Precious metals are about to play catch-up

We are witnessing a generational bull-market in all types of natural resources (energy, food and metals). This boom in commodities is largely due to supply and demand imbalances plus the ongoing monetary inflation, which is adding fuel to the fire.

Today, the various central banks continue to pump money and credit into the system and combined with the rising per-capita consumption levels in Asia and Latin America, you can begin to understand why the prices of commodities are at record-highs.

Why the uptrend will continue

For sure, this sector has already risen considerably in this bull-market, however I suspect that the uptrend will continue for several more years. Firstly, back in 2001, natural resources were the cheapest they had ever been in the history of capitalism, so this advance has commenced from a very depressed level. Secondly, when adjusted for inflation (even via the bogus official CPI data which understates the inflation menace), commodities remain extremely cheap.

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These days, some analysts are claiming that this bull-market in commodities is solely due to monetary inflation and that supply and demand imbalances have no influence whatsoever. I tend to disagree with their assessment because constant monetary inflation has been our reality since the early 1970's when gold was removed from the monetary system YET the prices of commodities (energy, food and metals) declined significantly between 1980 and 2001. So, it is clear that the debasement of currencies alone is not responsible for the ongoing surge in the prices of commodities.

In order to have a lasting bull-market in any sector, supply and demand must be out of whack. In the case of natural resources today, demand is rising ferociously in China and India whilst supply is struggling. Consider the energy market as an example: At the beginning of this decade, China and India combined used to consume roughly 8% of the world's oil and today they consume over 11%.

Now, to illustrate my point that supply and demand are important factors, I would add that this rising demand (regardless of monetary inflation) would not have translated into a higher oil price IF there was an endless supply of oil. In the current scenario however, the oil price is rising because supplies are extremely tight when compared to demand. In fact, I would argue that humanity is staring "Peak Oil" in its face.

Today the average Chinese person consumes less that two barrels of oil per year and the average Indian consumes less than a barrel of oil per year whereas the average American consumes 25 barrels per year. After reviewing this data, you don't have to be a rocket-scientist to figure out that demand for energy in Asia can only rise in the future. And unless we can find a way to increase supply, the price of oil will continue to appreciate.

If you have invested in commodities, you will be thrilled to learn that apart from energy, the inventory levels of other resources such as base metals or food are also extremely depleted. And these stockpiles are low due to the sudden and unexpected surge in demand brought about by the rapid industrialisation and urbanisation of China, India and parts of Latin America. A growing percentage of the three billion people in the "emerging" economies are now putting immense pressure on the planet's resources as consumers, and the scramble to find more commodities is on. Exploration activity, whether for metals or energy, is at multi-year highs and I suspect that billions of dollars will be spent in the years ahead as nations desperately look for additional resources to feed demand.

Precious metals failed to rally

It is interesting to note that after the brutal correction in commodities last year, energy, food and base metals have recovered, however the precious metals have failed to rally. Moreover, if you compare the performance of the various commodities over the past five years, you will realise that industrial commodities (base metals and energy) have outperformed the precious metals by a wide margin. This was expected as the economic activity has been very strong recently, and gold is a counter-cyclical asset. No doubt, it has been frustrating for investors to watch their gold holdings drift lower for a year. Despite the recent underperformance, I continue to believe that gold is also in a gigantic bull-market, which has a long way to run.

You must understand that in the case of base metals (copper, lead, zinc, nickel and tin), changes in industrial demand, and physical supply cause prices to rise or fall. However, when it comes to gold, investment demand alone is the single most important factor that can make or break a bull-market. And the investment demand for gold is directly linked to the public's inflation expectations.

Inflation expectations

If the masses are worried about future inflation, they tend to convert their cash to gold as a store of value. On the other hand, when the public is calm about inflation, the reverse takes place.

Banks are in the business of lending paper currencies so it is absolutely vital for their survival that the public's confidence in the monetary system remains high and that inflation expectations remain under control.

Every central banker knows that if the public really understood the inflation problem, the monetary system would come under strain. So far, the central banks have done a fabulous job of managing the public's inflation expectations. However, I am of the opinion that this is about to change. As soon as the public realises that inflation is much higher than the official CPI data, we could see a stampede towards gold.

Recently, precious metals have drifted lower which is typical at this time of the year. In fact, the wonderful summer sale is on! Remember, corrections during a bull-market are opportunities rather than a problem. Once this consolidation is complete this summer, I expect precious metals to soar towards the end of this year.

Puru Saxena is a contributor to The Daily Reckoning free e-letter - an essential read for anyone who's interested in their money, and gives you the unbiased truth about the stock market, gold, oil, inflation, China, the future of UK house prices, and more...