The commodities correction: is the market in a bubble?
Not a bubble yet: the punters arenât drilling for oil in Hyde Park – yet. Copper mines arenât springing up in Soho – yet. No one is planting cotton on London Bridge. And the CEOs of resource firms arenât exactly replacing David Beckham on the cover of fashion magazines. So itâs not time to say commodity markets are in bubble territory. That said, there is a real possibility they have hit a short-term high.
I say short term because thereâs abundant proof that the entire commodities complex is in the midst of a long-term super-cycle secular bull run. Take a look at the two charts and youâll see what I mean. The first shows the Goldman Sachs Commodity Index (GSCI) since 1969, unadjusted for inflation. In nominal terms, the index is in record territory. Itâs been quite a super-spike since the bottom of the commodity cycle in 2001. But in real terms, adjusted for inflation, the recent move up in the GSCI is more accurately represented for what it is – namely, the first of many powerful moves up in global commodity prices. That means if you havenât already stocked up on the best commodity shares in the world, you should be thinking about doing so. And that also means a correction in commodity prices would be welcome: right now, lots of commodity stocks are looking too expensive to buy.
This week, we present you with the top nine commodity shares you should own⌠if you can get them at the right price. These include three UK-based shares and six global commodity and resource giants. Many of these shares have been fully valued for some time now, but a few in oil and energy remain cheap on an earnings basis. If you see a late-spring/early-summer correction in commodity prices, youâll be able to buy at a discount, or at least below todayâs prices. Then it will be time to pounce.
To me, there are three clear signs that the top is in for commodity shares, at least for a few months: copper prices, oil prices, and contracting global liquidity/rising interest rates. Take copper first. Earlier this week, copper futures hit a record high on the London Metal Exchange (LME). Copper for delivery in three months went for $3,316 a metric ton – the highest price for that contract since 1986. Spot copper prices moved up $20 to $3,307. Copper is also being driven up by Chinese demand. Bloomberg reports that Chinaâs State Reserve Bureau wants to add 10,000 tons to Chinaâs copper reserves in the near future. The Chinese seem to be taking advantage of the dollarâs recent rally to trade their greenbacks for real assets. This sounds good, but there is a fly in the ointment: in macroeconomic terms, record copper prices do not traditionally predict booming growth, but recession.
The commodities correction: copper prices and oil prices
Copper is sometimes referred to as âDr Copperâ for its ability to diagnose the future of the market. High copper prices are inflationary, and when copper peaks, itâs often a leading indicator of either slower economic growth, or outright recession. With copper prices at or near all-time highs, inflation has finally made its way into raw materials and that means it is set to slow global growth.
Itâs not just copper either. The question on every analystâs lips is: âwhen will high oil prices begin to affect the worldâs economy?â Based on recent data, the answer is that they already are. Industrial production in France, the third-largest economy in Europe, fell by half a per cent in February. French factories, utilities and mines suffered as Brent crude began a climb that would take it to an all-time high of $55.70 per barrel in late March. Europeâs biggest economy felt the thirst, too. German industrial production fell by the largest amount in two years. This combination of bad news led the European Commission to cut its 2005 growth forecast from 2% to 1.6%. European Central Bank president, Jean-Claude Trichet, said he sees âno clear signsâ of momentum or growth in Europe. Anglophiles should stifle the urge to gloat. The Paris-based Organisation for Economic Cooperation and Development (OECD) reported that its outlook for economic growth in the US has worsened. The OECDâs leading indicators, which include energy prices, fell for the first time in three months.
Both copper and oil prices are telling us that inflation has picked up globally. Commodity prices are now so high they are putting the breaks on growth.With lower growth ahead, demand for commodities will slow and prices will fall – at least in theory. I say in theory because the wild card in this scenario is that Chinese and Indian demand has fundamentally altered the demand curve for commodities. Or, put another way, global demand for raw materials is increasing, supply isnât. Thus weâll see higher prices despite slower growth.
It is possible that commodity prices will stay high even if growth in all three major economic zones is less than robust. But I think it far more likely that, as growth slows in Europe and America, so will European and American demand for Chinese goods. Chinaâs demand for raw materials will abate (somewhat) as its global customers run out of cash. At a certain point, high commodity prices are a net negative for everyone around the world who must pay top dollar for increasingly scarce goods. We may have reached that point.
The commodities correction: the liquidity crunch
If Chinaâs demand is fuelled by the imperative for internal growth – and not the desire to export goods to the rest of the world – you might argue that the floor for copper and oil prices is much higher than itâs ever been. But there is a third factor that suggests a correction in commodity prices is in order. The worldâs money stock is growing at its slowest pace since 2001, according to figures from the OECD. The recent (albeit probably temporary) strength in the dollar has had an unintended consequence: itâs meant foreign central banks have not had to increase the supply of their own currencies in order to buy dollars. This is the favoured strategy of exporters who seek to remain competitive in the US market by keeping their currencies relatively cheap compared to the dollar.
The International Monetary Fund reports that annual growth in international currency reserves has slowed by 8% in the last year. In Asia in particular, dollar strength has slowed money supply growth in Taiwan, China, Korea, and Hong Kong. There is, not surprisingly, a high correlation between global money supply and commodity prices. The more money in circulation, the higher the prices go. And in a world rampant with money growth, you get âtoo much money chasing too few assetsâ – a recipe for exactly the kind of across-the-board inflation in asset classes that weâve seen since the spring of 2003. In a recent article in Strategic Investment (www.strategicinvestment.com),Dr Marc Faber wrote, âit would appear that global liquidity is past its peak and is now decelerating rapidlyâ and âonce global liquidity shrinks, commodity prices easeâ. Global liquidity – as measured by Foreign Official Dollar Reserves – seems to have peaked when the dollar rally began early this year. And as Dr Faber says, if it decelerates further, âwe should expect the upward pressure on commodity and oil prices to easeâ.
How severe will the correction in commodities be? And when will it be time to buy? Weâll keep an eye on this over the coming months, but we already know what weâd like to buy. Below, weâve compiled a list of our nine most-wanted stocks to buy post-correction.
Dan Denning is the editor of Strategic Investment and author of The Bull Hunter (John Wiley & Sons, New York, scheduled for release on 28 May).
The commodities
correction: nine top shares to buy
The following firms have a global business servicing a global market and are big enough to survive a correction. Three are UK-based, but operate globally; the others are based in the US, Mexico, Australia, China, and Korea. Itâs an international mix of shares that belong in the portfolio of any long-term commodities bull.
Rio Tinto Plc (RIO.L) Whatâs not to like about one of the largest miners in the world? It has big reserves of industrial ores and mines coal, aluminium, copper, diamonds, lead and gold. It operates in North America, Australia, New Zealand, Africa, and southeast Asia.
BG Group Plc (BG.L). Arguably the single-best natural gas investment, itâs making inroads into the liquid natural gas (LNG) market. It operates on four continents and profits in all of them.
Tate & Lyle Plc (TATE.L). Soft commodities have received less attention than mining and energy stocks. But in the universe of sugar, Tate & Lyle is the best. Of its customers, 41% are in America, where the low-carb Atkins diet is falling out of favour.
Suncor Energy, Inc (SU). An integrated US energy share, which means it explores for new resources, acquires them from other, smaller firms, and even refines and transports crude oil. At a forward p/e of 24, it is dearer than Anadarko Petroleum, but worth scooping if they fall.
Valero (VLO). The largest independent refiner on Americaâs Gulf coast, Valero benefits from the crunch in global refining capacity. It is up 54% since late January. Itâs one the few US refiners that can handle heavy or âsourâ crude, the kind of oil coming out of the Gulf of Mexico, and more prominent in global production that light crude.
Cemex (CX). Cemex recently acquired UK-based RMC Group, but its portfolio of cement operations is truly global. It can produce over 80 million tons of cement a year. China produces more than 40% of the worldâs cement, but consumes over 640 million tons per year, leaving a huge market for Cemex.
BHP Billiton (BHP). Australian-based BHP is one of the worldâs largest diversified mining firms. Its exports of iron ore to China for steel production have driven up the share price.
PetroChina (PTR). It may be Chinese, but itâs the 24th-largest firm in the US, by market capitalisation.
Posco (PKX). This Korean firm makes 28.9 million tons of crude steel a year and trades at four times next years earnings.
Category: Economics