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Commodity prices are on a tear.
Since touching a 52-week low on May 25, 2010, the Standard and Poor’s Goldman Sachs Commodity Index has risen more than 40% (first chart). This broad index represents a diversified group of commodities including energy, industrial metals, precious metals, agricultural goods and livestock (second chart).
Oil prices have skyrocketed on unrest in the Middle East and North Africa to trade at over $106 per barrel on Monday and Tuesday before dropping back to around $100 today following the devastating earthquake and tsunami in Japan.
However, the only real oil supply disruption so far has been a reduction of 1.1 million barrels per day from Libya, CNBC reported on Thursday. This interruption amounts to just over 1% of daily supply. Of course, unrest could continue to spread throughout the region.
Many industrial metal prices spiked in 2010 on the back of a global economic recovery. For example, the Standard & Poor’s GSCI North American Copper Index surged by over 29% last year.
On the precious metal front, news of gold’s rise in value over the past few years has been unavoidable. Many analysts attribute gold’s spike to fears of runaway inflation or economic collapse or, while highly uncommon, a combination of both. Perhaps proof of this thesis: viewers of Glenn Beck on Fox News are bombarded with commercials for gold companies enticing them to profit from the yellow metal’s rise.
And agricultural prices have flourished too, including grain, corn, wheat, soybeans and sugar, partially driven by news of droughts in Russia and China, flooding in Australia and a wet crop in Canada.
But, interestingly, there have been no reports of an actual shortage of any mainstream commodity.
Many would argue that because markets are forward-looking, they are simply anticipating the shortages that will result from supply shocks and robust global demand. This may well be the case, only time will tell.
More likely, though, what we are really witnessing is the international trading community chasing “fast” and “easy” money.
With interest rates in the United States, Japan and the European Union hovering near zero and with all three major economies having engaged in some form of “quantitative easing” (buying bonds on the open market to inject cash into the financial system), the markets are awash in liquidity.
This pile of cash should ideally serve to bolster bank lending and help companies of all sizes raise equity and debt to fund acquisitions and research and development. The good news is that to some extent this is happening, but there is still a vast amount of money on the sidelines that has not been committed to long-term ventures.
A great deal of this short-term money rests in the hands of traders who are chasing commodity prices in an effort to make a quick buck. The argument that commodity prices are rising based on the legitimate inflation worries of long-term investors is oversubscribed. We believe the recent commodities boom is primarily a short-term trading phenomenon.
As evidence, the ten-year U.S. Treasury Bond closed today yielding 3.40%. If underlying inflation were a genuine fear, investors would be unwilling to tie-up their money for ten years in exchange for such a wretched interest rate. In other words, there is an extreme disconnect between Treasury yields and commodity prices.
Another indicator of inflation expectations can be found in Treasury Inflation Protected Securities, or TIPS. These U.S. government debt instruments receive automatic principal adjustments commensurate with the rise in the consumer price index, thus protecting investors from the erosive effects of future inflation.
The spread between the yields on a traditional Treasury and corresponding TIPS can then be used as a proxy for inflation expectations. As the table below indicates, the TIPS market is indicating subdued inflation over the next five, ten and even thirty years, particularly when compared to a CPI-based inflation rate of 3.23% since 1914.
Absent further supply shocks (no small assumption), here is our best guess for commodity prices over the next year.
Because it is hard to stop a runaway train, commodity prices are likely to continue their surge in the near-term, but a pullback becomes more likely as the weeks and months pass.
The economic pressure from higher commodity prices will slow global growth projections sufficiently to weaken speculative demand and subdue the commodity craze. In other words, high commodity prices in and of themselves will cause the rally to reverse course.
An additional downside risk to commodity prices could come from larger than expected supply. For oil, this could mean greater stability in the Middle East and North Africa. For agriculture, bumper crops could materialize in coming harvests.
On the policy side, a less accommodative Federal Reserve that discontinues quantitative easing or begins gradually raising interest rates would also provide a substantial headwind to commodity prices.
We believe paltry bond yields are too cool and overpriced commodities are too hot, whereas certain equities seem just right, despite the potential for temporary setbacks along the way. If the market enters a legitimate correction here, which is more likely than not, we will most certainly look for buying opportunities.