It’s not all China’s fault.
I’m referring here to the rout in prices of commodities, ranging from coffee to zinc, over not only the course of 2013 but much of the last three years. The Dow Jones-UBS Commodity Index has tumbled 13.1 percent over the last year. Another index of stocks whose fate is tied to commodities (the Morgan Stanley Commodity Related Equity index) is ahead 10.2 percent in the same period, just over a third of the 28 percent gain recorded by the S&P 500 in the same period.
Of course, it’s inevitable that the slowdown in economic growth in China from the double digit rates recorded during the first decade of the new millennium would take its toll on demand for commodities ranging from aluminum and copper for industry to foodstuffs for the emerging middle class. And that slowdown, while it shows signs of flattening out or even reversing itself, isn’t likely to disappear overnight. If growth does recover, it will be at a more muted pace than we witnessed during that decade of frenetic growth.
Those years, not coincidentally, were also characterized by booming investment interest in commodities, and a change in the makeup of commodities markets bulls. For the first time, investment interest went truly mainstream as big institutional investors made sizeable allocations to the volatile universe of commodities beyond gold. New commodity mutual funds and ETFs made their debut and thrived. In China, the desperate need for commodities was reflected in its push to invest directly in everything from African mines to farmland outside its own borders.
THE CHINA EFFECT
Today, Chinese demand is particularly hard to gauge. On one hand, big metals producers like Rio Tinto (RIO) have continued churning out copper, zinc, aluminum and other key industrial metals in the face of a plunge in prices in recent years. Over the summer, China announced it would undertake some big new infrastructure projects.
Import data from August shows just how confusing the picture can be. On one hand, imports of raw materials – including those metals – fell from high levels recorded the previous month. On the other, there are signs that growth won’t return to its previous pace (or at least not enough to soak up some of that production glut in metals and some other commodities).
If you believe in reading the tea leaves, you can’t help but note the news that China’s own sovereign wealth fund has lightened up its commodities holdings. As recently as the end of 2011, China Investment Corp. had nearly a quarter of its assets invested in energy and global materials industries; within a year, that had been pared to 17 percent, according to the $575 billion wealth fund’s annual report, released last summer.
Who but the managers of China’s sovereign wealth fund is better positioned to gauge what’s likely to happen to Chinese demand? This may emerge (however stale the data involved) as the commodities market’s version of “don’t fight the Fed.”
You don’t have to be a bear on the outlook for China’s economic growth to want to steer clear of commodities this year. Copper prices entered bear market territory last May after a decline of more than 20 percent from their peak. Gold has been in freefall in recent years, although volatile and responding positively to geopolitical crises. (The Market Vectors Gold Miners ETF has lost half of its value over the last 12 months.)
The forecast for many agricultural commodities is similarly weak. In contrast to the drought-like conditions in many corners of the world during 2012, this past summer’s weather was more favorable, meaning that corn and soybean production output could set records. No wonder that prices for both these agricultural products have plunged.
I’d be more hesitant to argue that this means we’re in for a decade-long bear market than I was back in mid-2004. Many of the trends that people focused on back then in arguing we were about to embark on a decade-long cyclical bull market remain intact today. But – and it’s a big “but” – we’re almost certainly going to experience even more volatility in the coming two or three years than we have witnessed in the last few years. Only part of it has to do with what happens to Chinese demand.
THREE OTHER RISKS
One of the perennial issues for the commodities markets is the behavior of commodity producers, and in particular, metal mining companies. In many parts of this market, supply continues to outstrip demand and while pundits argue that will shift as Australian and Chilean miners cut back their output over the next year, the temptation to respond to any uptick in prices that follows will be tough to resist. (Self discipline isn’t a long-term behavioral trait of this industry.)
Then there’s the Federal Reserve and the pesky question of the tapering off of its support for the bond market, which creates new questions about the direction of the dollar (most commodities are priced in dollars) and the health of the U.S. economy. If the Fed tapers, what happens to the economy – and to demand for many raw materials?
There’s another wild card out there related to the Fed, which is leaning on Wall Street institutions to get out of the commodities business in the wake of this past summer's kerfuffle surrounding direct ownership of power generation facilities, metals warehouses and other assets.
Almost certainly, this will lead to one of the periodic retrenchments on the part of Wall Street vis-à-vis commodity markets, including trading and perhaps even investment banking. It has been a profitable business for banks, but won’t remain one for long with regulators peering over their shoulders, and their departure from the scene likely will take its toll.
Jack Ablin, chief investment officer at BMO Private Bank, argues that this kind of divestment could produce “one more leg down” for commodities markets. In a recent letter to investors, Ablin says he’s suggesting to clients that they remain underweight the asset class, although if it seems as if the next round of selling represents a “final capitulation,” there may be an opportunity to jump at cyclical lows.
Bargain hunting like that in the commodities arena is a far chancier endeavor than it is in the stock market, where precise, company-specific data is readily available. Fundamentals are what matter here, and the fundamental picture remains murky.
Unless and until there is some kind of coordinated global economic recovery, even a modest one, and producers show signs that they can not only shut in capacity but remain disciplined as prices begin to creep higher – or unless you’re very, very patient and can shut out the headlines, noise and volatility – this isn’t likely to be a very rewarding asset class for the next year or so.
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