump goes into reverse, prices will collapse.

Will it happen? Barclays doesn't even think that a bubble exists. One thing is for sure: we will be discussing it here for months to come.


Paul Murphy is Associate Editor of the Financial Times

 

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