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Commodities Re-Run?

Although the first quarter was challenging for both Russian and global equities, the first half of the year has proven very constructive for commodities investment. Russian clients will certainly be aware that the outlook for commodities is key to the future of their market. In this Comment, we compare recent market movements this year with last.

Back in April, I distributed research taking a long view on commodities, based on the outlook that stimulus plans from Russia to China to the US were all targeting infrastructure spending. Clearly I was not alone in thinking this. The outcome was a rapid rise in commodities prices, reminiscent of 1H08. Chart 1 shows a stunning correlation between oil price movement this year and last.

Chart 1: WTO Front Month Oil Prices, 2008-09
Déjà vu?

Bearish Dynamics

Now commodities are easing as we go into the summer months once more. Anyone recalling the pain of 2H08 might reasonably fear the near-term perspectives. Such concerns are only underwritten by my economic outlook: Neither in Russia nor in the US have we seen anything that can truly be described as green shoots. We have only seen a cooling-off in the rates of economic decline.

Such negative dynamics are highly concerning. Not only did we experience a shock decline that might logically have led to some kind of rebound, but we have also seen record amounts of fiscal spending thrown at the problem. The patient remains in intensive care.

Throughout the equity market rally I argued that the market was moving too soon, and that the longer-term economic outlook was less bullish than prices suggested. I clearly stated that oil was unlikely to stay above $70/bbl. As such, I am not surprised by the selling we are now experiencing. (Although it was impossible to time such a market move back down.)

In short, we have again seen a strong rally in prices and commodities that defies economic reality. Consequently, the justification to worry about sharp retreats this year is very real.

Not All Black

The market retreat is justified and understandable, but the commodity-based investment strategy I presented in April was not a short-term strategy. In a world of rebuilding and high government spending, the case for commodities based investments to outperform is a multi-year argument. Assuming that we avert a decline of the extent seen in 2H08, the current movement should be viewed more as a chance to buy than to sell.

The world in 2H09 will be a very different place from that it was in 2H08:

• Governments are more actively aware of the weaknesses in the banking sector. There is unlikely to be another “Lehman” event. (Note, I view such a Lehman event as a game-stopper for the capitalist economic model. It was the unexpected collapse of Lehman that caused the near total closure of the inter-bank market for most of 3Q08.) Without such a cataclysmic event, selling should track closer to fundamentals.
• Bank accounting has been modified to protect balance sheets in extreme circumstances. While further write-downs cannot be ruled out, their potential to damage sentiment is capped while fair value accounting is being permitted.
• The value chain will start to create demand eventually. Given the freeze in orders witnessed in 2H09, it is surprising that we have seen so little by way of inventory demand. But, businesses cannot run indefinitely on declining inventories, however weak their sales are. The chances of demand rising (albeit moderately) in 2H09 are real.
• The year-on-year (YoY) comparisons are getting better. Despite the current selling, consensus continues to see positive economic movement in 2H09. This is not something to get too excited about – growth comes against highly depressed levels and will remain anaemic. But, it is less cognizant with a disastrous market plunge.

In my assessment, I am clearly blending commodities demand with broader economic demand, but this is quite deliberate – the real world demand for commodities should be a primary cause of stabilising economies.

2009 Bubble

Why, then, are commodities-based trades failing? Politicians would call it speculation. Hedge funds would call it crowding. Investors would call it protecting their wealth, particularly against the debasement of currencies through quantitative easing.

Whatever the label, investment demand drove the commodities trade too far too fast. As is noted in a recent edition of the Financial Times, the growth in demand for commodities index funds has exceeded the demand growth from China. Although it is unlikely, it may be possible to argue that speculators are not setting prices, but it is hard to disagree that investment capital has impacted the dynamics of the commodities market.

Oil trading above $70/bbl, even as demand plunged was a questionable dynamic, not least as there is little evidence to support the idea that oil prices precede economic recovery. The current correction is a welcome event then. But, it need not inhibit the long-term growth dynamic.

Long-Term Demand In Place

In the short-term, demand for commodities is sharply down year on year. But, the longer-term dynamic is in place. Not least in a world of less rampant consumer demand, economic growth can be increasingly expected to come from state-spending and infrastructure investment. Nations are equipping themselves for the 21st century.

In doing so, they are underwriting commodities prices for the long-term. There will come a time for retail and demand driven investments. But for the foreseeable future, capital is best deployed at the top end of the economic value chain, and the sell-off underway is unlikely to prove as painful as 2H08. Be patient, but see this as a chance to buy for long-term returns.