CPM Group not throwing in the towel on commodities (September 12, 2008)

New York City-based CPM Group has released its commodities market commentary in August. Entitled The Long Term Sustainability of Recent Commodity Price Strength, the commentary says that there are macroeconomic and industry-specific fundamentals which suggest that “(commodity) prices may reach an interim peak and could spend much of the next year or two consolidating just below recent peaks.”

What will happen to commodity prices once the pause is over? CPM is bullish: “most of these developments suggest a pause, not an end, to the upward move in prices. There are other, longer term macroeconomic and fundamental reasons to expect such a consolidation phase will only be a pause, to be followed by continued strength in commodities prices in the long run of several years.”

The pause in the upward march in commodity prices is caused by recessionary conditions around the world. This indicates interim price consolidation, because recessions end. The recessionary conditions do not signal an end to the strong demand and firm prices for commodities, nor do they suggest the start of a commodity bear market.

While acknowledging the weakness in the residential home market in the U.S. and elsewhere, CPM points out that there are other large consumers of commodities that have not slowed down. For example, non-residential construction spending has surged to a record level in the U.S. and most of the rest of the world. Similarly, infrastructure spending continues to grow strongly in most parts of the world. Another positive factor is the growth in investable capital as a result of worldwide economic expansion since 2002. This capital is looking for investments, and some of it will find its way to commodities.

CPM says that a number of reasons led to the bull market in commodities since 2001. Fabrication demand for most commodities rose due to world economic expansion. In particular, the rise of emerging industrial countries has boosted demand for many commodities. CPM adds: “Even with the current global economic slowdown, demand is still rising strongly on a long-term basis, and remains very high compared to earlier levels.”

Coupled with higher fabrication demand, investment demand has also gone up, and these two sources of demand are still in place even in the face of the cyclical economic slowdown. Despite recessionary conditions, demand for many commodities continues to expand, although the rate of demand expansion is slowing. In markets where demand is falling, the declines are lower than what market commentary would suggest.

Turning to the supply side, response to elevated demand has been slow because of insufficient investment in mining during the 20-year bear market ending in 2001. The slow supply response has contributed to rising commodity prices.

CPM expects the slowdown to continue for the next few months, and the economic pain to grow worse until mid-2009. It predicts that there is a good chance of an economic recovery after that, which will boost growth rates. CPM Group expects the recession to be short and shallow, because it believes that the volatility of economic growth has been reduced by a number of factors. These include automation and computerization, which allow better planning in governments, private sector industries, and among investors. Other factors include economic and financial deregulation, globalization, low-cost shipping, the rise of non-bank debt financing, and better monetary policies.

All these factors are still in place, so they will support economic growth and greater consumption once the recession is over. CPM forecasts that world economic growth will average 5% per year. The company says: “In this environment, the current slow down in demand for commodities, and the recent short-term spike down in prices, should be seen as interruptions to a longer-term, multi-year upward trend.”

Could anything go wrong with this rosy scenario? It turns out that economic trends have become more volatile, so predictability of the future course of economic trends has become less certain. This is reflected in financial market volatility as well as volatility in commodities.

An alternative scenario is that of a more severe recession, compounded by structural weaknesses in the world economy, which include the massive U.S. budget and trade deficits, and the enormous debt in the U.S. economy. The probability of this scenario is higher than at any point since 1982, but it is still considered unlikely because these structural problems are manageable, and are offset by factors favoring growth.

Nevertheless, there are forces abroad in the economic and political spheres that could upset this positive scenario. If the economy takes a turn for the worse, demand for commodities will deteriorate, putting downward pressure on prices. Meanwhile, the gold price could march to a different drummer and move up if it continues to be viewed as a safe haven from a falling U.S. dollar, but this outcome is far from certain.

Even if this worst case economic scenario were to materialize, a recovery will eventually occur, starting at a later date than mid-2009, and once it gets under way, commodities will experience strong demand and higher prices.

CPM Group expects real commodity prices to rise for the next five to ten years. Thereafter it expects prices to return to the long term trend of declining real commodity prices as a result of technological improvements in the discovery, beneficiation, and use of most raw materials. It can be assumed that CPM’s projection is based on the assumption that sufficient mine supply will come on-line within this time frame to meet demand.