After a poor month of index return performance, the story for being long commodities should be revisited. There are five stories for why commodities will go higher and one major story for a continued downturn in commodity prices.
The rationale for higher commodity prices -
The long-term cycle -
The long-term up cycle for commodities is based on emerging market growth. This growth is still dominate for commodities. The improvement in wealth has changed the diet for many in these countries. The increase in overall GDP growth has increased the demand for building materials, energy, and foodstuffs. The growth in the EM middle class is significant and surpassing the size in the US. The marginal buyer of commodities will not be the US or other developed countries but will be the BRIC countries, and non-OECD countries.
The lack of long-term investment in mining agriculture and drilling has meant that supply will not be able to meet the current upsurge in demand. While this is not a peak-oil type story, the cost of finding, extracting and growing commodities has increased significantly. There is a lag between price increases and investment in commodities. There is also a lag between the investment and actual production. Higher volatility has also reduced the amount of investment in many commodities. Higher uncertainty will reduce long-term investments. Finally, in the case of agriculture there is less land available for production and the cost of inputs such as water have increased significantly
Even if there is a slowdown in growth in such countries like China, its overall size will still have an impact on commodities that did not exist even three years ago.
The natural business cycle -
The business cycle has turned up and commodity prices will increase with the surge in global growth. History has found that commodity prices have peaked late in the business cycle and the length of the current recovery is still relatively early. By this simple measure, there should be a room for significant increases in commodity prices.
The monetary policy cycle -
The aggressive easing by the Fed has lead to significant declines in real interest rates. The negative real interest rates have been good for the commodity markets. Analysis finds that negative real rates leads to more purchase of commodities because the cost of holding commodities has decreased. Easing monetary policy also leads to increases in inflationary expectations which will also increase the demand for commodities. A successful monetary easing will also increase overall economic growth which should have a positive increase on commodity demand.
The bubble story -
Tied to the monetary story is the idea that at low cash rates, there is increased demand for risky assets. This demand has gotten out of control and has pushed commodity prices to levels associated with a bubble. The markets have been pushed to higher levels given this unusual demand for risky assets and the lack of any return on cash assets.
The bad weather story -
Many commodity markets have been faced with bad weather which has affected the ability of commodity producers create or generate supply. The global drought in many agriculture markets have been matched by floods in other geographical areas. The poor weather has pushed prices to high levels given the low inventory to usage for many commodities.
The rationale for lower prices -
The false growth story -
The potential for a sustained decline in commodity prices is based on the false growth or recovery story. Reduced fiscal stimulus, ineffective monetary policy, and poor balance sheets in the developed world makes for a slow growth environment and a high likelihood for a double dip recession. There is a strong group of economist who are negative about prospects for the economy. However, the general consensus is that growth will actually increase in the second half of the year, but there do seem to be strong headwinds against a robust growth story.
The rationale for higher commodity prices -
The long-term cycle -
The long-term up cycle for commodities is based on emerging market growth. This growth is still dominate for commodities. The improvement in wealth has changed the diet for many in these countries. The increase in overall GDP growth has increased the demand for building materials, energy, and foodstuffs. The growth in the EM middle class is significant and surpassing the size in the US. The marginal buyer of commodities will not be the US or other developed countries but will be the BRIC countries, and non-OECD countries.
The lack of long-term investment in mining agriculture and drilling has meant that supply will not be able to meet the current upsurge in demand. While this is not a peak-oil type story, the cost of finding, extracting and growing commodities has increased significantly. There is a lag between price increases and investment in commodities. There is also a lag between the investment and actual production. Higher volatility has also reduced the amount of investment in many commodities. Higher uncertainty will reduce long-term investments. Finally, in the case of agriculture there is less land available for production and the cost of inputs such as water have increased significantly
Even if there is a slowdown in growth in such countries like China, its overall size will still have an impact on commodities that did not exist even three years ago.
The natural business cycle -
The business cycle has turned up and commodity prices will increase with the surge in global growth. History has found that commodity prices have peaked late in the business cycle and the length of the current recovery is still relatively early. By this simple measure, there should be a room for significant increases in commodity prices.
The monetary policy cycle -
The aggressive easing by the Fed has lead to significant declines in real interest rates. The negative real interest rates have been good for the commodity markets. Analysis finds that negative real rates leads to more purchase of commodities because the cost of holding commodities has decreased. Easing monetary policy also leads to increases in inflationary expectations which will also increase the demand for commodities. A successful monetary easing will also increase overall economic growth which should have a positive increase on commodity demand.
The bubble story -
Tied to the monetary story is the idea that at low cash rates, there is increased demand for risky assets. This demand has gotten out of control and has pushed commodity prices to levels associated with a bubble. The markets have been pushed to higher levels given this unusual demand for risky assets and the lack of any return on cash assets.
The bad weather story -
Many commodity markets have been faced with bad weather which has affected the ability of commodity producers create or generate supply. The global drought in many agriculture markets have been matched by floods in other geographical areas. The poor weather has pushed prices to high levels given the low inventory to usage for many commodities.
The rationale for lower prices -
The false growth story -
The potential for a sustained decline in commodity prices is based on the false growth or recovery story. Reduced fiscal stimulus, ineffective monetary policy, and poor balance sheets in the developed world makes for a slow growth environment and a high likelihood for a double dip recession. There is a strong group of economist who are negative about prospects for the economy. However, the general consensus is that growth will actually increase in the second half of the year, but there do seem to be strong headwinds against a robust growth story.
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