The commodity supercycle: myth or reality? Part 7

Another cautious voice is that of Clement Gignac, chief economist and strategist for Montreal-based National Bank Financial (NA-T). His emphasis is on the demand side rather than on supply. Gignac does acknowledge that commodities are already in a supercycle, because of the cycle’s long duration, the hefty percentage gains in commodity prices, and the large number of commodities involved. However the question is what happens going forward, because the outlook for demand is not all that rosy.

In the face of a slowdown and perhaps a recession in U.S. consumer demand, commodity demand cannot be immune. Even demand for oil is eventually affected by high prices, points out Gignac. Although in the short term we may not see much of a change in oil demand in response to higher prices, such a demand response can and does happen in the long run as people change their consumption behaviour, for example they use more public transit or they buy a smaller car.

Gignac does not buy into the decoupling theory, which states that economies around the world will not be affected by a slowdown in U.S. consumer demand. Even though Asia is developing fast, it will be negatively affected by a U.S. slowdown. In addition, soft commodities such as grains have now joined the rally, eroding purchasing power of consumers in emerging economies. Because food makes up a large proportion of the consumer basket in emerging economies (for example, 35% of the consumer basket in China and 45% in India), the effect of high food prices on consumer purchasing power is substantial, so demand will be negatively affected.

Gignac quotes a projection by the International Monetary Fund that worldwide growth will be only 4% in 2008, with a 25% probability that growth will slump to 3% in 2009. This sluggish growth rate is bound to weaken demand. In addition, when economies around the world slow down, the U.S. dollar may stabilize, and this can trigger a correction in commodities. Another potential factor is possible political action. When food prices are so high as to provoke riots and social unrest, governments may decide to step in and intervene in commodity markets to limit speculation.

Gignac does not like the fact that the commodity supercycle has now shifted gear into overdrive. When markets are in a state of euphoria, they can be vulnerable, so they become riskier. The business cycle has not been eliminated, and commodities are cyclical too. The commodity markets are also more difficult to analyze now, because there are many purely financial participants, such as hedge funds, whereas in the past participants were mostly trade players. This, says Gignac, makes commodity markets more volatile, because purely financial participants amplify both up-moves and down-moves. So when markets start falling, a deep correction and even a bear market may ensue as financial players bail out.

So Gignac feels that although the supercycle is real, it is now extended and therefore riskier. We have not entered a new era: fundamentals still apply, the demand side can weaken, and this can start a correction.