Commodities in Freefall and What it Means

Commodities

Commodities declined sharply last week, as the broad-based commodity ETF DBC declined more than 1%, with most of the weakness coming on Friday.  The ETF and most commodity indices moved to multi-month lows, implying more weakness ahead.

The decline in commodities came despite a weaker dollar and generally “OK” global economic data. Continued rotation out of the commodity space by investors was the main catalyst for the declines.

Gold imploded last week, falling 5% on Friday alone and 6% for the week.  The reasons for the weakness in gold are the same as they have been:  negative momentum and money rotation out of gold due to a reduction of risk globally and a total lack of inflation (and potential threat of deflation in Europe).

The one main catalyst for Friday’s decline, however, was the report that Cyprus will have to sell some of its gold (or pledge it as collateral against EU loans), which sets a significant precedent and obviously got gold longs very nervous.

Despite a very low speculative net long position and a rising monetary base, money flows are trumping fundamentals and clearly there is very heavy negative momentum in gold.  I was very, very surprised by the waterfall decline Friday, and clearly the technical damage done was significant.

What to do with gold now depends on your time horizon.  I, for one, continue to see all signs pointing to inflation over the longer term, thanks to continued central bank accommodation and excess liquidity.  I’m very confident inflation will be a problem in the future, and as such I would/am not selling longer-term gold holdings.  With gold and silver plunging again this morning we are in the midst of a sellers panic at this point, although I’m hearing there is decent support in the mid $1300’s.  Silver and copper also declined sharply last Friday and this morning in sympathy with gold, and both finished lower on the week (with silver hitting new 52-week lows).

Energy declined last week as WTI Crude broke through support at the $91/bbl. level and Brent crude fell basically to previous lows for the year.  Both commodities were pressured by general commodity market weakness.

Finally, grain markets were the outperformers last week as the entire complex rallied, bouncing from an oversold condition after a USDA World Agricultural Supply/Demand Estimate report showed that the supply of corn and soybeans hadn’t grown as much as thought (the report wasn’t bullish, it just wasn’t as bearish as feared).  Given the number of shorts in the grains, that led to a short covering rally, although the supply/demand picture remains uncertain and given the planting intentions for this year, it’s not certain that you’re buying “value” in the grains at these levels.

The weakness in the commodity markets remains an important topic to monitor.  On one hand, you can make the case the decline is justified, given recent supply increases in commodities like copper, WTI Crude and steel.  But, while those supply increases are totally legitimate, they are overshadowing the weakness in the global economy, which is something I think needs to be considered.

Commodities as an asset class are signaling one of two things:  1) That we are returning to a period like the 1980s where increased supply, reduced macroeconomic uncertainty and low inflation depresses commodity prices, and we see a renewed equity bull market where stocks significantly outperform commodities.  Or, 2) the weakness in commodities is signaling trouble on the macroeconomic horizon, as global growth stagnates and we all flirt with another bout of global deflation (which would better explain gold’s weakness than just money flows).  Scenario No. 1 is equity market positive, scenario No. 2 is very equity market negative.

I don’t know which it is, but it is one of the two.  I hope it’s the former, but I fear it’s the latter– as I still can’t get it through my head how we all get global economic growth without stimulating massive inflation across the globe.  The path out of this multi-year, global economic malaise is through economic growth and inflation—that’s what we should all want to happen—but commodities are telling us it isn’t happening.  And, while I hope we’re embarking on an 1980s-style equity bull market, I just can’t see how at this point.