Commodities: Bull Run in Early Stages; Short-Term Correction Ahead

 |  Includes: CRB, DBC, GSG
by: Disruptive Investor

This article looks into the factors impacting the short to medium term trend for commodities. Over the long-term, there is no doubt in my mind that every portfolio should have commodities and commodity related stocks for long-term. With the demand for commodities driven by 2.5 billion Chinese and Indians, the current bull run for commodities is still at a relatively early stage.

However, the long-term bullish phase for any asset class is interrupted by short-term corrections. At times, the corrections might easily be over 20% leading one to believe that the asset class has entered into a long-term bear market once again.

In my opinion, commodities are in for some sharp correction in the medium-term. Hence, short-term investors might consider reducing their exposure to commodities. I mentioned India and China as the key demand drivers for commodities. Currently, the following is the scenario in these countries –

China reported a consumer price index increase of 6.4% in June 2011. The Chinese Central bank has already increased interest rates five times since September. Further, there are already indications of the economy cooling down.

India, on the other hand is also struggling to control high inflation. The Indian Central bank has raised interest rates nine times since March 2010. Further rate hikes are not ruled out and there has been a relative tightening of liquidity in the system. Clearly, the growth would be impacted in near-term.

I am not suggesting a recession in China and India. However, a slowdown or a meaningful slowdown is enough to trigger correction in commodities.

Just consider the following – Chinese steel, lead, iron ore, zinc and aluminum demand (each) represent over 40% of the global demand individually. China is also a consumer of 39% of global copper demand.

Therefore, any slowdown in China itself is sufficient to trigger meaningful correction in commodities. Considering the current rate of inflation and policy maker’s actions, it is relatively easy to conclude that China is heading for a period of slow growth. Will it be a soft or hard landing is still to be ascertained.

Indicators of weakness in commodity markets

1) Marginal decline in the CRB commodity index - The CRB commodity index has declined marginally by 7% from a high of 370 as of end April 2011 to 343 currently. With the latest news on China inflation, commodity traders would further consider revising short-term positions. Hence, a downward trend in the index (in the near-term) cannot be ruled out.

click to enlarge images

Click to enlarge

Chart Source: Bloomberg

2) Meaningful decline in the Baltic dry index - The baaltic index is hovering below the 1500 levels, which happens to be much lower than last year when there was robust import aactivity of commodities in China

Click to enlarge

Chart Source: Bloomberg

Conclusion -

Any meaningful correction in commodities can be viewed as an excellent opportunity for long-term investors to consider exposure to commodities such as copper, iron ore and others. However, in the near-term, one needs to exercise caution on going long on commodities. The China growth story might just be in for a breather.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.