There has been a strengthening price cycle in hard assets over the past 8 years. In the past couple of years, as prices have doubled and tripled, many have been salivating over the double digit growth of China and India as the fundamental argument for endless demand and boundless prices.
Too often overlooked though is the fact that China's economy has already been growing at a double digit clip for the past 30 years. How can this long standing growth justify increases of 500 and 600% in many commodity prices over just the past couple of years? The answer that commodity fans hate to hear is that a speculative bubble has been driving commodity prices to recent heights.
Notwithstanding the developing country demand story, money flows into commodities have recently been driven primarily by a falling US dollar and sub-par investment opportunities in more conventional assets like real estate, stocks and bonds. “Hot funds” flowing from hedge funds and pensions desperate for yield are driving prices to a fevered pitch posing greater and greater risk to capital and world stability.
Ironically many pension funds today are facing daunting deficits because of their double or nothing speculation in stocks in the late 90's tech bubble. Rather than face the need to admit mistakes and increase funding, many are now grovelling ‘round the commodities craps table for one more hopeful toss against mounting odds.
John Hussman's piece this week is on point “Watching ringside for round two:”
“As a rule, once a market becomes overvalued and speculation becomes over-extended, it becomes wise to panic before everyone else does even at the risk of being early.”
“As for agricultural commodities, what we are observing is probably not a Malthusian breakpoint, but what I'd call “speculative hoarding.”
As the benchmark currency (U$) weakens there is a tendency for developing nations to save in the form of real goods.
As Joe Stiglitz notes one of the underlying forces behind rising oil prices is that producers are already drowning in US assets, and to sell them more oil (or other hard assets) is simply to accumulate more low-returning assets. In this sense their best investment then is to leave raw materials in the ground, warehouses, or silos.
Also watch Graeme Maxton, chief economist at The Insight Bureau as he points out that the recent rise in commodity prices is due to speculation, not fundamental shortage.
Meanwhile some people’s speculation is other people’s starvation as all around the world poor people are now rioting and dying from lack of basic food staples. see Avaaz.org. “>”The world in crisis.”
The greed inspired hope that emerging economies will now be ravenous for consumer goods to replace the demand of faltering western consumers, misses a fundamental level of Maslow’s hierarchy: without basic biological necessities like FOOD, no one lives to buy “stuff”.
I think the shock of coming months will be the velocity of correction in commodity prices.
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The cost of commodities is driven by the supply demand balance which has become positive for commodities prices since the turn of the century. I'm not an ecologist but it is clear resouces are limited and demand from BRIC is adding massively to demand.
S, I do agree with the secular demand story for commodities, but we must be careful not to focus only on the long demand story and overlook the interim market peaks and corrections that present a real threat to our capital in the near term. A significant part of the parabolic spike in prices over the past couple of years has been speculation agains the world's benchmark currency. Unfolding this sentiment will have a correcting effect on commodities. At the same time the presently slowing world economy will also naturally soften demand in the near-term, all within the ongoing secular demand story.
I'm not sure we've seen speculation drive 2 whole years of commodities prices here. Historically, speculation drives the prices largely when we see the commodity in contango and when inventories are rising. I do not see that across the board and keep in mind the CRB metric itself is highly skewed towards oil. I do agree that prices can get ahead of themselves sometimes, but I don't see the accompanying commodity equities rising. Nickel is 50% of its high, zinc similar, lead….. The junior mining sector is in the doldrums and arguably cheaper than it has been in 6 years. The ags companies are trading at high valuations, however, the expected rising profits in the handful of companies which hold the key to increased yield in agriculture should trade at such valuations when food stock carryovers are the lowest in 40 years – My guess is that they will look expensive throughout the whole cycle. In ag demand (2%) is double increasing supply (1%). That may not sound like much of a difference however it is a huge lag and results in huge price increases in commodities. As long as inventories are low and some of these commodities are not in contango, then one could argue correctly that these price increases are simply catching up to what the market should have seen in the inventory data over the past 2 years. Markets can remain undervalued for a long time. Agriculture across the board was at a 200 year real low a few years ago.
A slowing world economy need not necessarily soften demand at this juncture of the secular commodity bull. The mechanics of stagflation expose us to that possibility. A slow reflation can in fact drive new money into that pool chasing goods. Inflation is key and as we see grains must now effect higher prices in meat. Should we see that within the next 12 months, this will be a pivotal shift in the commodity cycle. The consumer will wake up to inflation and this commodity story will go from being a demand story (for the past 7 years) to being a demand and inflation story. Consumers will hoard. Companies will throw JIT out the window and stock up on key commodities. Bond exposure will reduce in non-commodity economies. Then perhaps we see commodities equities being revalued to PEs of 30 and above and companies being valued for assets in the ground while the dollar hits new lows. On top of this, all the ag related policies countries are putting into place have been shown historically to do the exact opposite of what they wish. With respect to agricultural prices you have to smile, because we have 4,000 years of pricing data to look at, yet virtually everyone ignores this.
Sure, we may see some commodities correct near term, however if you are investing via the major commodities producers it is difficult to justify exiting those positions because the valuations remain low with respect to their prospects even in the short term. I do not see a bubble in commodities equities. Rather, we could be on the verge of these companies finally being revalued upwards.
The key going forward is to watch and see if all commodities go into contango. If that happens, inflationary psychology is emerging.
-Sonny in NYC
thanks for your thoughts Sony, you make the bull argument well. I think we may see a cyclical bounce in the US dollar here after 7 years of decline. That is my greatest concern with respect to interim commodity prices. Time will tell over the next few months how this issue impacts.
Thanks Danielle. That is a concern of mine as well. I do also think there is a chance of commodities across the board correcting, though it seems like each day we get closer to contango across the board. What concerns me is that this could be a pivotal point in the cycle. Bull markets seem to be phased into 1)Stealth, 2) Recognition and 3)Euphoria. I agree that we could be on the verge of a cyclical downturn within the larger up movement. However, what if we at that pivotal point where we see recognition in the bond market and public recognition of inflation? At the gym, all I see on CNN these days now is talk of rising food and fuel. In addition, CNBC yesterday was laughing at gov't CPI figures. This tells me that we just might be on the verge of this changing from a demand story to a demand AND inflation story.
On the dollar, it's a difficult call for me because I don't see reasons other than technical ones that the dollar might bounce. I'm no chartist, but it does seem to me that this market in the dollar is so big that normal technicals jumps don't seem to occur – for instance the 7 failed 'rallies' in the dollar since October 2005 – each rally stayed under 3 cents on the USD if memory serves.
I agree that a small rally could happen based on overall sentiment re the Fed perhaps nearing their cycle end. I would not at all be surprised to see the euro go down a little. Europe and Canada have both adjusted their economies by a susbstantial amount – Canada 0.60 to 1.00 and Europe similar. Asian economies are next to adjust to a weak dollar so I do think they will be the story going forward. For me one of the most important factors to watch at this point is how much pain the Gulf and China are willing to stand with respect to inflation in their economies from pegging.
I find it tough to make a position move based on dollar weakness when triple deficits are still there, tax revenue shortfalls will probably become apparent soon, credit derivatives losses are only just starting to emerge and all the while currency traders have not at all priced in the destruction of the Fed balance sheet due to the swaps.
Enjoyed meeting you briefly at HA2008. Also, I am reading through your book and am enjoying your enlightening views. I'm also glad to see that we've read all the same investment classics.
all the best,
Sonny
very informative blog in here!