Commodity supercycle running out of steam
SERIOUS MONEY:The dawn of a new millennium marked the end of the secular bull market in stocks that had begun almost two decades earlier in the autumn of 1982. The magnitude of the subsequent decline in equity prices forced investors – albeit reluctantly – to accept that returns had been more than excessive during the heady days of the dot.comboom.
The verdict to emerge from investors’ soul-searching was clear – the high valuations afforded to stocks meant they could no longer be depended upon to deliver stellar returns year after year, while the notable increase in correlations among existing classes of risk assets amid the turbulence confirmed that the diversification benefits of traditional asset allocation models had been eroded.
Not surprisingly, the hunt for non-traditional assets began in earnest.
The search for alternatives coincided with an end to the two-decade downturn in commodity indices, as supply/demand dynamics converged to push prices higher.
Years of under-investment in the infrastructure of several raw materials combined with the emergence of China as a major source of demand.
That led many savvy analysts to conclude that commodities had entered the expansionary phase of a supercycle that could be expected to last for several years, maybe even decades.
The supercycle hypothesis took time to capture investors’ attention, as 20 years of false dawns had seen investable cash deployed elsewhere, but the game changed following a number of high-profile reports from respected analysts in 2005, including Alan Heap at Citi, not to mention the best-selling book Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market, penned by Jim Rogers, co-founder of the Quantum Fund with George Soros in the early-1970s.
Academic papers followed, demonstrating that changes in commodity prices and stock market fluctuations demonstrated a strong negative correlation through time.
Inviting returns alongside the potential for significant benefits on diversification proved hard to resist, and the sheer size of the funds that poured into the non-traditional asset class helped underpin the most pervasive commodities boom in modern history.
The cyclical upturns of the early 1950s and early 1970s fall well short of the most recent boom, both in magnitude and duration.
The global financial crisis and the steep economic downturn that followed brought an end to the seemingly irrepressible rise in commodities.
Indices of metal and mineral prices declined by more than 30 per cent from the peak in 2008 to the trough in 2009.
However, the setback proved to be temporary, as the world’s emerging economies soon returned to a high-growth trajectory, and the resource-intensive nature of their growth brought the expansionary phase of the commodity supercycle back to life.
The revived bull market has sputtered of late and investors are questioning whether the commodities space is still an attractive home for investment funds.
To provide a satisfactory answer, investors need to know whether supercycles actually exist and, if so, can the supply/demand dynamics be depended upon to justify investment.
More than three decades ago, Walt Whitman Rostow identified a commodity supercycle that is roughly 50 years in length, with expansionary phases extending from 1790 to 1815, 1848 to 1873, and 1896 to 1920.
More recently, John T Cuddington and Daniel Jerrett employed more sophisticated econometric techniques in two separate papers, and provided evidence that supports the existence of supercycles for both crude oil and metals.
It is clear that commodity supercycles – spanning anywhere from 20 years to 70 – do exist.
But that alone is not sufficient to support the case for investment in basic materials.
Do supply/demand conditions point to a continuation of the expansionary phase, or is it running out of steam?
The demand-side enthusiasts cite the rapid industrialisation and urbanisation of China as a reason to remain bullish. The Middle Kingdom’s economy has doubled in size in just seven years, and the resource-intensive nature of its growth means it has accounted for more than 80 per cent of the increase in global demand for nearly all energy and metals products over the same period.
However, per capita consumption of energy and most metals is already well above the figures apparent in economies with comparable levels of GDP per capita, while the high investment share of GDP – at more than 40 per cent for a decade – calls for a rebalancing of the economy.
Consensus estimates look for economic growth of 7 to 8 per cent a year in the decade ahead, but simple arithmetic suggests that a successful rebalancing of the economy towards consumption would lead to a growth figure closer to 5 per cent.
The demand-side case is weakening but the bulls believe supply-side constraints will continue to support prices.
It is important to note that two decades of declining prices meant producers did not commit to new investment projects until they could be sure price increases were permanent and not just another false dawn.
Obviously, after a decade of rising prices, such caution is no longer evident.
The expansionary phase of the commodity supercycle is running out of steam, while investment flows have eroded the diversification benefits. The motivation for commodity investment is questionable.