Today’s article is a follow up to last week’s piece entitled, "Commodity Bubble Revisited." The premise of last week’s article was to make the case that commodities were not in a bubble in the last bull market that ended in 2008 with a climatic top. Today’s article makes the case that the secular commodity bull market that began earlier this decade is resting, waiting to pounce on the global market like a crouching tiger under the right conditions rather than a bursting bubble. While it is true that certain fundamental drivers that have underpinned the secular commodity bull market have changed -- think of a shell-shocked U.S. consumer rediscovering the meaning of saving -- other fundamental shifts remain in tact and will propel commodity prices to new highs in the years to come.
Broken Supports: Leverage Giveth & Leverage Taketh Away
One of the supports to the commodity bull market was the U.S. consumer increasing consumption which fueled the demand for commodities used to make the goods the U.S. purchased. This support has had a stake driven right through its heart. What can not be disputed is that the era in the U.S. of living above one’s means is over, finito, caput. In the 1990s U.S. consumers lowered their savings rate from double-digit territory to roughly 2% by the end of the decade. When the economy softened during the 2001 recession consumers turned their homes into ATM machines by pulling equity out of their homes to finance consumption levels AND reduce their savings rate below 0%! E.E. Cummings' quote would describe the situation for the U.S. consumer of the last decade, “I'm living so far beyond my income that we may almost be said to be living apart.”
The question for the U.S. consumer is what’s left to leverage? Homeowners' equity as a percentage of market value of residential real estate has plummeted from 70% in 1984 to less than 43% currently, and 401Ks have been reduced to 201Ks. The leverage that propped asset markets up and gave the false sense of prosperity is the same leverage that has worked in reverse to take those former profits away. Just take a look at the figure below showing the record destruction to household balance sheets.
Source: FRB Flow of Funds
The secular bear market that began in the U.S. with the inflation-adjusted peak in the stock markets in 2000 has been more devastating to date than the last secular bear market that began in the late 1960s. At least during the late 1960s and 1970s the U.S. economy was producing jobs against the backdrop of a flat to declining stock market. In stark contrast, this decade has been truly devastating as we have had virtually no net gains in the trailing ten year job growth rate as well as negative ten year stock returns. Job growth over the last ten years in the private sector has been a pathetic 502,000 jobs while the government sector has increased by 2,201,000 jobs, more than four times the private sector’s growth!
Source: BLS, Stand & Poor’s
Source: BLS, Stand & Poor’s
What is important to understand is that the U.S. consumer has nothing left to leverage and is now realizing it must begin to save, and that means lower retail sales and less demand for commodities to produce those goods. The current decade has shown a “jobless recovery” compared to prior decades and the next five years are likely to continue this theme.
Source: BLS
Hat Tip: Brian Pretti, ContraryInvestor.com
The principal reason behind this is that job losses will not likely turn positive until late this year at best and most likely not until 2010 at worst. When the economy turns around employers are likely to increase the hours for their workers whose hours they have been slashing over the last year rather than hire new employees who they have to train. This slack in employment in terms of part-time workers is captured by the U6 unemployment rate, which is now at 16.5% compared to the headline U3 rate of 9.5%. If employers decide to increase the hours of their part-time workforce rather than hire new employees, any economic recovery that develops here will likely be anemic in terms of job growth.
Source: BLS
A weak recovery in employment will translate into reduced retail sales and overall aggregate consumption levels. As mentioned above, this will then lead to reduced demand for commodities to produce those goods as the U.S. consumer turns into a headwind for commodities rather than a tailwind as in the past. The U.S. consumer’s spending habits have been broken, and now a return to savings and thrift has begun.
"The easiest way for your children to learn about money is for you not to have any."
Katharine Whitehorn
It’s Not About U.S.
While the world has been used to the U.S. being the engine that drives global economic growth, this decade we witnessed the resurgence of developing nations with popularized terms such as “Chindia” (China/India) and “BRICs” (Brazil, Russia, India, China). There has truly been a shift in importance coming from developing nations and it is showing on multiple fronts, including share of world market capitalization. The U.S. share of world market cap has fallen from roughly 45% in 2003 to 29% currently, while China’s share has risen from roughly 1% to 9% over the same period.
Source: Bloomberg
While China’s stock markets share of the global market has risen considerably this decade, what has also grown is China’s share of global energy demand. This can be best illustrated in the following graphic which shows that China’s oil consumption growth since 2003 has been far and above any other nation, with the closest competitor (Saudi Arabia) coming in at a rate that is 71% below China’s growth rate.
Source: CFTC
China has not been the only developing nation to display rapid growth as many other developing nations’ oil consumption growth rates this decade have been far greater than developing nations. So much so that developing nations now eclipse developed nations in terms of energy consumption as the following article illustrates (emphasis added).
The centre of gravity in the global energy market has changed and we need to wake up.
The last year will go down in the history books for many reasons: the events in financial markets; the takeover of much of the banking sector by governments worldwide; and the presidential election in the United States, to name but three.
But one event went almost unnoticed. 2008 was the year when the centre of gravity in the energy market tilted sharply and permanently towards the emerging nations of the world. For the first time ever, non-OECD energy consumption outstripped that of the OECD nations.
This really is a decisive moment. People have been predicting such fundamental shift, with its implications for the world economy and geopolitics, for some time. Now it has happened.
Source: Bloomberg
Source: Bloomberg
Secular Fundamental Supports Remain In Tact
The driving forces that led to the Non-OECD countries surpassing OECD countries in terms of share of world energy consumption have not disappeared in the wake of the global correction over the last two years. One of the drivers is growing populations and the needed commodities to sustain those populations. Casey Research put out an excellent chart last year that illustrates this very point quite clearly.
Source: Casey’s Charts, July 30th, 2008
Since 1998, the share of world energy consumption for the BRIC countries has risen from roughly 20% to 30%, and will likely continue as their populations are projected to increase over the next few decades, with Russia being the exception as it has been experiencing negative population growth. India and Brazil are estimated to experience the greatest population growth with the US showing a slightly faster growth rate than China beginning next decade.
Source: Bloomberg
The growth in NON-OECD and BRIC country populations is only one part of the support for commodities going forward, but the other tailwind for commodities is that these countries energy intensity on a per capita basis is quite low relative to developed nations like the U.S. Even making the assumption that the BRIC country’s populations will remain stagnant for the next few decades, simply witnessing a greater energy usage on a per capita basis as these countries further industrialize will create support for commodity prices in the future. The gap between BRIC countries energy intensity and the U.S. is quite sizable, with U.S. energy intensity at roughly 5 to 25 fold greater than other BRIC countries. Just imagine what would happen to commodity prices if China’s energy consumption increased more than ten fold to bring it to parity with the U.S., which is not likely as global oil production simply could not sustain a world in which China consumed per capita the same amount of energy as the U.S. does.
Source: Bloomberg
Some maintain that technology will allow for greater improvements in energy efficiency, and in truth we have been witnessing this trend over the last two decades as growth in GDP has exceeded growth in oil consumption, but the marginal improvement in this trend has been decelerating over the last few years and BRIC countries are nearly at parity with the U.S. in terms of energy efficiency. While a large gap in per capita oil consumption between BRIC countries and the U.S. gives room for greater commodity usage and demand, the gap in energy efficiency is not quite as large and does not posses as great a mechanism to ease the usage of commodities for a given level of economic output. Make no mistake, improvements in alternative energy technologies will go a long way in curbing demand for fossil fuels. It is just that reductions in costs and efficiency of new alternative energy technologies will take time and government support and will not significantly reduce oil demand until much further out.
Source: Bloomberg
Preparing For Tomorrow
While it is true that a major support for the Chinese economy, and thus indirectly commodities, has been the U.S. consumer, and that support will be much diminished, the Chinese government already realizes this and has taken steps to support its internal consumption. One such example is China allowing Wal-Mart to open stores within the country. The first Supercenter was opened in China in 1996, and after more than ten years the number of Supercenters has grown to 77 with locations all over the country.
China appears to have been successful as after the entry of Wal-Mart, the country’s retail sales have grown from low single-digit year-over-year (YOY) growth rates to greater than 20% last year. Even amidst the global crisis over the last year retail sales in China have remained in double-digit territory and are already rebounding.
Chinese Retail Sales (Y/Y % Chg)
Source: Bloomberg
To further grow domestic consumption and reduce the country’s reliance on exports to the U.S., the country has lowered its reserves requirements for banks in order to spur lending as well as lower the domestic rate of banks for savings deposits to discourage citizens from saving and foster greater consumption. Their efforts are working as total loans of financial institutions has risen to more than a ten-year high of 30.6% YOY.
Source: Bloomberg
Source: Bloomberg
Not only is China working to fuel domestic consumption to drive their economy going forward, the country is also stockpiling commodities to meet future needs in order to sustain future growth. China has conducted billions in transactions this year to secure commodities by either buying commodity producing companies and/or making loans to energy companies with payment in oil rather than dollars. A prior article was penned earlier in the year on this development (Myopic vs. Strategic Thinking), with a few examples of China’s commodity buying this year provided below:
- Feb.10, 2009: China’s Minmetals to Buy OZ Minerals for .7 Billion
- Feb. 13, 2009: China makes billion move to ensure supply of essential minerals
- Feb. 24. 2009: Australian Iron Ore Exporter, Fortescue Metal Held Talks With China Investment
- March 30, 2009: Chinese to buy stake in Terramin Australia
- April 15, 2009: Chinese buy majority stake in Ontario's Liberty Mines
- June 29, 2009: China Plans to Raise Oil Reserves 160% Over 5 Years, Nikkei Says
- July 3, 2009: Venezuela, China May Sign New Loan-for-Oil Accord, Chavez Says
- July 3, 2009: China National Petroleum Is in Talks With Repsol
The net result of China’s commodity buying spree has been a surge in the country's imports of energy products, base metals, and soft commodities, many to record levels as shown below.
Source: Bloomberg
Source: Bloomberg
China knows that an increase in global growth without a measured increase in commodity production will lead to higher prices and shortages and the country is moving to lessen such an impact. Earlier in the decade the world was not prepared for the dramatic increase in world economic growth as oil production did not keep pace, leading to a dramatic rise in oil prices. This can be seen below in which world crude oil production and world GDP have been normalized to 100 in 2001. The levels of world GDP and oil production tracked each other closely from 2000-2003, but subsequently diverged as oil production could not keep pace with economic growth. It was only at this point of divergence in 2004 that oil prices began to rise and track world GDP.
Source: Bloomberg
Perhaps the U.S. Commodity Futures Trading Commission (CFTC) should familiarize itself with the above chart as the agency is considering imposing tighter restrictions on commodity traders, AKA “speculators,” which it blames for rising commodity prices. Did speculators drive world GDP during this decade? If not, then the price of oil can not be said to have been manipulated by commodity traders as the above chart shows their argument is utter nonsense. What is also interesting is that the agency is completely ignoring its own report that it produced in collaboration with other government agencies last year that came to the conclusion that high oil prices were not the result of “speculators.” A brief excerpt from the report stating such is provided below (emphasis added):
Interim Report on Crude Oil: Interagency Task Force on Commodity Markets (July 2008)
The Task Force’s preliminary assessment is that current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors. During this same period, activity on the crude oil futures market – as measured by the number of contracts outstanding, trading activity, and the number of traders – has increased significantly. While these increases broadly coincided with the run-up in crude oil prices, the Task Force’s preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices…
If a group of market participants has systematically driven prices, detailed daily position data should show that that group’s position changes preceded price changes. The Task Force’s preliminary analysis, based on the evidence available to date, suggests that changes in futures market participation by speculators have not systematically preceded price changes. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information – just as one would expect in an efficiently operating market.
Crouching Tiger, not Bursting Bubble
In summary, while it is true that one of the primary drivers of the last commodity bull market was ever increasing U.S. consumption levels that are adjusting to a “new normal” that is below the prior peak, other fundamental underpinnings remain. These include population growth, rising energy intensity, and the inability for production to meet rising demand are likely to continue to support higher commodity prices in the future.
An additional support for commodity prices would be a weak US dollar as most commodities are priced in US dollars, and a renewed weakness in the US dollar may be at hand. There has been a lot of attention in the financial press that the 50 day moving average (50d MA) has crossed above the 200 day moving average (200d MA) on the S&P 500, but few have paid attention to the fact that the US dollar witnessed the same event, except in reverse. For the third time in the last eight years, the 50d MA has crossed BELOW the 200d MA on the US Dollar Index, with significant declines in the US dollar following such occurrences as the chart below highlights.
Source: StockCharts.com
While a significant decline in the USD may be the next catalyst for renewed strength in the secular commodity bull market, the likely greatest movements will be seen once the US economy stabilizes and developing nations begin to recover, which commodities may already be discounting. The CRB Raw Industrials Index has displayed a similar path as the S&P 500 when it began its secular bull market back in 1982. Overlaying the 2002-present path of the CRB over the S&P 500 from 1981-1990 shows the CRB index’s 2008 collapse akin to the 1987 stock market crash. As the 1987 market crash was a dramatic pause in the secular bull market that did not end until 2000, the 2008 crash in commodities is likely to act as a pause in the commodity secular bull market as commodities are like a crouching tiger waiting to pounce once again rather than a bursting bubble.
Source: Bloomberg
