Three reasons why commodity super cycle is alive and well

By Chris Watling
With the sharp falls in commodities prices in the second half of 2008, investors are questioning the concept of the commodity super cycle and the rationale for investing in that asset class.
Indeed, this year's 15 per cent rally in commodities is being ascribed to temporary factors, including speculative short covering and stockpiling in China. Last year's near 40 per cent pullback in commodities, though, should be viewed as a healthy correction in a secular commodity bull market. Indeed, there are three reasons for expecting commodities to perform well over coming years.
First, the structural strength in the global economy resides in the emerging market economies. Since experiencing significant economic hardship during the series of EM crises between 1997 and 2001, these economies have been paying down debt, increasing savings and building reserves. As a result of that structural economic strength and the stimuli now being applied to these economies, we expect the EM economies to act as the major driver of global growth over the coming decade. Most importantly, given the voracious appetite for commodities in these industrial- ising economies, demand for major global commodities should rise significantly. Already China's consumption of copper has risen rapidly in 2009, as the fiscal stimulus plan and rapid lending growth combine to drive a recovery. Our long-term demand forecast suggests consumption of key commodities by the Brics (Brazil, Russia, India and China) alone, especially China, will account for the majority of global consumption by 2020 as their economic growth remains rapid and becomes increasingly commodity intensive.
Second, the Federal Reserve is boosting the money supply by creating commercial bank reserves, the modern day equivalent of printing money. This year the Fed has announced and embarked upon its version of quantitative easing, which it prefers to label credit easing. By creating commercial bank reserves at the Fed and using those reserves to purchase $300bn of US Treasuries and $1,250bn of mortgage backed securities, the Fed will more than double the monetary base. If successful in reigniting the economy then our analysis of the history of quantitative easing over the past 150 years points to eventual high inflation. Furthermore, given the concerns expressed by Washington policy makers about the fragility of the recovery and the structural weaknesses of the US economy, it's likely the stimulus will be removed too late. Commodities, as a physical asset, are a store of value and consequently a natural hedge against inflation, and should perform well in that environment.
Third, the commodity super cycle is alive and well. Last year's pullback in prices was a typical mid super cycle break in the commodity price upswing. Both the recent two commodity super cycles experienced major pullbacks several years into their bull runs. Both times the pullbacks proved temporary and the upswing resumed. During the last commodity super cycle (1968 through to 1980) commodities fell by approx 25 per cent from mid 1974 through to the end of 1975. Equally in 1937, during the first half of the 1932 to 1951 super cycle, commodities also suffered a major correction, falling a cumulative 40 per cent before resuming their upwards trajectory. Both mid cycle corrections were similar in size to last year's weakness. Both were also associated with major global recessions.
Indeed, the existence of the commodity super cycle can be shown back to 1750 (ie as the start of our data series) while academic work exists showing long cycles in prices dating back to the 12th century in Europe. Since the mid 1700s the average bull cycle has been 20.7 years with average cumulative gains of 293 per cent and a range of gains of between 135 per cent (1788 to 1814) and 689 per cent (1932 to 1951). This latest cycle began in 2001 and is therefore eight years old. To date, cumulative gains are 76 per cent. If history and long-term demand expectations are any guide, then several years of significant upside should be expected.
The writer is chief executive of Longview Economics
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