For the last two weeks, we’ve been hearing mostly positive views about the commodity supercycle. In the last of a 3-part series, more supercycle skeptics have their say.
One of the cautious voices on the commodity supercycle is that of Clment Gignac, chief economist and strategist for Montreal-based National Bank Financial. Gignac acknowledges that commodities are already in a supercycle: the cycle’s long duration, the hefty percentage gains in commodity prices, and the large number of commodities involved are all proof of that. 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 will not be immune. Even demand for oil is eventually affected by high prices, Gignac points out. 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 by using more public transit or buying a smaller car.
Gignac does not believe in 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 quickly, he says it will be negatively affected by a U. S. slowdown. In addition, soft commodities such as grains have now joined the rally, eroding the purchasing power of consumers in emerging economies. Because food makes up a large proportion of the consumer basket in emerging economies (35% of the consumer basket in China and 45% in India, for example), high food prices will substantially affect consumer purchasing power, and also, therefore, demand.
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, which could 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, as they have recently, 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 into overdrive. When markets are in a state of euphoria, they can be vulnerable, so they become riskier, he says. 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, Gignac says, 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 price decline.
Other cautious commentators are concerned about the influence of investment demand on commodity prices. They include Gene Epstein, writing for Barron’s; Caroline Baum, writing for Bloomberg; Jeffrey Korzenik, chief investment officer at Vitale, Caturano and Co. in Boston, Mass., who wrote about the subject in Market-Watch.com; and Mack Frankfurter, chief investment strategist at Managed Account Research in Santa Barbara, Calif.
Although each has his, or her, own point of view, together they paint a picture of substantial investment demand in the commodity market, which may be an important factor in high commodity prices — even causing price distortions. A number of them say that investment in commodities has become vastly more accessible to mainstream investors, with the introduction of commodity-linked exchange-traded funds (ETF), mutual funds and structured notes. Examples of these are the Barclays iShares Silver Trust (SLV-X) and SPDR(R) Gold Shares (GLD-N), formerly Street Tracks Gold Shares ETF. This accessibility attracts investment dollars that would not otherwise have found their way into this market.
Even big institutional money is flowing into commodities. Clark McKinley, spokesman for the pension giant California Public Employees Retirement System (Calpers), says that the fund has so far invested US$1 billion in commodities, partly in a commodity index and partly in commodities themselves. The pension fund’s current guideline is to invest 1.5% of its assets, or US$3.6 billion, in commodities, so it can be expected that more of its money will flow into this asset class. (Portfolio managers do have leeway around the 1.5% guideline, so they are not compelled to invest more in commodities).
In his Barron’s article in March, Epstein quotes independent analyst Steve Briese as estimating that index funds held US$211 billion worth of bets on the buy side in U. S. commodity markets, while Bianco Research analyst Gregory Blaha estimates the figure at US$194 billion, out of total bullish positions of US$568 billion in March. Clearly, index funds exert a strong influence on this market.
With this kind of speculative money chasing commodities, these commentators make a strong point. Commodity prices are affected by investment demand. However, this also makes frothy prices vulnerable to correction. If prices were to turn southward, that could trigger a stampede for the exits, which could start a painful decline. In Epstein’s Barron’s piece, Briese says a price collapse of 30% or more is possible, and that he believes the smart money is betting on price declines in commodities.
Another facet of commodity investment is the political angle. Regulators seem concerned about the effect of investment demand on commodity prices, although their concerns revolve mostly around oil and grains, rather than metals. Mark Lapolla of Sixth Man Research, and Mike Masters of Masters Capital Management were recently asked to report to the U. S. Congress on the role of large institutions that invest in commodities via passive index reports funds, MarketWatch.com reports. Lapolla believes that institutional investors do influence commodity prices, and once the two researchers present their findings to a Senate committee in Washington, it is possible that Congress will intervene in markets to limit speculation.
Opinions on the commodity markets vary from the bullish to the cautious. Based on upbeat growth projections, particularly in Asia, the bullish camp believes that, this time, it’s really different. The skeptics are not quite as enthusiastic. They say that all the superlatives around the commodity market are exaggerated. It also helps to remember that in previous bull markets, investors who piled into commodities or commodity- related stocks during the latter part of the cycle usually ended up in tears.
— Parts 1 and 2 of the Commodity Supercycle appeared in previous issues of The Northern Miner.
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