Commodities | Jan 11 2007
By Chris Shaw
The start of 2007 has seen markets doing the opposite of most consensus views, as commodity prices have fallen sharply and the US dollar has been stronger. According to GaveKal Research investors should now be questioning the outlook for both assets, as there are signs conditions in both the commodity and currency markets are changing.
Looking first at commodities, GaveKal notes the past few years have seen prices at levels well in excess of the marginal cost of production, an outcome that historically has occurred only a few times and then only for a few years at a time, which has been the case again this time.
The question then is can the price boom of the last few years be sustained or is it simply the result of a pick up in demand that has yet to be matched by higher supply thanks to a lag from years of under-investment in exploration and new production capacity?
GaveKal points out the commodity story this time around has been boosted by two elements, stronger demand resulting from the growth of countries such as China and India as their populations move from third world to first world standard and the resultant demand for commodities this would produce, as well as the argument commodities are uncorrelated to other asset classes and so should be part of a diversified portfolio.
The problem with these arguments in its view is they simply don’t stack up so well upon closer inspection. Taking the second argument first, research into commodity prices over much of the last century shows they have been a poor long-term investment and significantly generated negative returns as prices have followed the marginal cost of production, which has fallen over time. Within this though there have been a number of shorter periods when prices have performed very strongly.
While the global population stands at around six billion its growth is now slowing, with GaveKal pointing out much of the growth is now occurring in the world’s poorest countries. This makes the assumption that demand for commodities will continue to increase at a strong rate a dangerous one to make from an investment viewpoint.
Finally, the group points out technically the commodities sector has broken out of its uptrend, even though global growth remains solid. This begs the question of what would happen if global growth slows, an outcome looking quite possible given the recent trend around the world towards higher interest rates.
There is also the inflation element, as higher inflation supports commodity prices. GaveKal takes the view the global economy is moving away from inflation and towards a deflationary boom thanks to lower production costs, which again puts pressure on commodity prices. Add in the fact the supply response is coming over the next few years and it is easy to question the ‘Super Cycle’ prophecy.
Turning to the US dollar, the group has argued for some time the greenback is undervalued against the euro and should be significantly stronger, as indicated by the fact fundamentals, valuations and technical factors are all in its favour.
It suggests the outlook for the US dollar has been boosted by the fact the two primary European growth drivers, which it classes as exports and the financial revolution in Spain, France and Italy, are now showing signs of running out of steam.
Exports are struggling as US consumption slows, while recent increases in official interest rates by the European Central Bank have slowed the construction and consumption booms recently enjoyed by much of the region.
Could 2007 be the opposite of what had been expected given the performance of various assets over the last few months of last year? As Market commentator Dennis Gartman wrote recently, the opening week of the year is often a good indicator of what is to come, a view seemingly shared by GaveKal research in terms of the likely direction for commodity prices and the US currency.