Commodity Desk Analyst
Morgan Stanley & Co. June 2015
Commodities have finally healed from the financial crisis and are again driven by idiosyncratic shocks that have sparked lower correlations across commodities and against other asset classes. Still, when you step back and look at the bigger picture, their price action appears to indicate a larger multiyear "supercycle." What markets have called the commodity supercycle peaked in 2008, with annual returns remaining weak since the Great Recession. The US dollar appears to be in a mirroring multiyear super cycle, troughing in 2008, but appreciating over the past four years and surging over the past year. On a five-year-average basis, commodity returns are near historical cyclical lows. On an economically weighted G20 currency basis, the dollar is just off of its historic high, with median market forecasts now pointing to a broad reversal of the dollar into next year. The inflection point for these important and related cycles appears to be at hand, suggesting the start of a sustained reversal.
SUPPLY AND DEMAND DECISIONS. Commodities priced in US dollars-as all the major commodities are-should be strongly related to the strength of the global economy in US dollars. This is not just a foreign exchange tautology. Dollar changes are driven by relative shifts in US versus non-US economic and monetary conditions, and these dollar changes impact global commodity supply and demand decisions.
Take, for instance, a Brazilian soybean farmer whose expenses are in the local currency, the real. Since soybeans trade in dollars, if the dollar appreciates against the real, the farmer will get more money for his crop. That could well encourage him to produce even more the next year. That, in turn, could result in oversupply and falling prices, an example of how an appreciating dollar can depress commodity prices.
The strong dollar's headwind on global growth is addressed in the International Monetary Fund's (IMF's) latest World Economic Outlook, published in April. In the outlook, the IMF revised downward its US-dollar global GDP forecast for 2015. The revision indicates the largest contraction in global GDP since 2009, the second-largest contraction on record-and consistent with the decline in commodity prices. IMF estimates of global US-dollar GDP growth have been particularly weak and slow income growth has resulted in poor demand for commodities.
IMPROVED OUTLOOK. If the dollar stabilizes and eventually reverses, as the IMF implicitly projects, the global growth outlook and the commodity cycle become a lot more bullish. The IMF's new outlook projects stronger annual US-dollar global growth from 2016 through 2020, resulting in a rebound in this five-year commodity cycle. This growth is consistent with near-double-digit average annual excess returns through this period, regressing returns of the Morgan Stanley Backwardated Basket Index on 20 years of IMF estimates (see chart). (Backwardation is when forward prices for a commodity are below the spot price, offering a risk premium to long-only investors.) Adjusting IMF estimates using the market's median G20 currency forecast would suggest a stronger cycle for excess returns, with total returns even higher in a rising interest rate environment.
If the dollar cycle is ready to turn, as indicated by the markets, and the related global dollar-income cycle is rebounding, as the IMF believes, global commodity markets may be poised for another supercycle based on commodities' strong fundamentally and empirically supported relationship with global dollar income.