The Effect of Complacency,
Tightening and Fear on Commodity Prices

Last Friday’s turnaround in the equities markets – as well as precious metals, ADR’s and many other sectors was quite interesting. An Associated Press report noted “Stocks surged higher … as investors overcame their initial disappointment with the government's January employment report, believing the moderate job growth would help keep interest rates stable in the near future.”

One might ask what would have been the reaction had the report indicated real progress -- giving credence to what we would call the “illusion of progress” that underlies many Wall Street and government growth estimates. One cannot say for sure, yet drawing from the near panic that ensued after a slight change in Fed wording last month, it is fair to say a strong number may have had the opposite effect.

In a sense, we have been living in the best of all possible worlds. Many gold investments have been based on the precept the economy is precariously balanced and at any moment a slight shove will drive us over the edge. A bearish posture proved quite rewarding in 2001 and 2002. However, gold has continued to appreciate over the past year, while this type of thinking has been almost 100% wrong since the invasion of Iraq last year.

While there seems to be no real reason to think the present advance in the equities market is anything more than a cyclical upturn within a secular bear market –many smart investors have underperformed – wedded to a perceived need to base their exposure on micro fundamentals, rather than the fervor that has been created through excessively loose fiscal and monetary policy.

Therefore, even though precious metals are usually viewed as a “flight to safety” investment, gold’s advance over the past year has been positively correlated to advances in U.S. equities. We would argue this is because the related carrying costs are highly correlated with interest rates.

Why is this important? Until last Friday, we had been seeing a severe correction in gold and other commodity investments. One can attribute this to some extent to an overbought/oversold phenomenon, yet a more important variable has been the perception that the economy has begun to enter into a sustainable recovery. This concurred with the change of Fed rhetoric, which caused many participants to believe we might shortly see an upward move in rates.

A move toward tightening is considered highly undesirable as it indicates a definitive move beyond the “perfect storm” that presently exists, and which has allowed a simultaneous move upwards in almost every asset class.

Given that few individuals (at least among the people we speak to) except sell side analysts, brokers and retail investors appear to truly believe current growth is really due to any real underlying strength in the U.S. economy – as opposed to being the result of unprecedented fiscal and monetary stimulation – it’s sustainability is in question. Therefore any move upwards in rates or even the hint of one -- could quickly bring an end to the party.
We believe this explains the real deterioration seen over the past few weeks and the return of the bad = good reasoning that accompanied the release of the weaker than expected employment number.

The problem, however, is ultimately interest rates will be raised. Absent real fundamental strength, this may be caused by upward pricing pressure caused by the ongoing stimulation, the need to prevent a rapid fall in the dollar, and a weakening in Asian purchases of U.S. treasury securities to name a few possibilities.

It is true this may not be for a long time and the U.S. may very well be experiencing a Japanese-style phenomenon where we see a very weak pricing environment for years to come. The question therefore is whether any rise in rates will be based upon real fundamental strength or the need to maintain foreign investment inflows. The problem is this is not likely to be clear at the time and one can be reasonably sure the Fed and others will make ever effort to interpret the move as one of strength rather than weakness.

Many investors are therefore likely to use the movement toward higher rates as a reason to reallocate their portfolios in the belief that rates are rising due to the need to combat the inflation and other pressures resulting from an economy that in the words of President Bush is “strong and getting stronger”. While we do not have great confidence this is the case, over the short term, the perception may prove troubling for the metals complex.

Where does this leave us? With the need to be cautious. Fundamentals point to higher gold and resource prices – especially when measured in dollar terms. This is due to a bias toward 1970s-style stagflation, where excessive stimulation is being used to prop up an economy that simply needs to take a rest. The result is additional asset inflation, built upon anemic fundamentals, which lack the ability to grow additional jobs or sustainable upward earnings momentum.

Resources, however, will by no means move up in a straight line. Absent greater uncertainty any move toward, or hint of, higher rates is likely to negatively impact commodities – at least until investors realize the move is more a reflection of a lack of confidence in the U.S. economy, rather than an economic tightening in response to stronger sustainable growth and strengthening fundamentals.

That said, there are many developments that could trigger the uncertainty needed to drive commodities higher. Aside from obvious ones such as international terrorism, one likely development over the next few months may be the rise of a resurgent and more coherent Democratic party -- which will create more uncertainty as they move to more effectively challenge the policies of the Bush Administration. Other factors might include a disorderly depreciation of the U.S. dollar, more corporate scandals, the lack of any real progress on Iraq, unexpectedly weak economic data or the emergence of tensions in other parts of the world.

Therefore, we are not suggesting the time is right to lighten up on resource investments. In fact there is some evidence to suggest the present consolidation is moving behind us. The key point is there is a real possibility that any move toward higher rates, or the perception of one, could cause a temporary bump in this uptrend.

It is an interesting dilemma as policy-makers need to show progress on the economic front – but not so much progress that there is a demonstrated need to raise rates – which is likely to provoke downward movement far greater than what has been seen in the past few weeks. Investors, therefore, need to prepare themselves for this possibility and to position themselves in whatever manner best suits their individual circumstances.