Wednesday, August 06, 2008
Commodity Correction Or A Bubble Bursting?
Are we seeing the collapse of the commodity cycle or as some may like to refer to it as the commodity bubble? CRB Index of 19 commodities fell 10% since June 30. This was the biggest monthly decline since 10.5% drop in March 1980, when US was in recession. Natural gas plunged 32% to lead July's biggest losers. Corn dropped 20% and nickel sank 16%.
Tight supply/demand fundamentals support bull case for commodities, but speculation may amplify price trends to overshoot or undershoot fundamentals.
Wasn't commodity supposed to be a safe haven to fight against inflation? We still see most countries grappling with inflation brought on by the huge upswing in the commodity prices over the last 4-5 years, in particular kicking in strongly over the last 24 months.
High inflation may eventually slow economic growth and demand. Expectations of monetary tightening and stronger dollar may be crunching the commodity bubble. Though many tend to cast aside the role played by speculators in causing commodity prices to overshoot, what we are seeing now should be a prime example of massive unwinding by speculators, which is not predicated on real fundamentals.
I still think commodities is in an upcycle and prices will recover very soon. That is because the demand for most commodities stems from emerging markets. Although there is some slowdown, the inherent demand is still very strong. The weaker US economy is not a big factor in causing the commodity prices to correct rapidly. What we are seeing now is massive commodity index fund liquidation, speculative unwinding and deleveraging.
We have to remember that despite the current sharp drop, the CRB Index remained up nearly 40% y/y. Which is to say that the last 20% price hike in commodity this year has been mostly pure speculation. I see oil prices stabilising around US$105-110, even so that would still be a 30% y/y increase.
Oil is the market leader and is also where most speculation reside. The rest are only following the herd mentality. Which is also why the sell down has been wholesale and not selective at all. Only when the selling has climaxed would the respective and unique fundamentals governing each specific commodity and soft commodity be properly re-priced.
That said, sharply lower commodity prices is supposed to be "good" for equities but we haven't seen that because the commodity is a bubble onto itself. The cashing up by commodity index funds will probably not find its way back into equities.
Equity markets have other problems at its back: the slowdown in the US; the US consumer spending contraction owing to housing problems; a tightening environment in most countries ... hence commodity prices is not the sole driving factor.
One big reason why equity markets did not move up higher is the "collateral damage" factor. We have seen clearly over the last 3 years how inter-related the markets are. A sudden collapse in one asset class can cause collateral damage to other asset classes as funds are hit hard, thus having to cover the asset contraction by selling other asset classes. Equities will still see the current commodity price collapse as a positive factor, but the dust needs to settle first.
p/s photos: Kang Hye Jung
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