When Prices Change, but Relativities Do Not

When Prices Change, but Relativities Do Not

“Speculative manias generally occur during periods of profound economic upheaval.”

Joseph Schumpeter

“A contemporary pamphleteer calculates that the 2,500 guilders paid for a single tulip bulb would have bought twenty-seven tons of wheat, fifty tons of rye, four fat oxen, eight fat pigs, twelve fat sheep, two hogsheads of wine, four tons of beer, two tons of butter, three tons of cheese, a bed with linen, a wardrobe of clothes, and a silver beaker.”

Edward Chancellor, “Devil Take the Hindmost”

In Edward Chancellor’s masterpiece on speculation, “Devil Take the Hindmost”, Amsterdam became the financial capital of the world following the sacking of Antwerp in 1585, when thousands of mercantilists (and their capital) fled the Spanish, creating the most developed economy in Europe. It also benefitted from previous rampant speculation in Antwerp - royal loans were particularly sought after with leverage, until King Henry II of France suspended payments on his debts in 1557. That was the beginning of the end for Antwerp as Europe’s financial capital.

The Dutch imported commodities from all over the world, and invested in farming and industry throughout Europe. They facilitated the most sophisticated capital markets in Europe, and created Europe’s first central bank, the Amsterdam Wisselbank, enabling Dutch merchants across the globe to settle their accounts in a single currency.

Such vibrant trade and capital markets then attracted investment from all over Europe into various financial instruments such as bills of exchange, annuities, maritime insurance, commodities and shares.

With the immense interest in the Amsterdam financial system also came speculation in financial instruments such as futures and margin lending, where speculators could take out loans for 80% of the value of the East India Company, for example.

Such a broad-based flurry of activity across all types of mercantilism laid the foundation for an episode of euphoric speculation in the 1630s. Earning the highest incomes in Europe made the Dutch a nation of consumers, the East India Company was profiting handsomely, and wars elsewhere in Europe aided the emerging Dutch textile industry. With population growth through immigration supporting a construction boom, the Dutch economy was the strongest in Europe.

And to aspirational Dutch consumers, no flower was considered more desirable than the tulip.

Chancellor explains further:

“The intense feeling of the Dutch for flowers can partly be explained by the geography of the Netherlands, whose flat terrain and rich soil provided the perfect ground for the cultivation of bulbs, while a shortage of space allowed for only modest gardens, arranged in tiny parterres, at the center of which were planted prize flowers whose bright colours set of the drabness of the surrounding countryside. Most prized of all flowers was the tulip. In the middle of the sixteenth century, the Imperial Ambassador to Sulemein the magnificent, Ogier Ghislaine de Busbecq, introduced the first tulip bulbs into Europe from Turkey (its name came from the Turkish ‘tulipan’, meaning a turban. During its early years in Western Europe, the tulip was confined to the gardens of the nobility and specialist botanists. A few years after Busbecq’s return, tulips were observed in the Augsburg garden of the Fuggers, an exotic horticultural novelty for Europe’s wealthiest banking dynasty. In 1573, the ambassador presented some tulip bulbs to the famous Dutch botanist Carolus Clusius, who distributed them and described the flower in his Rariorum plantarum historia. Clusius, who is said to have charged an enormous price for the sale of his tulip bulbs, became the first victim of the growing passion for this rare plant when one night his bulbs were dug up and stolen.”

Part of the speculative attraction of tulip bulbs was the uncertainty of the colour of flowers produced by each bulb. What was not known at the time was that varietals of each bulb were caused by a virus that attacked the bulb, which as Chancellor describes, became a game of chance including wagering and futures markets, so becoming “as standardised and undifferentiated as a note of the Wisselbank or a share in the East India Company”.

As spring of 1637 approached, the tulip market collapsed, as the realisation quickly came that settlement failure would be of epic proportions (price was generally agreed by credit notes for cash settlement on delivery). At its peak, tulip bulbs were selling for as much as fifteen times the price of a house. Eventually, to borrow from Charles Mackay, the people that went mad collectively slowly regained their senses, one by one.

What is particularly interesting about this time in Dutch history is that while there were many structural reasons for most asset prices in the Netherlands to rise, there was still a sense of proportion to the rest of the economy. Yet in one particular market, prices lost all sense of proportion to other commodities and assets, which made the Tulip Mania bubble so visibly obvious that it would have a short lifespan.

Such animal spirits are the same today as they were back then.

Contrast the Tulip Mania anomaly to asset markets today, where a sense of proportion across all asset markets has been distorted by central bank policy, which is now beginning to reverse with rising interest rates. The extent to how much reversal will take place will be dependent upon the commitment of central banks and governments to arrest current inflation rates. But they will at least be equipped with the knowledge that any near-term softening on inflation will subsequently lead to more inflation, and more public protestations on the rising cost of living.

Given the almost uniform increase in asset prices in recent years, it would seem reasonable that any correction to such asset prices would be expected to be broadly uniform. However, asset classes have different sensitivities to interest rates, especially rising rates.

Even venture capital has been a prime beneficiary of a low interest rate regime, notwithstanding that venture capital providers use very high discount rates in deciding the likely success of a project.

Monetary policy settings impacting FX markets can also heavily distort asset markets, especially those with USD denominated debt.

Equities have varying degrees of sensitivity to rising interest rates, as does corporate credit and real estate. However, those asset prices that have the most sensitivity to rising interest rates are those that are the most leveraged. So, positioning a portfolio in advance of an asset price correction, due to central bank actions, is undertaken with limited advance knowledge of where the most leverage exists.

History is littered with asset price distortions, and in most liquidations it is typically the highest quality assets that are sold first, due to their greater liquidity. This means that in the aftermath of an asset boom, particularly one driven by unprecedented credit creation, correlations between assets can become wildly non-fundamental over the short term. While this can create opportunities, the challenge for investors is that their portfolios still contain a negative correlation to rising interest rates, with the magnitude being indeterminate.

So how does an investor mitigate, or lessen their portfolio’s negative correlation to interest rates?

By definition, creating a new portfolio from the same pool of assets should not materially reduce the sensitivity of that portfolio to rising interest rates.

While predicting the future is difficult at best, the current geopolitical environment contains some structural insights. Food and energy are relatively inelastic in terms of demand, and the world right now is experiencing supply upheavals for both, with limited scope for short-term correction for reasons such as;

Ø  Increasing fertilizer costs

Ø  Reductions in fertilizer use (creating longer-term reductions in soil quality)

Ø  Russian sanctions

Ø  Increasing LNG costs across fragmented global markets (a key input for fertilizer)

Ø  Lack of CAPEX into fossil fuels not yet being replaced by renewable energy investment

Ø  Long lead times for increasing the supply of fossil fuels, should governments change their position on such fuels

Ø  Such supply shortages of food and energy feeding back into higher global inflation

While commodity prices experience periods of high volatility, over the longer-term increased demand is usually met by expanding supply. But this takes time, particularly for non-agricultural commodities.

Key inputs for batteries, for example, such as nickel, platinum and silver are not being met with expanded supply. Grain supply is contracting and not easily replenished without declining fertilizer costs. War in Eastern Europe, as well as limited spare capacity for oil and its derivative products are also structural supply headwinds.

Of added attraction is the relatively low starting valuation point for commodities relative to other asset classes, as the following charts show:

Chart 1: Commodities to Equites Ratio

Chart 2: Goehring & Rozencwajg Commodity Valuation Model:

Since the Global Financial Crisis of 2008 (and through many other phases of financial history), commodity prices have behaved inversely to asset price escalation.

What this has meant is that increased liquidity conditions and credit creation have been tides that have lifted all asset market “boats”. And while it is possible to reduce asset price correlations by rearranging exposures to the same “boats”, to meaningfully detach one’s portfolio sensitivity to rising interest rates, investors must consider introducing exposure to investments that lay outside of such existing “boats”.

Commodities might be a good starting point, as their relativity to asset prices has changed significantly, some of this due to the recent strength of the USD, as they are the most advanced in their tightening cycle.

Footnote:

The Netherlands today is easily the largest producer of tulips in the world, producing as many as four billion bulbs per annum - most of which are exported.