Commodities and the long run

20 Aug 2011 by Jim Fickett.

With growing demand and limited/shrinking supply, commodities will enjoy a long-run tailwind. But in addition to the usual business cycle volatility, there is likely to be a major pullback in commodity prices once the current credit boom in the developing world runs its course.

I like owning commodities. Politicians benefit, in the short run (and what else is there, for politicians, than the short run?) from policies that will eventually lead to a collapse of the dollar. In a world of paper money managed for the short term, and excessive influence by those who create financial crises, I like owning something of real, intrinsic value.

Furthermore, commodities have a long-run tailwind. The best deposits of many commodities are used up and a rising world population combined with worsening economics of mining (or loss or forest, or deterioration of soil) will lead to upward pressure on prices in the long run.

The long-term uptrend will not, however, be smooth. Mining companies, for example, are always behind the economic cycle, rushing to do more exploration and development when demand is high, and being ready with increased production when demand is low again.

Some have spoken of a commodity super-cycle, with long-term increasing demand from the developing world. I would add to that a volatility super-cycle, where credit-driven expansion worldwide will eventually pull back sharply.

Today the Aleph Blog quoted some predictions from a (private) newsletter by Michael Pettis:

  • BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis. …
  • Chinese debt levels will continue to rise quickly over the rest of this year and next.
  • Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.
  • Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

Take the timing and other details with a grain of salt; no one can really predict such things. But I agree with the general sentiment – much of the current bull market in commodities is driven by an unsustainable credit boom not, as usually reported, by long-term sustainable growth in the developing world. A crash in energy and metals prices, in particular, is quite likely in the next few years.

This presents some difficulties for the investor. On the one hand, in preparation for the longer-term threat of inflation, one would like to gradually build up more real assets. On the other hand, one should take advantage of volatility to buy low and sell high. If we are lucky, each credit collapse will provide a buying opportunity to prepare for the next round of rescues/bubbles/inflation.

Due to the tailwind, I think it is good to give commodities the benefit of the doubt. But one shouldn't become too enamored of any particular investment, and rebalancing regularly, in order to take advantage of unusually high or low prices, is also in order.