Where is the catalyst for a sustained commodities bull market?

Commodity prices have had a poor few years since 2011. However, since the start of the past two months commodity prices have bounced with the Bloomberg commodity index up 15%. Is this just a ‘dead cat bounce’ or the start of something more sustained?

Its worth considering what has driven past rebounds in commodity prices and whether there are any similarities. What is clear is that every sustained, secular, long term bull market in commodities has resulted from a catalyst.

The industrialisation of the US in the late 19th century, and the German build-up prior to World War I, drove an upswing in commodity prices in the early 20th century. The next upswing came after World War II because of the rebuilding of Europe. More recently the industrialisation of Japan, and many other emerging Asian economies, also contributed to an upswing in commodity prices in the 1970s and the early 1980s.

The most recent supercycle in commodity prices had its origins in 1998, when prices approached their lowest for 20 years (equal to depression levels, when adjusted for inflation). This was followed by the emergence of China as an industrial force, highlighted by China joining the WTO in late 2001.

Research examining centuries of commodity price data has tended to sketch a pattern of 15–20 year super-cycles (a period of rising prices), followed by a slide in prices over the following 10–15 years when excess investment leads to a flood of supply.

The idea of a catalyst was supported by Schumpeter who described periods of short-term volatility that can change the otherwise overriding trend in commodity prices. This change may be driven by an exogenous or unpredictable factor, such as rebuilding a country following a war.

So where could that catalyst come from this time? According to Bank of America Merrill Lynch (BAML):

“sustained commodity out-performance thus requires a secular catalyst and today that would need to be an inflation-shock…Inflation could rise in coming years should a fickle Fed pursue policies to encourage wage inflation and/or we see a broad socialist shift in global economic policy.”

Even though US inflation expectations are rising, and likely to continue to rise given the recent rise in oil prices there appears to be little scope for a dramatic jump in inflation (notwithstanding the risk that central banks could engineer it). The bank advises caution saying that a secular rise in inflation is unlikely and by concluding that we’re still in the midst of:

“the formidable deflationary forces of debt, deleveraging, demographics & technological disruption.”

The other catalyst could be a new source of industrial demand. Its difficult to see where this could possibly come from given many emerging economies advanced state of development and the lack of any other country with the population size and government that could cause such a shock. Otherwise a supply shock could also lead to higher commodity prices. But even here the impact is likely to be muted given the high price elasticity of supply of US shale production, high stock levels and more efficient manufacturing supply chains.

Note that even within these long periods of rising or falling prices there may still be lengthy periods when commodity prices run counter to the longer-term trend. In addition, not all commodities will necessarily behave in the same way during the period of a commodity cycle. So even though, the main industrial commodities may still see weakness in years ahead, other commodities (e.g. lithium) may show completely different trends.

Related article: History points to nickel leading rebound in base metal prices

Related article: Copper and oil prices: Lower for a bit longer?

And this is the most important point to bear in mind. Completely forgotten about in the recent upswing in commodity prices since the start of the year is that this is just likely to be a brief interlude before prices start falling again. Remember, past cycles have resulted in falling prices for 10-15 years as excess investment unwinds. The most recent super-cycle had arguably greater amount of excess investment than previous cycles, and so more to unwind.
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