Firming Commodity Prices Would Indicate Economic Stabilization

This bear market has demonstrated that cyclical commodities are not an effective hedge to a stock portfolio in a deflationary bust and a liquidity crisis, but those conditions are not likely to persist over any investment horizon measured in years rather than months. A firming of cyclical commodity prices, signs of which have been seen in the industrial metals complex, would be an indication that the global economy has stabilized.

For investors with a longer-term view, the current crisis is almost certainly sowing the seeds of future commodity price appreciation. Massive government reflation and stimulus efforts will cause inflationary pressures to build over time, which will support hard asset prices. Infrastructure spending is bullish for commodity prices, and tighter credit conditions, along with lower prices, puts pressure on the supply of commodities as suppliers curtail production or cancel projects.

Though it has pulled back recently from key resistance at the $1,000 level, gold has continued to lead the commodity complex, which is not surprising given the degree to which confidence in paper assets and currencies has been damaged. The case for owning gold as an insurance policy against monetary inflation and financial instability seems very much intact. As such, gold should continue to provide a valuable portfolio diversifier and hedge.

The opportunity cost of holding gold, which produces no dividend or interest income, is now very low given that the Federal Reserve has cut the official U.S. overnight lending rate to zero to 0.25%, and foreign central banks are quickly moving their interest rates in that direction.

Over the past five years, the ratio of the price of the S&P 500 to the price of the Dow Jones-AIG Commodity Index, which holds a diversified basket of commodities, has ranged from a low of 5.4 to a high of 9.1. The current ratio of 6.7, which is approximately in the middle of this range, suggests that neither asset class is at an extreme valuation relative to the other.

Comments

[Prudent Man...:]

If I read this correctly, there is confusion between inflation, stagflation and recession. I never heard anyone with credibility believe that commodities, including gold, were a hedge against recession. In fact just the opposite is true. After piling on "carrying costs" and price deflation you have a loser.

Mar 16 10:13 AM

[Conan the B...:]

One does not need a Long term view on the Basic metals.

Infrastructure builds seem to be at the core of most stimulus packages. Ours will not start until 2010, by the time ours kicks in, I expect most of the Basic metals and Miners to be up substancially from present levels.

Anticipation VS actuality.

Mar 16 10:13 AM

[Conan the B...:]

Prudent: Has the US economy ever moved out of recession without the participation of the Basic Materials group?

Just because materials prices rise doesn't mean they will be passed on to the public instantaneously.

Meanwhile, Bernanke, for all of his rhethoric over the weekend, is playing a very dangerous game with money supply.

Net Free Reserves are now negative.

Mar 16 10:21 AM

[mac.barron:]

I would be interested to read what Mr. Steinhilber's take is on the way that the Chinese are playing these markets. Although they have continued to buy U.S. Treasuries at auction (so far), the Chinese have also been buying up commodities and shares in natural resource companies at a rapid pace. Certainly the global economic slowdown has dampened commodity prices for the time being but the medium to longer range picture is more volatile.

I am also curious about the weight given to gold which is, in many ways, a market in and of itself and only a component of the DJ-AIG Index.

Mar 16 11:10 AM

[Irishscot2:]

Biggest reason for current firming in commodities is reduction in output to meet the decline in demand. Any increase in demand will spike prices up, but will not signal an economic recovery, just slight increases in demand caused by the "stimulus". What you want to watch is global freight activity (NOT THE BDI - Only a measure of rates, affected currently by a 15% cut in capacity, BDI is an effective measure of a downturn, not a recovery) - when it picks up you will see some recovery. Remember to compare to 2007 numbers as 2008 was horrible - numbers up on 07 will show economic growth, numbers up on 08 will depend on their span to 07 to tell if it's growth or just stabilization.

Bottom line is that this has a long way to run and more debt will not be the answer to long term recovery.

Mar 16 11:15 AM

[xsellside:]

Also, I think a good indicator of economic activity would be looking at commodities where supply is not growing, ie., copper. An incremental demand will show up in market prices quickly.

Mar 16 11:32 AM

[William Cowie:]

Another indicator to watch is the Baltic Dry Index, which shows the firming of shipping rates that apply to moving commodities. The BDI fell off a cliff last year, along with commodity prices, and in the past has been a leading indicator for commodity prices.

Mar 16 12:02 PM

[Vuke:]

China and India February auto sales were reportedly up 25% and 20% respectively, Chinese cement production 17%. While no guarantee of a future commosity boom we have to remember there are some 4 billion people out there that want to live as we do, with cars, tractors, TV's, cell phones and computers.

That's an awful lot of copper, cement, rare earths and steel, never mind the oil and uranium to run it all.

And, thanks to cheap money, more and more can afford the "good life". And for those that want to preserve wealth, it bodes well for gold.

Mar 16 12:19 PM

[mr freddo:]

It appears that China is taking advantage of the downturn by buying commodities and industrial metals all over the world. It seems like only yesterday that the incredible expansion being undertaken in China was endangered by soaring commodity prices.

As Irishscot2 mentioned, in the current environment, mining and drilling projects are being cancelled or postponed, reducing the future supply and creating the scenario for future scarcity and dramatic price increases once the infrastructure projects kick in and the world economy starts to recover.

I agree with the author on gold as a solid hedge against inflation. Because it gets so much attention though, I think other metals like copper may see faster price appreciation once the stimulus and recovery kicks in.

Mar 16 12:52 PM

[William Cowie:]

I also think our expectations need to be realistic. It's unlikely we're going to see a "boom" in the overheated sense of 2007. More likely, a steady rise in demand, for which there will be an adequate supply. But at least demand will be increasing, not decreasing.

Mar 16 02:32 PM

[Conan the B...:]

One must stop thinking of what is occurring "here".

Commodities are a Global play, A few of the large major players have shut more than a few of their marginal mines.

I track the copper inventories at the London Metals Exchange on a daily basis, they peaked out a few weeks ago and are down about 10% since.

How much is from Chinese buying is unknown.

Mar 16 04:43 PM

[aarc:]

Recovery in commodities could be slow.

Capacities are being shut down - not being destroyed. They can be re-deployed to meet future demands which is expected to be anemic at best.

Until full production capacity cannot meet rising demands, recovery is expected to be slow for commodities.

One exception could be agriculture. There is a growing shortage of food as draught in China and Australia are threatening the global supply capacity vs demand. This is the case where capacity cannot be easily ramped up if global weather conditions don't improve in the near future for agriculture.

Mar 17 03:11 AM

[aarc:]

One big problem with a price recovery or possibly over-appreciation of agricultural products due to supply shortages is that it is counter-productive.

Instead of helping economic recovery. It might as well become the primary factor in the near future towards economic destabilization and be able to stop any economic recovery effort on it's track or worsen the current recession further depending on how fast inventory supply runs out.

Mar 17 03:22 AM

[kelm:]

Please do not ignore the fact that supply is being reduced in many essential industrial commodities so while a price rise in commodities is a good investment and shows that the supply/demand imbalance is tilting in favor of rising prices it does not prove that economic activity is ticking up.

Specifically, little to no investment is being put into producing oil fields and exploration and development are being curtailed as well as OPEC production cuts. Natural gas rigs are being shut down due to low prices. Australia has seen the closure of one of their largest nickle mines, the Congo is seeing most of its copper mining and smelting operations closed etc. So supply is being restricted worldwide.

It is definitely time to look at the charts for the major commodities and look for bottoms being formed though. Prices are at record lows, especially adjusted for inflation. When you couple the low price, with the lack of investment in producing operations to maintain output, with no new exploration, with facilities being closed, etc we are set for a massive run-up in price due to supply constrictions whenever economic activity does pick up. Whether the time to get long is right now or over the next few months it is the time for investors to start taking a hard look at how they are going to play this.

Mar 17 11:05 AM