Will inflation stoke up the dying commodities boom?

In 2008, the benchmark CRB commodities index slumped by 36%. But some analysts now think that aggressive fiscal and monetary policies could improve the outlook for raw materials in the second half of 2009 or early next year.

In 2008, commodities 'fell off a cliff', with the benchmark CRB index slumping by 36%, the worst drop since its inception in 1956. Early this year they tried to scramble back up, with oil rebounding from $34 a barrel to around $50, and nickel and zinc futures gaining around 30% before easing again over the past few days. The slide is unlikely to be over yet. The key issue for raw materials is that the synchronised global economic expansion that underpinned the bull run of the last few years "has morphed into a synchronised global recession", says the Australian Financial Review. With Europe, Japan and America all shrinking together, and growth in the developing world rapidly slowing, it's no wonder the World Bank recently warned that global GDP could contract for the first time since World War II. And as leading indicators continue to deteriorate, the prospect of a recovery is slipping "even further into the future", says Citigroup.

Base metals look vulnerable...

The slowdown in China, the top consumer of most base metals, bodes ill. RBS reckons GDP growth will total just 5% this year, the weakest since 1990. Its manufacturing sector, worth 43% of GDP, has shrunk for five consecutive months and exports have slid for the first time in seven years. And the government's fiscal stimulus package is unlikely to be sufficient to offset weak investment in the mining and manufacturing sectors, says Deutsche Bank. As demand has fallen away, supplies have been increasing; nickel stocks on the London Metals Exchange are at their highest levels since 1995. In the aluminium market, where Merrill Lynch now expects Chinese consumption to rise by just 2.8% this year (down from 40% in 2007), they finished last year at a 15-year high, according to Deutsche Bank, which expects a "significant supply surplus" in copper and zinc too this year. Falling production won't be significant enough to balance markets this year. So any rally in industrial metals prices in the first half of this year is a selling opportunity. It reckons nickel will average $7,716 a tonne in the first quarter; it is currently over $11,000.

...and so does oil

Don't count on a quick recovery in the oil price either. Global oil demand dropped for the first time since 1983 last year and is set to slide further; and inventories in the developed world will reach their highest level in ten years in the next two months, lowering prices to $30 a barrel in the first quarter, according to Goldman Sachs. Opec production cuts will take time to gain traction against the sharp fall in demand, says Deutsche Bank, which suggests that the average price of oil will still be $40 in the last quarter of 2009.

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The return of inflation

Some analysts are pencilling in an improving outlook for raw materials in the second half or early next year as aggressive fiscal and monetary policy averts a deflationary slump. Whether it does or not, however, government efforts to tackle the malaise portend higher inflation as governments print money to revive economies. Inflation, moreover, is a convenient way of reducing the "monstrous amount of debt" that governments are taking on in their fire-fighting efforts, notes Merrill Lynch. An inflationary environment is good news for hard assets, such as commodities, and especially good news for the hardest asset of all, gold. We could see a rise in base and precious metal prices later this year as investors begin to anticipate a return of inflation.

Food price rallies are on their last legs

Last year many investors hoped that the inexorable rise in the global population and demand for food would bolster agricultural raw materials' prices in a global downturn. But this slowdown has shown that while everyone must eat, "they can eat less or more cheaply", says David Fuller on Fullermoney.com. What's more, "supply can catch up much more quickly" than in the base metals sector, with "a good crop cycle or two". Rising supplies and easing demand, along with the global flight from risk, saw wheat prices fall by more than 50% last year.

Nonetheless, many agricultural commodities are trading at major discounts to their long-term average in real terms cotton is around 60% below its average price since 1972 while the scope for sudden supply disruptions in the agricultural sector has meant that it has been able to rally during downturns, says Deutsche Bank. Moreover, some markets remain tight, with corn and wheat inventories still historically low. So the sector is worth keeping an eye on: there may be some upside in cotton, where US plantings will fall to their lowest levels in over a century.

The recent cocoa rally may be on its last legs, however. Prices have hit a 23-year high as supplies from the Ivory Coast, a major producer, are a third below last year, and global stocks are already at a 20-year low. But Fortis points to the prospect of falling demand and says the worst-case scenario on the production side has been factored in.