Three reasons why Stephen Roach is bearish on commodities

published 29 September 2006

For the second time in five months, commodity markets are coming under serious selling pressure. I don't think this is a fluke. The demand underpinnings for industrial materials could well be deteriorating at precisely the time when yield-hungry investors have legitimized commodities as a serious asset class. This challenges the increasingly popular notion of the commodity super-cycle and suggests that prices of economically-sensitive energy and non-energy industrial materials may well have seen their peak for this cycle.

Commodity prices: what's the damage?

Most of the broad commodity indexes have tumbled sharply in the past several weeks. Declines range from 8% in the CRB futures index to 9% and 14% for the S&P and Goldman Sachs indices, respectively. Meanwhile, spot oil prices are down 17% from their highs two months ago, and there have been sharp declines in copper (-7%), aluminum (-9%), zinc (-10%), and nickel (-12%). While these adjustments are significant trading events, they barely make a dent in the major run-up in commodity prices that has occurred over the past three years. But cyclical turns have to start somewhere. And as I see it, the recent sell-off in commodity markets may well be a hint of more serious action to come.

The cyclical bear case for commodities has three legs to its stool - the Chinese producer, the US housing market, and the asset allocation call. The China factor is, by far, the most important element on the demand side of the commodity equation. Over the 2002-05 period, China's share of the total growth in global consumption of industrial materials was off the charts: 48% for aluminum, 51% for copper, 110% for lead, 87% for nickel, 54% for steel, 86% for tin, 113% for zinc, and 30% for crude oil (see Chapter 5 of the IMF's September 2006 World Economic Outlook as well as my 2 June dispatch, "A Commodity-Lite China"). China's powerful growth dynamic is both rapid in the aggregate and skewed heavily toward exports and fixed investment -- a sectoral mix that favors commodity-intensive activities such as urbanization, infrastructure, industrialization, and residential construction. As long as this growth dynamic remains intact, China's demand for commodities would appear to be insatiable. That is what is now changing.

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The Chinese government has once again sounded the overheating alarm. And like the case in 2004, the authorities have taken action to slow this white-hot economy. Monetary policy has been tightened and a series of administrative edicts have been issued aimed at slowing down investment projects in a number of "hot" sectors - namely, aluminum, cement, steel, coal, glass and other building materials, autos, and residential ;property. In an economy that is as fragmented as China, the quantity restraints imposed by the central planners are likely to have greater impact than the financing restraints imposed by the central bank. The August data flow just released out of China points to the first signs of the long-awaited cooling off -- meaningful deceleration in the growth rates of both industrial output (+15.7% y-o-y in August versus +18% in June and July) and fixed investment (+21.5% in August versus +30% in the first seven months of 2006).

While one month's data should never be taken all that seriously in any economy -- especially in China with its notorious data problems -- these signs could well be indicative of a legitimate turn to the downside. If that's the case and Chinese industrial output growth decelerates further into, say, the 12-13% y-o-y zone, then it is almost a mathematical certainty that this slowdown would produce a major downturn in global commodity demand. That follows from China's dominance in driving world commodity demand described above.

The US housing market is the second leg of this stool. I continue to believe that a post-housing bubble shakeout is a distinct negative for US commodity demand. This works through two channels - the residential construction impacts and property-related wealth effects on personal consumption. The former remains a heavily commodity-intensive activity; for example, the Copper Development Association estimates that 46% of total copper usage is earmarked for building construction - with about two-thirds of that total going to the residential homebuilding sector. As homebuilding goes, US commodity demand will most assuredly follow.

Moreover, the wealth effect of ever-rising home values may have added as much as 0.5% of "extra growth" to real consumption in the US over the past decade -- at least that's the difference between average annual real income growth (3.2%) and real consumption growth (3.7%) since 1995. As the housing market tanks, the wealth effect could well work the other way as consumers elect to rebuild income-based saving rates, which have fallen into negative territory for the first time since 1933. That will not only produce an added hit on US commodity demand, but since end-market demand in the US is the biggest source of Chinese exports, it will also act as a further depressant on the Chinese economy. That underscores the distinct possibility of a "double whammy" on China's commodity demand - driven both by its internal cooling-off campaign as well as by the collateral damage from post-housing bubble adjustments in the US.

The asset allocation play is the final piece of this puzzle. The recent multi-year upturn in oil and materials prices has legitimized commodities as a serious asset class for institutional and even some retail investors. Virtually every institutional investor I visit these days now has a commodity department. Even retail investors have jumped into these markets. Assets under management by Commodity Trading Advisors (CTAs) now stand at over $70 billion - essentially triple the total three years ago and up at about a 40% average annual rate over that period (see Chapter 1 of the IMF's September 2006 Global Financial Stability Report). Moreover, this most likely is only a small portion of the commodity asset class.

This changes the character of commodity markets - transforming them from one of the best real-time gauges of economic activity to markets that have taken on some of the trappings of financial assets. That exposes commodity markets to Shiller-like "amplification mechanisms" that have exaggerated price movements in other asset classes in the past (see Robert Shiller, Irrational Exuberance, second edition, 2005). Such was the case with a broad array of metals and other industrial materials that experienced near parabolic price increases last March and April.

Just as return-hungry investors chased these markets on the upside, they could well run like lemmings to get out on the downside. When the search for return and the preservation of value comes into play, an asset class behaves very differently than a market driven purely by fluctuations in physical supply and demand. This is a new and important dimension of the commodity play. In and of itself, the asset allocation factor doesn't point to a downturn in commodity prices. But it does suggest that meaningful price declines triggered by the fundamental factors noted above could well be amplified by defensive strategies of commodity investors.

The multi-year run in commodity prices has been a transforming event in the global economy and world financial markets. It has become conventional wisdom to believe that this super-cycle has years to run on the upside. I am deeply suspicious of this conclusion. History tells us that commodity prices have some of the greatest mean-reverting tendencies of them all. I am not looking for a crash in commodity markets. But as China slows and the US property bubble bursts, a broad and protracted downturn can be expected in most economically-sensitive commodity markets, including oil. Investor involvement in these markets can only compound the downside.

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