Commodities: Opportunity During Recession

Recession has become a buzzword. Everybody is losing confidence but it is well said that crisis generates opportunity and one should know how to turn crisis into opportunity. Commodities are the field which generated opportunity in every phase of the business cycle. In general, commodities tank after the market crashes or a recession occurs.

If we look back, occasionally it is evident that there are new peaks in prices after recessions. Two dimensions could be attributed to these higher prices after recessions. First, production cut due to lack of demand and liquidity, and secondly, various monetary steps to revive the economy, including interest rate cuts, relief packages, tax cuts etc.

With the help of historical data, we can see that what happened in the 1929 crash and its aftermath tells a similar story. For example, in 1929, corn prices were dragged down by approximately 80% from its peak due to a crash in the market. However, in 1937, it made a new high, higher than the 1929 peak. We can see a similar trend during 2009 to 2010, as supply is shrinking in almost all commodities. On the other hand, the governments of major economies are making historical decisions to revive the economy.

With the Fed gambling with the US dollar, we can say that commodities still have legs, as we know that commodities perform better amidst a weak dollar. Due to the essential nature of commodities for human lives, investors shift their funds into commodities during war and financial crisis. The historical risk premium, during the 1959 to 2004 period, on commodity futures has been positive at about 5 percent, supporting the fact that commodities get continuous and somewhat definite returns in times of crisis as well.

Commodity prices rise even during recession. Currently, many commodities are moving up on the hope of improvement in demand. Nowadays, all metals, energy and agricultural products are in the headlines due to their eye catching upside movements in prices. Most people are talking about a more than 60% fall in crude oil prices, which is now on the path of recovery. The fall in oil prices is not the ideal sign of recession, as in the last nine years, oil prices have declined three times by more than 50% and each time it was not the end of the bull market. During the tough time from 1959 to 2004, commodities offered better returns to investors and proved less risky as compared to stocks.

We know that this not an ordinary recession, and people are taking it as “a once-in-a-century credit tsunami” after the Great Depression. Since 1954, the average recession in the U.S. has lasted 17 months. The entire world is coming forward together and doing everything in their hands to create liquidity, and we know that liquidity is bullish for commodities. However, any concrete changes from these stimulus packages will take several months to occur.

Commodities are cyclical in nature and thus rise and fall on the business cycle. According to an analysis based on multi year data, different commodities behave in different ways in different business cycle phases. Let's divide the business cycle of commodities into four parts, as mentioned below:

Business Cycle Phases

• Late Expansion: During this phase, expectations of profit are at their high point and stock prices are sky high. Banks approve loans easily. Generally during this period, energy and metals outperform other commodities.
• Early Recession: During this phase, uncertainties arise in the market and the market for physical investment gets saturated and people get less profit. Nevertheless, commodities earn positive returns, while stocks and bonds earn negative returns. In the early recession stage, a few commodities, including sugar, coffee, soybeans etc., perform well due to their higher demand. In this recession also, we have seen that sugar gave good returns despite the mayhem in the market. Even crude oil and base metals gives positive returns, which was evident in 2008.
• Late Recession: The recession continues and the cycle enters the late recession phase. Markets moves on the hope that the economy will revive and some immediate monetary measure like interest rate cuts, tax cuts etc. provides liquidity in the market. Profits are moderate but at an increasing pace in this phase. During the late recessionary business cycle, some commodities, such as maize, soybeans, sugar and gold outperform other commodities and other investment avenues, which we have already seen in 2009. Gold has already become the hot favorite investment avenue and the entire world is diversifying money into gold. We are already into this late recession phase in which various majors takes place to stimulate the economy but nothing much occurs on an actual basis.
• Early Expansion: In early expansion, stocks and bonds outperform commodities. Stocks gives better return than bonds. A recovery in the equity market offers support to the commodities market. The market witnesses spontaneous movements, optimism, and higher-than-expected profits during the early expansion phase. Some impacts of various governments as well as other measures can be witnessed. The market feels the pinch of supply tightness in the course of improving demand. Ongoing production cuts in the metals and energy sectors are likely to bring the prices to comfortable levels. There is concern in the market that these cuts will turn into a supply squeeze when demand will reoccur after taking these financial measures. For example, China alone has closed about 27 percent of its capacity of aluminum, and the market has yet to see the impact of that. In the same way, OPEC has cut crude production by mbpd, which will positively impact prices at the time of recovery.

In general, commodities perform better during late recession and late expansion phases, with the decline in interest rate and fresh inflow of money. Base metals get more returns in the early recession phase as compared to the late recession phase, while agro futures display patterns quite strongly even in the recession time. However, it is not compulsory that the business cycle will be predicted with crystal-clear accuracy, but it does provide an historical perspective which can be used to evaluate the commodities market.

At present, cooling inflation has given a sigh of relief to the market but due to monetary measures taken by various economies, has changed the outlook of inflation and it is expected that it will reoccur soon as the market is flooded with new printed money to provide liquidity into the economies. Moreover, commodity assets under management have also expanded their business in this quarter, which slid last year.

Some positive news has begun to emerge in various economies, giving a ray of hope that they are approaching the end of this rout. China PMI numbers, a rise in the CRB Index and Baltic Dry Index, rising energy and base metals demand in China and other countries, positive home sales and consumer confidence data have given the same indication. There is an expectation that commodity funds' assets may double in 2009. There is an expectation in the market that the worst is probably over; however, trading is expected to remain volatile for a few months as negative news is still coming in. Geneva-based WTO has predicted that world trade is likely to shrink by nine percent this year, the biggest contraction since World War II, which will cap the upside of commodity prices.

Commodities have been going through a bottoming process and with the supply cutbacks, when demand returns in a big way - probably fourth quarter of 2009 or in beginning of 2010 - we may see a return to strong gains in commodity prices. There is a light at the end of the tunnel. We hope that this tunnel should not much longer than people are anticipating.

Comments

[SJD:]

Well done analysis. Good points for consideration.

May 04 10:01 AM

[Igoro:]

During which of the four phases would ownership of mutual funds or ETF's that own baskets of stocks be the optimal strategy?

May 04 10:48 AM

[H. E. Canada:]

I refer you to an earlier post by Tim Iacono, 2/20/2008, with a chart of what stocks, bonds and commododities returned, on average, in the various phases of the last seven U.S. economic cycles since 1959: seekingalpha.com/artic...

IF one believes this chart is a rough guideline of asset performance in this recession then the important question is, where are we in the cycle, i.e., on this graph today?

IF we are in the late recession stage, 50-year history says commodidites are not the assets where one would expect to see high returns.

May 04 06:13 PM

[one eye:]

I agree with Freya. Anyone following Bespoke's graphs can easily see that commodities are steadily rising even though The US Economy gets worse.

May 06 01:23 AM

[popey:]

So in the 1930s it took 8 years for corn to recover fully. And you are calling a recovery in commodities markets after 1 year, 2008 to 2009.
Please explain the 5-7 year timing difference.

May 23 07:08 PM

[Vandana Bharti:]

Dear,

Thaks for the feedback and question, scenario of agro commodities, especially corn, which is used for multi purpose, is completely different from 1932. Population has blasted in these time period. significant amount of production is moving in bio fuel anf many more uses. hence we can expect aquic recovery this time on demand supply analysis. However, I am not giving here one year time period, it will improve in 2-3 year time period.


On May 23 07:08 PM popey wrote:

> So in the 1930s it took 8 years for corn to recover fully. And you
> are calling a recovery in commodities markets after 1 year, 2008
> to 2009.
> Please explain the 5-7 year timing difference.

Jun 15 01:57 AM

[Freya:]

On the other hand, it really means very little where we are as far as commodities are concerned.

The 2002-2003 Bear ended only after two stimulus packages and a surge in commodities due to external demand. The same kind of demand we see now.

Whether we participate or not is irrellevent. Whether the Developed world participates now or later is also irrellevent. What matters is that more than 2/3rds of the World is starting to spend again and risk aversion is dying a painful death.

The US did not lead the way out of the last recession. They are not leading now either.

So there is definitely going to be a another vicious drop here. Use it as a buying opportunity. I would not jump the gun just yet though.

May 05 03:15 AM

[Tradebiz:]

Well.... Commodities have been going through a bottoming process and with the supply cutbacks, when demand returns in a big way - probably fourth quarter of 2009 or in beginning of 2010, we may see a return to strong gains in commodity prices. There is a light at the end of the tunnel. We hope that this tunnel should not much longer than people are anticipating.

Oct 09 02:53 AM