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23 April 2014

Supercycles, New Paradigms and Hubris

Well, the carousel is still turning, but the count of those continuing to enjoy the ride is getting smaller and smaller. The news that Barclays is about to announce a withdrawal from major parts of its commodities business is simply the continuation of a trend apparent for some while now, amongst the top-tier banks. UBS, Deutsche, Morgan Stanley, J P Morgan et al - joining earlier retirees like Rothschild and HSBC - have all cut or severely curtailed their commodity trading activities in recent times. They came to the business (specifically, the metals business) in different ways - for example, Barclays took a lower-tier LME broker (Deak Morgan, which had itself grown out of the wreckage of the Johnson Matthey banking activities), J P Morgan got their hands on the 1980s and 90s LME powerhouse MG Ltd (after a few other name changes en route), Deutsche ended up with Sharps Pixley, but that was just a little brick in their edifice. What is clear, though, is that they all had one thing in common. 

Heady Days

Remember the heady days just after the turn of the century, when the ‘Supercycle’ was apparently born and the ‘New Paradigm’ was going to change the somewhat secretive world of commodity trading and expose it to the ‘Wall of Money’ just waiting to be invested in the earth’s natural resources? That’s the carousel ride they all wanted to jump on. (Possibly as a result, something else quite a number now have in common as well is that they are, or have been, involved in regulatory investigations into a number of issues; that’s for a different article, though.)

But Real Change?

It’s interesting now, with a few years of hindsight to work with, to think about those phrases. Supercycle? Well, I suppose so, if you define a supercycle as being like a normal cycle, but just a bit more so - a regular economic cycle on steroids, perhaps. But the new paradigm and the wall of money? Simply using words to obfuscate, quite frankly. The boom in commodity prices had a lot more to do with straightforward economic cycles and the way different parts of the global economy were poised to develop at different rates than with any change in the fundamentals of the system. In simple terms, in the years immediately after 2000, the Chinese economy was set to boom, sucking in raw materials at a rapidly increasing rate. A bunch of smart people managed to see that coming, and they were the wall of money. A couple of my colleagues at the time grasped things very quickly, and decamped to a company with lots of its own cash and relative freedom from regulation; one of the major investment banks - never too shy of punting its own money  - was to the fore, and a group of hedge funds who had an understanding of raw materials were also early in the game, together with a few powerful physical traders.

Repackaging and Complex Products

Cash, nerve and trading skill - probably roughly in that order - were the essence of success in riding the wave of commodity prices in the early years of this century, but the banks on the whole didn’t think like that. First, they saw the money their hedge fund and physical trading customers were making, and wanted a chunk of it. Not unreasonable, in the circumstances. But straightforward trading of commodities was never really going to fit; their distribution networks were set up to sell equity and fixed income products, mainly, and so they decided that commodities needed to be packaged to look like those. So, despite the exchanges - LME, Nymex, ICE and so on - which were already happily and successfully trading commodities, the banks needed to employ more and more quants to intellectualise the market and produce all sorts of more esoteric derivatives and synthetic products - ETFs, ETCs, ETNs and lots of other notes, trackers and indices - all designed to give the illusion that commodity investment - a clear case of a capital appreciation trade - could provide some more conventional coupon or dividend-like payment, and all to attract mass new investors to the sector. Well, for a while that all worked; but really, those products needed the price to keep rising to maintain their attractiveness to those investors (and for the avoidance of doubt, I’m not suggesting that there was anything irregular: over-complex and misguided, in my view, but perfectly clean.)

Back to Reality

Unfortunately, prices never keep on rising; over the period, in the end, the aluminium price has not really changed - and the world is awash with the stuff, creating a different set of problems. Copper and nickel both hit giddy heights, and then dropped again; the current strength in the nickel market is nothing to do with a ‘new paradigm’ - it’s down to that good old commodity market staple: disruption of supply, in this case caused by the Indonesian export ban and uncertainty about the Russia/Ukraine crisis. The other metals - yes, prices are a bit higher, but really the move is not particularly different from what we have seen before.

Banking and trading have always been businesses closely linked together - the reasons are too obvious to need restating. The markets for natural resources - just like the rest of the economy - are cyclical; what this last decade or so has shown us is that it’s a lot easier to tell us a business has changed than it is actually to effect that change. The banks clearly had a few years of bumper commodity profits, which I would contend could have been harvested by a simple buy and hold strategy, without all the complexity, but they are now reaping the regulatory whirlwind and public opprobrium. Hubris is probably the best word to use. But, to be balanced and give credit where it is due, as we should, the top-tier banks were consistently real liquidity providers to the market - and that’s where their loss will genuinely be felt by other players. 


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