“History is not on your side. If you want stable prices, you have to have stable money. The middle class is being wiped out and it has to do with the value of money. How are you able to defend this policy of deliberate depreciation of our money?” – ~ Congressman Ron Paul, speaking to Federal Reserve Chairman Ben Bernanke last week before the House Financial Services Committee on Capitol Hill.
As one might expect, Mr. Bernanke’s answer to this question was less than illuminating. Fed Chairmen don’t usually speak clearly until they become ex-Fed Chairmen. However, the actions of the Federal Reserve, as well as other central banks around the globe, offer some clarity on why the commodity markets are red hot in 2008. Without overstating the case, global money supply growth is just as hot, if not hotter. As illustrated in the charts below, year to date money supply figures are striking. As an example money supply growth in Russia is up 44%, India up 23%, Australia up 23%, Brazil up 18%, U.S. up 16% (M3), UK up 12%, etc.
“I don’t anticipate stagflation. I don’t think we are anywhere near the situation that prevailed in the 1970’s” – Fed Chairman Ben Bernanke speaking before Congress last week
Unfortunately, Fed officials were equally unconcerned in the early 1970’s. In those days, we had a war to finance, large social programs to pay for, spiking oil prices, and accommodative monetary policy. Sounds vaguely familiar. The only difference is today we are not energy independent, not a creditor nation, and not a nation of savers. Oh, and the massive Baby Boom generation, young and productive in the 1970’s, is now starting to retire by the millions. History may not repeat itself, but the comparisons to the 1970’s are not comforting in the slightest.
As you can see from the chart below, year to date gains in almost all commodities have been spectacular.
Growing Demand
The commodity story is not solely one of inflation. There are other factors such as growing demand and limited supply. We are all familiar with the massive industrialization taking place in China and India, representing 40% of the humans on earth. While the breakneck pace may slow this year, the need for increasing amounts of commodities will continue for many years.
“China will remain hungry for commodities over the coming 15 years. Crude oil and metal ores lead China’s commodity imports. As incomes rise and agricultural land becomes scarcer, China’s demand for agricultural products such as meat and wood is set to increase. Our forecast model for China’s import demand until 2020 shows that demand growth rates will remain in lower double-digit territory over the next decade for most commodities.” Deutsche Bank Research – June 2006
The grain market has been on fire, particularly corn and soybeans, as demand rises from the food, feed and fuel sectors simultaneously. Demand is especially strong in China and from US ethanol production. While wheat prices hit record highs in December 2007, it is the one commodity that begun to pull back in 2008.
Supply Issues
Despite the skyrocketing prices, the inventories of many commodities are lower than they were during the 2001 recession. Discovering, permitting, extracting and shipping natural resources can take years, even decades. It will take time to overcome the past two decades of massive underinvestment in resource exploration and development. This is why commodity bull markets can run 15 years or more before significant new supply brings prices back down. In addition this is the first commodity bull market with the specter of Peak Oil looming ahead, if not already knocking on the door. That alone can have huge implications in terms of supply, price, and future expectations of market behavior.
Nickel Stockpiles
Source: Bloomberg
Tin Stockpiles
Source: Bloomberg
Lead Stockpiles
Source: Bloomberg
Zinc Stockpiles
Source: Bloomberg
Aluminum Stockpiles
Source: Bloomberg
Copper Stockpiles
Source: Bloomberg
Significant domestic power shortages in both China and South Africa are expected to limit production of coal, steel, aluminum and iron ore in China and platinum, rhodium and aluminum in South Africa. Geopolitical issues in the Middle East and Nigeria will continue to hurt oil supply growth. In addition, global crude oil refining capacity is tight and refining specifications only get more stringent.
Investing and Speculation
Money is pouring into commodities from all over the world, as investors seek a store of value in tangible assets, which have value independent of the money supply. The supplies of dollars, and other major currencies, are expanding rapidly (as shown above) making “hard assets” much more attractive. This trend will likely continue, and perhaps accelerate as Sovereign Wealth Funds look for ways to lessen their dollar exposure.
Edward Meir, an analyst at MF Global, made the point concisely in a recent research note published in MarketWatch.
“The fact that commodities were all up across the board yesterday despite an uninspiring macro backdrop also suggests that fund and investment money is finding its way into the commodity space on perceptions that these investments will do better over the course of the year.
Commodities are seen as an asset class where underlying demand is growing and where investments are entered into through contracts that are liquid and where price-discovery is transparent. This stands in stark contrast to the almost toxic swatches of alternative investments we see elsewhere, such as non-government debt, CDOs, and mortgage paper, all of which in varying degrees, are suffering from poor liquidity, price opacity, and anemic investor demand.”
As noted above, with the financial sector in deep peril, the great wave of excess global liquidity created by the central banks is flowing to the one area that is moving up, commodities. This of course adds to the extreme momentum of the last two months.
Bubble Trouble for Commodities?
The real trouble is with the dollar, and other major currencies, destroying their value through excess money creation. The commodities are just reflecting their debasement, like canaries in a coal mine. For instance, as oil has more than tripled in dollars the past four years, oil priced in gold has been stable. The oil price is not out of control. The dollar is simply imploding. But politicians want to tax the evil oil companies for “excess profits.” That should fix the energy problem.
If the commodity inventories were overflowing and global demand were plunging, then one might worry about a commodity bubble. At the present, this is not the case. In addition, commodities (especially energy) are the lifeblood of economies around the world. Supply is not likely to outstrip demand as long as global population expands and nations grow and develop. There is far more concern that future oil supply limitations will lead to shortages and rationing in the years ahead. This is far different than the Dot.com bubble of the late 1990’s, where tech companies produced routers by the millions, and projected the growth track to continue to Jupiter and beyond!
There is a bubble out there. It’s a currency and credit bubble that unfortunately is losing altitude by the day.
Nothing Grows to the Sky
The current rate of explosive growth in commodity prices is clearly unsustainable. Of course if we see a meltdown in the global financial system, all bets are off. Without a financial meltdown, commodities will likely pull-back and consolidate at some point this year. Prices retreat after parabolic advances. That is the way markets work. But this doesn’t necessarily mean the end to the commodity bull-run. The fundamental elements are still there, in spades. The Fed and other central banks are still creating currency at alarming rates. The growth story in Asia will continue. The supplies of most commodities are limited, particularly oil, the most crucial commodity of all. These are not the fundamentals of a looming bear market.
Historically, secular commodity bull markets last an average of 18 years. This bull may take a breather in the months ahead, but it looks to have many years of rampaging ahead. Long-term investors would be wise to stay aboard for the ride.
Today’s Markets
U.S. stock indexes were nearly flat Monday, after a report on construction illustrated surprising weakness in spending on commercial projects, the latest indication of a troubled economy. The Institute for Supply Management reported that U.S. manufacturing contracted in February, with its index falling to 48.3% from 50.7% in January. The reading, the lowest since April 2003, was better than the 47.5% forecast by many analysts.
The Dow Jones Industrial Average fell 7.49 to close at 12,258.90. The S&P 500 Index was narrowly higher, up .71 to close at 1,331.34. The Nasdaq closed lower, ending at 2,258.60, down 12.88.
Gold futures closed with strong gains Monday, after rallying to a record high of $992 an ounce, as oil also touched new highs, propelled by the U.S. dollar's tumble and continuing investment flows into commodities. Gold for April delivery hit a record of $992 an ounce on the New York Mercantile Exchange. The contract finished up $9.20 at $984.20 an ounce.
Wishing you a good evening,
Tony Allison
