There is a growing feeling among some global strategists that the surge in commodity prices over the last decade is now coming to an end. This is still a debate, with savvy investors on both sides arguing their case, but worth thinking about given its implications for economies and asset class behaviour.
The bearish thesis is quite simple. The current bull phase in global commodities was led by China’s industrialisation specifically and fast emerging-market growth in general. The Commodity Research Bureau (CRB) spot commodity index has grown by more than 170 per cent since 2002, after it declined by 28 per cent over two decades (1981-2001), according to FactSet Research Systems, which provides global financial and economic information. While China’s industrial build-out has driven global commodity prices to a new – and likely sustainable – higher equilibrium, much as with the rise of Japan in the 1970s or the rebuilding post-World War II in the late 1940s, the days of continually rising prices seem to be over.
China’s growth has been underpinned by exports and investment; a slowdown in both areas presages a cooling in commodities. China saw a surge in investment, with its investment-to-GDP ratio climbing from 35 per cent in 2000 to 48 per cent in 2011. This ratio was rising when GDP was growing at faster than 10 per cent a year. Given all the rhetoric emerging from China regarding a balanced growth model, this ratio is unlikely to stay at such elevated levels. It will decline — and that too in an environment where GDP growth itself is likely to fall from double digits to around sever per cent. Also, China has laid out clear targets to improve the efficiency of commodity and energy use across sectors, by shutting down and replacing old, inefficient capacity. This will further constrain commodity use. On exports, given the state of the global economy and the relative weakening of Chinese manufacturing’s cost competitiveness, the days of 25 per cent export growth are unlikely to return. Thus, while Chinese commodity consumption will not decline, its pace of growth will slow markedly — keeping prices stable to slightly down in nominal terms, but clearly declining in real terms. The next big hope for commodity consumption, India, seems at least a decade away from being able to materially accelerate commodity consumption growth rates.
While China was the main factor driving the decade-long commodity boom, we should not ignore the weakness of the dollar over this period. Given that most commodities are priced in dollars, there is a negative correlation between the two (a negative 54 per cent correlation since 1970, according to Macquarie). Turning points for the dollar and commodities also tend to coincide. The CRB index bottomed out in November 2001, while various real estimates of dollar value peaked in February 2002. During this commodity boom (2002-11), the dollar fell more than 25 per cent, but it now seems to have bottomed out. Given the relative strength of the long-term economic outlook for the US compared to Japan and the European Union, another period of sustained dollar weakness looks unlikely. If the dollar were to strengthen over the coming years, that would be a very significant headwind for higher commodity prices.
Another factor underpinning the bear thesis is the upcoming wall of supply. Given two decades of weak commodity prices till end-2001, it took a minimum of two years of sustained strong prices to convince the mining giants that high prices were for real. Since most mining projects are large and lumpy, the typical cycle time to get a new asset into production is five to seven years. Combine the above: while many of the new greenfield projects planned in the early years of the commodity boom are already in production, projects conceptualised at the peak of the boom will now come into production over the coming years. For example, Macquarie has analysed iron-ore demand-supply dynamics and concluded that new iron-ore projects worth 1.5 billion tonnes are under development globally — this is 80 per cent of current demand. This is not unique to iron-ore; across industrial commodities, project pipelines are full. Though all this supply will not fructify, clearly many projects will come on line. And as demand tapers, this new supply will cap prices.
The final pillar of the bear argument rests on financial flows. Over the last decade, commodities have become fashionable as an asset class, and many financial investors have become active in the space. Over the last five years, the amount invested in commodity funds has more than doubled to over $400 billion; commodity exchange-traded funds have become rampant; and in certain markets like energy, futures volumes are over 25 times daily real-world demand. As commodity prices cool, flows into this asset class will also slow. Regulators also, finally, seem determined to avoid price spikes due to speculative demand, and have many regulatory tools available to smooth price action.
Nobody is saying that commodity prices will collapse from here. In the short term, they could even rise with a third round of quantitative easing. However, even if prices merely stabilise, and decline in real terms, that will be a big change compared to the past decade. It will reverse the terms-of-trade shock experienced by commodity importers.
If one accepts that the commodity price boom is near its end, this has significant implications. First off, for India, which is a large importer, a decline in real commodity prices is an unalloyed positive from both an absolute and relative sense. It will take pressure off the fisc and the rupee, as well as boost corporate margins. It will also boost India’s relative attractiveness in the emerging market world, especially compared to commodity heavyweights Brazil, Russia and Indonesia. In a weak commodity environment, India’s growth profile actually strengthens, unlike many other large emerging economies.
On a macro level, the cooling in commodities should boost equities as an asset class. Equities tend to perform well in the decades between commodity booms and poorly during the commodity boom itself. In an environment where commodities are unlikely to do well in real terms and gilts are delivering negative real yields, equities could become the asset class of choice. Over the last decade, equities have delivered almost no returns, and are under-owned both among retail and institutional investors. Given the relative return profile of competing asset classes, could their time have come? If equities do well, equities in emerging market should lead the pack.
The stars are beginning to align for India to deliver good equity returns. It is now in our hands to mess up — unfortunately, this is exactly what we have done in the past few years. With the economy growing at sub-six per cent, inflation at eight per cent and the rupee at 56 to the dollar, you would think India has had enough of a wake-up call. Let us hope someone is listening.
The writer is fund manager and CEO of Amansa Capital