Epoch Times: Mr. Hepworth, what can commodities tell us about the economy?
Douglas Hepworth: They are descriptive. You will often see a battle between equities and commodities. Equities are telling you about the future. Commodities are telling you about the present.
What do people look at buying equities? Earnings expectations and growth expectations. They are discounting the future.
Commodities are not driven by financial flows, they are driven by real-world supply and demand; they are immediate.
A quick and dirty rule of thumb: If global GDP growth is 3.5 percent, commodities break even. If it’s 5 percent, they gain 20 percent. If it’s 2 percent they lose 20 percent.
So what do we have? We basically have 3.5 percent, that’s what commodities are saying.
Epoch Times: What about the equity market?
Mr. Hepworth: It says: Growth is around the corner, it’s big growth, it’s real, it’s legit, and it’s going to come. Now, 3.5 percent global growth doesn’t justify equities at these levels. So who is telling the truth, who is lying?
Normally, the bond market would be the arbiter of that. Except for the bond market now says nothing. Its entire signaling power has been [removed.] There is just no information.
Epoch Times: So what do investors do?
Mr. Hepworth: You either hedge your bets or you go all-in on one of the two. If you go all-in, you could be saying: “Equities are lying, I believe commodities.” But that doesn’t mean you are going to buy commodities. It means you sell equities and you buy bonds.
Epoch Times: Because there won’t be any growth?
Mr. Hepworth: Correct. If equities are right, you are going to reduce equities and you buy commodities. You don’t want to be in equities, they already discounted the growth.
Epoch Times: So commodities could benefit from the growth equities are predicting?
Mr. Hepworth: Yes. Equities do their best at the start of an expansion and do the worst at the start of a contraction. Commodities do their best at the end of an expansion and do their worst at the end of a contraction.
Epoch Times: So why are equities still going up?
Mr. Hepworth: I think it’s a use of money thing. They tend to go up when there is excess liquidity and fear of putting it to real work. If you don’t want to build inventories and you don’t want to build infrastructure, where do you keep it?
You don’t want to keep it in cash. Bonds yield nothing, cash yields nothing, but there is inflation. So you put it in equities.
Epoch Times: How does your firm measure commodities as a whole?
Mr. Hepworth: Any reasonably diversified basket of liquid futures will deliver. We look at how much of commodities have been produced globally, how much has been traded between nations globally, and how much has been trading on futures exchanges.
The desire to hedge and the liquidity is captured by the futures. The production captures the relevance and the imports and exports capture how global this relevance is.
Epoch Times: So what determines the final mix of that basket?
Mr. Hepworth: We force diversification. If you just look at how much is produced, how much is traded and the futures, you would end up with 75 percent energy—just because it dominates. We constrain energy to force that diversification.
It’s an art. What we wanted to do was to find out which basket was the best one to go with a portfolio of financial assets. Which basket of commodities will provide the best risk-adjusted return together with a portfolio, which is comprised mostly of equities and bonds.
Epoch Times: What do you expect for 2014?
Mr. Hepworth: I think that whatever good there will be is going to be led by the United States. [North America] is in a pretty unique space at this moment. We are on a path toward energy independence, which has a tremendous effect on [our trade deficit].
At the same time you have Mexico, which is now price-competitive with China on labor costs. I think this hemisphere is in pretty good shape.
On the flip side, you have Japan exporting deflation. They have a lot, they put a lot in storage; they are giving it back.
I think China is probably going to get some artificial growth. It is going to flip from being restrictive to being expansionary. Xi Jinping needs it. And the worst is over for Europe.
I actually think that 2014 is going to be a turning year back toward global growth. Good for commodities, just not immediately.
Douglas Hepworth is an executive vice president with Gresham Investment Management LLC, a New York-based firm specialized in commodity investment strategies. Mr. Hepworth has spent the last 26 years working in different positions on Wall Street including 12 years with Gresham.
The interview has been edited for brevity and clarity.
