We are likely witnessing the painful, undignified death of the commodity investment “supercycle.”
Oil prices cracked below $70 per barrel after OPEC declined to cut production. Gold sank toward $1150 an ounce after a Swiss vote to compel more central bank gold buying failed and gold holdings in the SPDR Gold ETF (GLD) shrank to a six-year low. Copper sagged beneath $3 per ounce on tepid China manufacturing activity.
As I discuss with Yahoo Finance Editor-in-Chief Aaron Task in the attached video, this collectively represents a global phenomenon of not enough dollars chasing too much “stuff” – an inversion of the classic (and flawed) monetarist definition of inflation.
This deflationary wave has swamped a huge commodity production and investment infrastructure that off more than a decade ago with the rise of China as an industrial power and voracious refiner of raw materials.
A concurrent Wall Street boom in “alternative investment” strategies meant to offer “all-weather” returns independent of stock and bond performance provided new investment demand for commodities from metals and oil to foodstuffs. The financial crisis panic buying in gold was an added kicker to commodity lust.
This process is now working in reverse. A decade of increasing productive capacity has fattened supplies of commodities just as the world economy grows less commodity-intensive and investment demand wanes with traditional equity and bond markets performing well.
The idea that commodities were even a proper investment asset class for long-term investors was never fully demonstrated. Commodity prices tend to be mean reverting through successive cycles rather than instruments that produce cash income or build economic value.
Yet many in the financial industry promoted the idea of a “supercycle” fed by global industrialization and “peak oil” supply constraints. For sure, commodities look quite oversold in the short term and sentiment has turned severely against them, supporting the chances for a trading bounce or pause in the declines.
Yet even if the lows are in for oil or gold, the big picture is now looking decidedly less “super” for long-term commodity bulls. In one representative example of flagging investor interest in commodities, assets in the bellwether Pimco Commodity Real Return Strategy fund (PCRIX) have fallen below $13 billion – down by more than a third in two years.
The deflationary effects of collapsing commodities have a few important implications for investors and policy makers.
-Easy-money central bank policies can stay that way for longer – or get even easier. Some Federal Reserve policy voices have already been arguing that the Fed should focus more on how far short its main core inflation gauge has fallen of its 2% target. The drop in headline inflation due to sinking energy costs will possibly exacerbate this situation. This will give Fed Chair Janet Yellen clearance to forestall any interest-rate boost, while emboldening stimulus efforts by central bankers in Japan and Europe.
The idea that a commodity crash could fuel more easy money, currency devaluation efforts and financial-market speculation has spread.
Michael Block, strategist at Rhino Trading, spells out the trader logic in his morning comment: “Weaker commodity prices in dollars also meant weaker yen and that was enough to get the Nikkei up another [0.75%] overnight.”
-Investors will scramble to rethink the energy sector. Oil-exploration stocks were among the most popular among professional stock pickers in the first half of 2014. Value investors could argue the group was cheap, with price-to-earnings multiples below the broad market, and growth seekers loved the surging production estimates from North American.
Now the violent drop in crude-oil prices has undercut the profitability of many North American projects, analysts are slashing capital-spending forecasts for next year and high-yield bond investors are getting nervous about the outsized debt loads shouldered by the sector.
In this setup, investors should eye the most volatile energy stocks for clues about a selling climax and potential rebound, not the commodity prices themselves.
The PowerShares S&P SmallCap Energy ETF (PSCE) has cratered by nearly 40% in the past three months. This group is likely under the sway of indiscriminate risk-reduction and year-end tax-loss selling.
But the stocks could well stabilize or rebound ahead of the oil price itself. At some point, this sector will have priced in much of the bad news, perhaps including some defaults, and the bounce will be ferocious.
-Could we see another “deflationary boom?” A long stretch of very cheap oil was an important and underappreciated element of the ‘90s consumer, technology and stock market boom.
It’s far too early to say that oil will remain this low or stay cheap for years, of course. And the stock market has already begun bidding up U.S. consumer-oriented stocks on this “windfall trade,” in a sign that the market is sniffing out a fresh new “story” to animate the next phase of this bull market.
Of course, the other thing we saw in the ‘90s was a succession of financial accidents resulting from overheated markets and volatile flows of hot capital. Mexico, Russia and Southeast Asia had currency and credit crises that fractured U.S. stock and bond markets in brief but violent bursts.
With the Russian ruble in freefall with oil and many crowded trades being challenged by quick-moving market storms, investors should stay watchful of collateral damage from windfalls.
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