Commodities Vs. Shares.

Commodities Vs. Shares.
March 28th. 2008 - Australasian Investment Review – (AIR)

The AMP’s Dr Shane Oliver, the group’s chief strategist, says a winning trade over the last few years and particularly since the sub-prime mortgage crisis really hit, has been to be overweight commodities and related trades such as resources shares and underweight financial shares, such as banks and listed property securities.

He says this looks like it might be coming to an end for a while, as the worst appears to be over for financials and as the US/global economic downturn impacts cyclical shares.

The commodity super cycle is alive and well..

For several years our view has been that the long-term trend for commodity prices is up reflecting very strong structural growth in commodity demand in emerging countries as they industrialise and constrained supply. As such the trend in real commodity prices, which was down from the mid 1970s to the late 1990s, is likely to remain up. See the chart below.

There is no reason to change this view. The commodity super cycle is alive and well.

The demand potential in emerging countries, notably China, is huge. While China’s total copper consumption is double US levels, its copper usage per person is less than half US levels suggesting lots of scope for a catch up.

Similarly, Chinese oil usage per person is less than 10-15% that of rich countries. Also the rising value of the Renminbi will make commodities cheaper for Chinese users. Rising income levels and the increased use of agricultural products for fuel will also see ongoing upwards pressure on agricultural demand.

Just as we have seen in the last six years or so supply will struggle to keep up with commodity demand over the long term.

The commodity boom has become very speculative and vulnerable to a short term correction.

However, while the long-term trend in commodity prices is likely to remain up the risk of a serious commodity correction is high.

The last six months or so have seen commodity prices surge higher with gold breaching $US1000 an ounce and oil breaching $US110 a barrel despite the downturn in the US. According to the Goldman Sachs index covering energy, metals and foodstuffs, commodity prices are up 28% in the last six months and 52% over the last year.

This reflects continued strength in emerging countries and various supply set backs but commodity prices have become supercharged by a falling $US and massive speculative interest. The impact of a falling $US is fairly simple.

Commodities are mostly priced in $US so when it falls in value they have a tendency to go up - as commodity suppliers who are mainly outside the US demand higher US dollar prices to compensate for a falling $US and non-$US buyers can afford to pay more. However, it’s the speculation that has arguably played a bigger role in recent times. Over the last few years there has been a huge increase in funds investing in commodities.

This makes sense as commodities are a useful diversifier and given their long-term return potential. However, speculative inflows into commodities became an avalanche in the last six months as investors piled into what seemed like a sure thing when other assets were going backwards.

Reflecting this, long speculative positions in commodities reached extreme levels.

This is illustrated for gold below. It is worth noting that base metals are less vulnerable on this front than precious metals, oil and foodstuffs.

Banks and listed property securities.

On the other side of the equation, the extreme losers over the last six months were the banks and other financials such as listed property securities. They have been hard hit by the sub-prime mortgage crisis and the resultant credit crunch which has forced up the cost of capital, reduced its availability and seen huge losses announced by global banks with worries of more to come.

The divergence between commodity plays and financials can be seen in the Australian share market.

While financial shares are down sharply over the last year, resources shares are still up solidly (buoyed by high commodity prices) with the result that resources have outperformed financials by 50% over the last year. See the next chart.

Reversal in fortune likely.

The past two weeks have seen some reversal in the commodities versus financials trade, with financials putting in a strong bounce as commodities and resources have softened a bit. While it’s unlikely to go in a straight line, we expect further out performance of financials over commodity plays for several reasons:

Firstly, US authorities seem to be pulling out all stops to stabilise the US financial system with the Fed putting in place various mechanisms to prevent another Bear Stearns. Similarly action by the US Government and Congress to stabilise the mortgage market is accelerating.

With financial shares having fallen 30-40% in both the US and Australia, price earnings multiples now well below historical averages and dividend yields very high it’s likely that a lot of the bad news is already factored in so the worst may be over for financial shares.

It’s interesting to note that US REITs (i.e. real estate investment trusts or the equivalent of Australian listed property trusts) which had a 40% fall from their high last year and led the slump in financials generally are now actually up 2% so far this year.

Secondly, the recent popular perception that commodities and hence resource shares have become some sort of “safe haven” against financial turbulence, inflation worries and a falling $US leaves them very vulnerable to a return of investor confidence.

That seems to be underway at least for now, inflation worries seem overblown and largely a function of high commodity prices anyway and there are some signs that the $US is trying to stabilise.

Thirdly, it’s likely that the next round of worries in relation to the US/global economy will centre on the real economic fall-out from the housing slump and credit crunch.

This is likely to affect cyclical shares such as resources far more than financials which have already factored in a lot of bad news.

Fourthly, while emerging countries are likely to remain relatively strong, their industrial production is already slowing and some further moderation is likely in response to the impact of the US consumer downturn on US imports. It’s also worth noting that the Chinese authorities are continuing to try and slow the economy and Chinese industrial production is showing some tentative signs of moderation.

In regard to the global downturn it’s worth noting that both leading indicators for the OECD countries alone and for the OECD countries plus Brazil, Russia, India and China suggest that momentum in commodity prices should be falling not rising. See the chart below.

Finally, there is still significant potential for an unwinding of large long speculative/overweight positions in commodities/resources and short positions in financials.


Some moderation in commodity prices and a rally in financial shares over the months ahead would have several implications.

Firstly, softer commodity prices will likely help remove some of the pressure on inflation that has been leading to mutterings of stagflation and fears that central banks would be constrained in cutting interest rates. To the extent that surging commodity prices were driving inflation worries they were actually becoming more of a problem than a benefit for share markets.

Secondly, softer commodity prices may weigh on the $A in the short term further delaying a run to parity.

However, with commodity prices and Australia’s terms of trade remaining high the $A is likely to remain relatively strong. We continue to see a range down to $US0.85 on the downside and potentially up to parity on the upside at some point.

Thirdly, just as financials led the bear market in shares they are likely to lead the eventual recovery. Shares generally have had a nice bounce over the last week or so, led by financial shares and look to be building a base for further gains. It’s premature to say that we have seen the end of the bear market in shares generally & the next 3 to 6 months are likely to remain rough.

However, it’s likely that the bulk of the damage has been done and any further weakness is likely to be more focused on cyclical shares. But if financials can hold their own and outperform it will be a good sign in signaling the start of the next bull market in shares.

This article is contributed by Australasian Investment Review – (AIR) You can subscribe for their free newsletter at

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