Backwardation

By Marius-Cristian Frunza
Weekly Briefs

Paper or physical? It is an old and yet very actual debate that all informed investors face at a certain point. The growing popularity of digital trading platforms has led to the democratisation of investing. In regular times, holding paper may seem a reasonable option. But is this the right choice when asset prices are hyper-inflated, and the supply of goods and materials is scarce?

The term backwardation (or normal backwardation) describes a market configuration where the spot price of an underlying asset or a commodity is trading above its prices in the forward or futures market. Signs of backwardation due to structural shortages started to appear in different commodities markets such as lumber, zinc, lead, copper.  Moreover, the all-time high temperatures recorded in the Northern hemisphere lead to poor agricultural production, thereby limiting the supplies of grains.

The investing frenzy triggered by the pandemic attracted a lot of liquidity in both traditional and alternative markets. While the prices of “paper” investments beat one record after another, less is known about the price trajectory of  “physical” assets. This perspective applies not only to commodities but also to the stock market. For instance, a Tesla vehicle is a better investment than a Tesla stock? Is the price of Amazon products growing faster than its stock? Such questions have no simple answer because the inflation index is computed on a basket of goods and services that do not necessarily encompass the full range of products consumed in a country.

Besides oil and gold,  many commodities markets exhibit spikes in spot prices due to production shortages. When a market is in backwardation, holding the physical asset delivers a premium, known as convenience yield. Under these circumstances, investors face a big dilemma. While it is clear that cash loses value due to inflation, what alternatives are available other than “paper”? Portfolio diversification is not just about asset classes but also about the type of assets. Quantitative easing is distorting the actual price of all “paper” investments. Centraphysical investments such as grains, metals, or land l banks are buying back daily huge amounts of stocks and bonds. But they are not buying for even a fraction of the QE.  Therefore, prices of “physical” assets might be closer to fundamentals than prices of “paper”.

Investors need to think seriously about rainy days. Rainy days will come when the raining cash strategy of the Fed will reach an end. Therefore, it is crucial to implement some form of hedge against a foreseeable slowdown in QE.  Currently, buying tangible assets other than real estate is one of the very few alternatives.

The price of a commodity will never go to zero. When you invest in commodities futures, you're not buying a piece of paper that says you own an intangible piece of company that can go bankrupt. James Beeland Rogers Jr, American investor

Market overview

As expected, the US economy delivered strong growth over the summer and expanded 12.20% in Q2 over the same quarter of 2020. Moreover, data from the Labour department show that jobless claims dip to a new low last week since the beginning of the pandemic. The number of redundancies fell by 29,000, nearing 348,000 in mid-August, amid a new massive wave of infections caused by the Delta variant.  The US recovery is showing resilience, and the Dow Jones has managed to remain above 35,100.

Focus:

GeoVax

The first generation of vaccines for the new coronavirus was developed and approved in a race against the clock, under the pressure of social and political forces. However, while they proved their efficacy in protecting the population against the disease, the current vaccinal solutions proposed by Pfizer, Moderna and Astra-Zeneca exhibit severe limitations against the newer variants of the virus, thereby hindering their usage in the foreseeable future.

Earlier this week, GeoVax, an Atlanta-based biotech company, presented at the European Society of Medicine General Assembly a new strategy for coronavirus vaccines aiming to induce broader immunity by including multiple components from the target virus, thereby making the vaccine efficient against new variants.

If Geovax’s vaccine gets FDA approval, it could represent a game-changer for the global vaccination strategy. Under this optimistic scenario, Geovax will eclipse Moderna and Biontech.

Commodities:

Wheat

Hot summer, drought, low grain production… Following the unprecedented high temperatures recorded during June and July, the resultant severe drought affected the wheat crops all over the Northern Hemisphere. The US, Canada, Ukraine and Russia reported lower expected productions due to the climatic conditions. For instance, in the US, 89% of the spring wheat harvesting areas are affected by some form of drought. As a result, the CBOT front-month wheat futures on CBOT experienced a short rally over the summer, and the prices could soar in the autumn amid a foreseeable shortage.

Commodities:

Coffee

The price of coffee futures listed on the Intercontinental Exchange (ICE) has almost doubled since the beginning of the pandemic in March 2020. The coffee crops in Brazil, the world’s largest coffee producer, were severely touched by the extreme weather. Moreover, turmoil in global shipping, COVID and political unrest in Columbia pushed the price of the beans to climb by 25% in August. As a result, the major retailers are building stocks to hedge a future rally in coffee prices. The retail cost of an espresso could quickly increase in Q4.

Market outlook

As expected, the Dow Jones Index lost territory over the last week but hung in the last trading above 35,100. However, the perspective of non-transitory inflation and a new wave of Delta-variant related infections are putting investors in a risky spot.

After a bumpy trajectory and several technical corrections, Bitcoin’s price soared above 49,000, confirming the beginning of a new rally.

General Disclaimer

The information and data published in this research were prepared by the market research department of Darqube Ltd. Publications and reports of our research department are provided for information purposes only. Market data and figures are indicative and Darqube Ltd does not trade any financial instrument or offer investment recommendations and decision of any type. The information and analysis contained in this report has been prepared from sources that our research department believes to be objective, transparent and robust.