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Don't Believe the Hype

Updated: Jul 20, 2023

We here at RG are big believers in reversions to the mean. It’s an integral part of how we manage portfolios, which is why it’s so interesting to notice that, every time we steer too far to the left or right as a community, we get jolted back to the center of the political spectrum. This month, markets are demonstrating how this works, and so are a whole range of other entities that built their reps on extremism.


· It was just a few weeks ago that Will Smith made a fool out of himself at the Oscars. As Kareem Abdul Jabbar wrote, “With a single petulant blow, he advocated violence, diminished women, insulted the entertainment industry, and perpetuated stereotypes about the Black community.” The super-woke Hollywood audience let him go back to his seat as if nothing even happened, and then they gave him an award and a standing ovation 45 minutes later.


· In an interview with the Hollywood Reporter less than two years ago, the staunch anti-2nd Amendment, anti-NRA and just all around anti-gun Alec Baldwin was asked, “How are your gun slinging and horse-riding skills?” to which he answered, “They’re always at the ready. I’m an actor of the old school. So if you read my resume — my motorcycle riding, my French, juggling, my horseback riding, my gunplay — is all right at my fingertips at all times.” The italics are mine.


· The left-leaning superintendent of my school district, Cheryl James-Ward, recently said that Asians do well in school because they are wealthy families who come from China. She didn’t even stop with that single ignorant comment-- she kept digging, saying that Latino families “don’t have that type of money” that Chinese families have, so their students don’t receive the same kind of support at home. I don’t know who should be more offended, Chinese families or Latino ones, but suffice it to say that they’re all a little fired up with Dr. James-Ward.


· Twitter. Ahhh, Twitter—what a wonderful story this week, yes? We now know beyond any shadow of a doubt that the company is run by far-left zealots; we know this because they wouldn’t accept the 40% premium that Elon Musk offered them, clearly demonstrating that the company’s existence has nothing to do with sustainability and shareholders and all of those mundane things.

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Two weeks ago, reflecting on the consequences of the West's response to Russia's invasion of Ukraine, Jeff Currie of Goldman Sachs warned that commodities are entering a volatility trap.


He highlighted two self-sustaining factors in the report-- physical and financial - that are likely to last years rather than weeks, prompting higher prices and higher volatility.


In the period since his report, bank have reported their quarterly earnings and confirmed the 'financial' element of Currie’s thesis. Specifically, Currie explained that volatility is both curbing liquidity and restricting access to the very credit required to maintain orderly physical and financial trading of commodities.


Moreover, it is exacerbating the medium- to long-term capital shortages that have built up after a decade of low returns and ample supply that were induced by political and ESG concerns. We’re essentially getting jolted back to the center of the energy policy spectrum this month after having drifted too far away from oil too fast. (Economically, at least.)

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Goldman’s research illustrates how this “volatility doom loop” creates more illiquidity which leads to more volatility and so on and so on.


Currie’s team has shown that, as oil becomes more volatile, the range of possible outcomes becomes wider, thereby presenting an inherently greater potential for loss. That shifting distribution drives up the total Value-at-Risk (VaR) which drives down the amount of commodities that can be hedged with any given amount of risk capital.


Wouldn’t you know, most of the big banks reported earnings last week, and sure enough, commodities trading exposures have been going up on Wall Street ever since Russia’s invasion of Ukraine. In turn, that has left them vulnerable to large swings in asset values.


As Bryan Jung reports, Goldman Sachs and JPMorgan both reported a rise in commodities trading risk measures, according to their first-quarter earnings disclosures, with Goldman reporting its highest uptick in a decade.


· Goldman’s average daily Value at Risk (VaR) in commodities hit a total of $49 million in Q1 2022, up from $32 million in Q4 2021.


· JPMorgan Chase reported its average daily VaR in commodities at $15 million in Q1 2022, up from $12 million the previous quarter.


· Citigroup does not report VaR alongside its earnings but disclosed that its VaR in commodities was up year-on-year every quarter in 2021, with a peak of $48 million at the end of last year’s second quarter.


If Goldman's Currie is correct, this will lead to a reduction of risk capital, which will lower market participation, which will drive down liquidity, which will increase volatility, which will further discourage potential lenders and investors, which will exacerbate the already lower participation and higher volatility.

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This volatility trap is a direct consequence of attempting to move too fast to a new economy based on alternative energy. As commodity producers under-invested in new supply, commodity inventories depleted. Volatility increased as the market lost its ability to buffer even small shocks in supply and demand. This volatility in turn kept commodity producer assets unattractive by raising the uncertainty surrounding the investment's true value, which lowered its appeal to investors. Capital continued to stay away from the sector, keeping new supply capacity low, leading to our current situation.


Such a volatility trap can create persistently higher commodity inflation by way of a supply constrained market, which is why Goldman's forecast for $125/bbl Brent crude in the next few months strikes us as likely. Throw a little more geopolitical unrest on that dumpster fire and you get left with Credit Suisse’s Zoltan Poszar's warning that, hey, you can print money-- but not oil, iron, or wheat. As Poszar concluded his widely read research report last month, commodity reserves will be an essential part of Bretton Woods III because wars are historically won by those who have more food and energy supplies.


While many (kooks) this decade have predicted the birth of a new monetary system, the nuance of Zoltan's particularly troubling vision of the monetary future has gotten a lot of attention. As he put it, "We are witnessing the birth of Bretton Woods III-- a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West."


We advise not to believe the hype. Maybe trade it, but don’t believe it. We figure Zoltan has been too busy writing for South Park to get this one right:





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