Are you in or out of commodities?

by Carlos Andres on August 17, 2011

An article was published by Yahoo Finance earlier today, August 17, 2011, entitled:

Gold, Oil & the Dollar: Correlation Breakdown Is Concerning Says Yamada

By Matt Nesto | Breakout

The article discusses what appears to be a breakdown in the correlation between the gold, oil and the dollar, as gold continues to rise in the face of weakening oil and dollar prices.  The participants in the video discussion conclude that the trend here is muddled and therefore commodity investors should perhaps tread carefully.  At the end of the discussion, they pose the following question to viewers and invite a response:

Are you in or out of commodities?

I provided the following response by email.  I hope you find it insightful.

Yahoo Finance: Are you in or out of commodities? – A Response

The short answer is yes, I am definitely in commodities.  The CRB’s Continuous Commodity Index (CCI), their equally weighted index of 17 commodities consisting of energy, metals, livestock, grains, and tropicals, bottomed in the neighborhood of 225 more than a decade ago (1999-2000).  It is currently at 637, sporting a 183% gain since that time.  The DOW is down roughly 3% since early 2000 and the S&P 500 is down 20%+ over the same period.  All of the above are inclusive of current market weakness.

This is a good place to start any discussion of whether one ought to be “in or out of commodities”.  Of course it shouldn’t be the end of such a discussion, since hopefully we are wise enough to know that past performance is no indication of future results.  The next set of questions should go something like this.

  • What factors drove this steady move higher in commodity prices over the last decade or more?
  • Are these drivers likely to fall, persist or grow in the future?
  • Have additional factors emerged that would either support or mitigate continuing higher prices?

I would argue that their are 4 major drivers to consider in this context.

[1] The East as Exporter to the West - This is the model that the western governments and media present to the public.  It goes something like this.  Asia’s (in particular China’s) economic welfare and growth are tied to its exports to the developed western world (the US & Europe).  Therefore if there is economic weakness in the west there will be no economic growth in the east.  This model makes the assumption by extension that global commodity demand is driven by Asian imports which then manufacture these raw resources into goods that are subsequently shipped to the west.  Using this model then, it is assumed that since there is recession in the west, export driven economies in the east will slow and emerging/frontier markets providing natural resources will slow.

[2] The Rise of Asia & Domestic Consumption of Commodities – The above model ignores, with significant consequence to its credibility, the dramatic growth of domestic commodity consumption (metals, minerals and agriculture) in Asia (led by China).  China in particular (home to the largest population on the planet at 1.6B people compared to 320M in the US) is experiencing unprecedented population growth, urbanization, income growth and growth of the middle class.  The population is growing.  This population is exiting the countryside by the 10’s of millions and entering the big cities looking for a higher standard of living and finding it (even if only marginally).  The country has a burgeoning middle class of roughly 300M (the size of the entire population of the US) that is buying cars and flat screen TVs.  These dynamics are driving rapid infrastructure growth and thus placing an historically unprecedented demand on global commodities.  It is this dramatic growth in global resource demand and the resulting geographic shift in the pattern of demand towards Asia that has been the driver of rising commodity prices over the last decade.  This is not a temporary or reversible trend.  We believe, along with many other astute observers that these are sustainable structural shifts that invalidate the view that only western economic activity drives global commodity prices.

[3] Monetary Inflation Contagion - Finally, in response to the ongoing global financial crisis, western governments are increasing debt levels and the money supply at alarming and unprecedented rates.  All of this money has to go somewhere, and one funnel leads to price inflation in the commodity sector.  It’s just basic supply and demand at work here.  Massive increases of inventories of anything relative to everything else around it, can’t help but lead to lower value.  Money is no exception.  This ocean of money is putting upward pressure on global commodity prices right along with unprecedented demand from Asia.  Making the problem worse is that resource rich emerging and frontier countries, that are weathering the economic storm reasonably well due to Asian commodity demand, still find themselves having to import this monetary and price inflation.  This is because they must print money at similar rates to the faltering developed western economies in order to keep their foreign exchange rates low and thus the prices of their exports competitive.  This is the proverbial race to the bottom.

[4] Shrinking Commodity Supply – Mining in particular is a capital intensive long-term proposition.  It takes time (years) and money (billions) to bring new supplies on-line to meet permanent changes to structural demand (think the US and oil in the 70’s), assuming that sufficient new supplies can be found to match annual consumption.  There are several commodities, not the least of which is oil, in which exploration success is flat or falling and is nowhere near able to replace the amount being consumed each year.  Thus falling supply also argues for higher prices over the long term in the face of growing global demand.

Over the short term, I believe that numbers 2, 3 and 4 will be more than sufficient to off-set the negative effects of number 1 on global commodity prices.  In the long-term, when economic growth returns to the west, it’s look out above!

Carlos Andres
Managing Editor & Chief Analyst
The Frontier Research Report


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