Published in the Nikkei Asian Review October 1st 2015
Peak oil, peak commodities, the planet running out of food and natural resources. It was only a few years ago when scary scenarios reminiscent of the post-apocalyptic movie Mad Max were taken quite seriously in financial markets. Now the world is confronted by the opposite phenomenon – a commodities glut that is inflicting serious damage on commodity-dependent countries such as Brazil and Indonesia and commodity traders such as Glencore and Noble Group as well as mining companies large and small.
Since peaking in 2008, the Thomson Reuters Core Commodity Index has fallen some 60%. When adjusted for inflation, the current level is close to a 20-year low. Other indices tell slightly different stories, but the big picture is clear enough. Commodities are in a severe bear market, with the declines of the last 18 months being particularly steep.
The proximate cause is the slowdown in the Chinese economy – inevitable after the explosive growth of the last 30 years. Chinese economic statistics are as hard to read as ever, but it is safe to conclude that the industrial sector is suffering from significant overcapacity in many areas and that the deceleration in the overall rate of growth will be permanent. China’s headlong industrialization was of a scale and speed that has never been seen before and will never be seen again.
The deeper cause is the inherent cyclicality of the commodities complex. Over the past two hundred years the world population has grown by six times and urbanization and industrialization have massively increased the demand for natural resources. Even so – despite the prognostications of the gloomy clergyman Thomas Malthus and his modern day successors such as the ecologist Lester Brown – there has been no structural shortage of foods, industrial metals or other raw materials. Periodic mismatches of supply and demand have caused prices to soar, but the higher prices have stimulated substitution of new materials, pioneering of new technologies and exploration of new sources of supply – which brought prices crashing back to earth again.
GOLD STILL EXPENSIVE
The twentieth century saw the invention of cheap and plentiful materials such as plastics and silicon and new energy sources such as nuclear power. There is no reason to suppose the twenty first century will be any different. Being bullish on commodities as an investment means being bearish on human ingenuity as supported by the incentives of the price mechanism. And that has never been a good idea. Even at the height of the recent commodity boom, the Russell 1000 Total Return stock index had outperformed the Commodity Research Board Index by 240% over the preceding 25 years.
In the world of equities, bull markets are generally more prevalent and longer-lasting than bear markets. In commodities the reverse is true. Because there are significant time lags in bringing new technologies and mines and oilfields on stream, bull markets tend to be explosive while bear markets are long drawn out affairs. The last world-wide panic about resource shortages began in 1971 and peaked in 1980; it was not until 2002 that a new bull market took off, with a new set of buccaneering entrepreneurs taking centre stage. If we follow the same template from here on, the start of the next bull market in commodities may be another fifteen years away, by which time some of today’s major players will have disappeared off the radar screen and no doubt a new cast of colourful characters will be ready to emerge.
The good news – for commodity producers, at least – is that the severest hits to prices are now almost certainly behind us. Last time around the CRB Index fell a total of 47% from its 1980 peak. After the wipe-out of the past few years that decline has been comfortably exceeded. Furthermore back then the bulk of the damage – 90% of the total peak-to-trough decline – was done in the first five years of the bear market, with the second brutal downwave in 1985 removing all hope that the setback was temporary. As the peak of the recent cycle was in 2008, it is likely that the most tumultuous phase of the bear market – when optimism turns to despair and the economic consequences become unmistakeable – is drawing to a close.
Even so there will be individual commodities that still carry significant downside risk. One likely candidate is gold bullion, which remains at an extremely high level in real, inflation-adjusted terms. Leaving aside the temporary ”spike” of 1979/80, gold has not been more expensive since the Conquistadors landed in the Americas 500 years ago.
NO MOVIES ABOUT GLUTS
The overall global impact of the commodity meltdown is hard to assess. In the 1980s there were adverse consequences for commodity-dependent countries, such as some in Latin America and Africa, and regions such as Texas – and for the banks who supplied them with credit. For the developed world as a whole, however, the result was a protracted economic boom as inflation and interest rates fell. This time too, not having to pay the “China price” for inputs is a clear benefit, but the overall macro-economic implications are cloudier. Interest rates are not going to get any lower and deflationary risks remain in many parts of the world. Softer commodity prices might have a depressive effect on expectations and the overall price level, just as rising commodity prices helped to embed inflationary expectations in the 1970s
They are also likely to have a negative effect on capital flows, as commodity producers have been huge exporters of capital during the boom times. Financial markets could suffer, as could the markets for high-end real estate, sports franchises and contemporary art.
Fear of shortages may be hard-wired in the human brain, leading us to worry about threats that are fading away and downplay those that loom large. That could be why Mad Max returned to our screens this year, well after the commodity boom was past its peak – as indeed was the case with the last Mad Max movie which appeared in 1985. It is hard to conceive of a successful dystopic movie about an era of industrial over-capacity, commodity gluts and weakened financial architecture. Yet those are the risks that lie ahead as the great commodity boom of the noughties retreats into history.