Focus 2 - Perspective April 2011
Soft Commodities and Long-run Cycles
by Hugh Peyman, Emerging Markets Pioneer, Research-Works.
As commodity indices continue to set fresh records on a weekly basis, the question is “how long can this be sustained?” At Research-Works, we believe commodity prices are approaching a crossroads. It could be the key inflexion point that will signify the direction of commodity prices for the next two decades – downwards until 2030 or so. Despite the media hype since last summer about record low US corn stocks, the ‘La Niña’ related weather phenomenon affecting wheat and fears of food shortages in North Africa, we expect to see real commodity prices starting to decline by 2012 - not very far away now. Some may even have already seen their peaks in or before 2008/09, though with the current rally many commodities may have time for one last hurrah over the next 8-20 months, driven not just by short-term fundamentals but also liquidity and inflationary expectations.
Our theory is that real average annual commodity prices rise for about one decade and fall for about two. The history is convincing: in real terms, when 15 leading commodities are assessed, the average long-term cycle since 1945 has risen 9.0 years while the CRB (Commodities Research Bureau) Index rose for 8.5 years in the same period, a very close fit. Going further back to 1865, the average long-term rise of the 15 commodities has been 9.5 years in each cycle. Hence, each cycle seems to rise approximately one decade, remarkably consistent across a wide range of commodities.
We are now in the tenth year of the current long-term real price upcycle which started in Q3 2001. As such, commodity markets are currently displaying all the characteristics of late cycle behaviour – new participants rushing in, overlooked laggards outperforming and ratcheting up volatility.
Prices themselves are also showing classic late cycle signs. Market leaders are not the traditional heavyweights like oil, copper or even gold (which has only risen 26% in the last 12 months compared with the indices up 36%). The recent leaders have been the normally less traded and less familiar commodities like cotton (up 175% over 12 months) and tin (66%).
All that this says to us is that we feel even more convinced in our belief that, by 2012, it will be clear that the real average annual price will have peaked in over 80% of commodities in this long-term cycle, which largely began in the second half of 2001. We are now in the last hurrahs, a period of increasing volatility and classic late market behaviour in any asset class.
One of the soft commodities we feel may have already peaked is wheat. Wheat prices almost doubled from June last year after fires in Russia, flooding in Australia and Canada, and fears about a potential drought covering 7.8m hectares in China sent prices to a peak of $8.54 per bushel on 9 February 2011. At that time we remained sanguine and argued that, given that the Chinese winter wheat crop was in dormancy, coupled with average rainfall patterns in the eight affected provinces and large scale irrigation efforts, the drought was not yet a danger to the crop. Since then, the area affected by drought has fallen by two thirds to 2.5m hectares.
Improving weather in the China and US wheat belt has reduced fears about possible emergency imports and has led to falling prices. Recent forecast upgrades by the USDA (United States Department of Agriculture) to the Argentinean and Australian crop have further added to bearish market sentiment, with prices down 22% to $6.66 as of 14 March 2011. Should higher output be seen in many countries in 2011/12, prices could well have further to fall.
The key to our argument is that higher prices bring forth supply. There is no better indicator to show this than recent US farmland price trends. A recent auction to rent 2,150 acres of farm land in Kansas for five-year leases went for an average $123/acre, 208% higher than last year’s county average. The attendance was 250 people compared with an average 50-100 people. This is not an isolated incident. Farmers in Iowa are paying up to $11,000 per acre compared with $6,000 per acre two years ago. Meanwhile, farmland prices in central Illinois have appreciated by 4% a month over the past four months, according to sales figures. In the words of a fifth-generation farmer in the US mid west when faced with prices this high, farmers in the US, Australia and Russia will ‘take the hint and plant fencerow to fencerow’.
There are always exceptions: some 15-20% of commodities may see their prices rise for more than 9-10 years. We would expect that copper, natural rubber and softwoods would be the most likely to rise for longer as their supply has failed to keep up with demand.
However, as 80-85% of commodities begin a two-decade down cycle we would point to machinery manufacturers who use significant quantities of base metals in inputs, like steel, as well as food processors that have experienced sharp input price rises in the last few years as benefactors and investment opportunities. From the raw material standpoint, inflationary expectations will decline. Indeed they will transmit deflation, with major implications for consumer psychology, wages and the macro outlook.
Other articles from the April 2011 edition of Perspectives:
- WELCOME: Peter Bourne looks back on what has been a volatile quarter for the global economy
- OUTLOOK: Looking deeper reveals strong foundations – By Tristan Hanson
- FOCUS 1: Splitting the facts from fiction in Japan – by Simon Finch
- FOCUS 2: Soft Commodities and Long-run Cycles by Hugh Peyman
- NEWS: Further success for Ashburton’s Funds and our involvement in Jersey’s elite rugby programme
Click here to download the April 2011 edition of Perspective as a pdf document.