Commodities Decline: The Perfect Storm

Commodities have rolled over in a dramatic way in the third quarter. The Dow Jones – AIG commodity index is 25% off its late June highs. Crude oil has dropped $40 and is trading at a five month low.

Commodities were very extended on the upside prior to this decline and have been hit with a perfect storm of (1) a sharp reversal in the U.S. dollar, which after a six-year decline, appears to have put in an important bottom; (2) conclusive evidence of slowing global growth; and (3) liquidations on the part of leveraged market participants (i.e. hedge funds) and the unwinding of the momentum trades that had been put on in the spectacular prior run-up in commodity prices.

What is the outlook for commodity investments? Our view is that most of the downside risk has been taken out. Longer term investors should maintain strategic investments to the asset class for its appreciation potential and diversification benefits. However, investors should not expect a quick rebound and may have to wait until 2009 for the next commodity price up-leg to get underway coincident with a recovery in global economic growth.

From a longer-term perspective, commodities remain in a secular bull market supported principally by powerful demographic-driven demand trends and secondarily by inflationary monetary policies. Emerging markets, led by China, account for most of the growth in global demand for raw materials.

Fear of a sharp slowdown in emerging markets is feeding into current price declines in commodities, but emerging markets collectively are still growing quite briskly. China’s real GDP growth peaked at 12.2% per annum and has since backed of to around 10%. It may continue to slip back to the 7-8% levels seen in the late 1990s, but is unlikely to drop below that level. The continued strong growth and development of emerging markets in the coming years will keep a solid floor under commodity prices.