Commodities: boom, bust, or supercycle?

It can be said with some confidence that these days nearly everyone agrees on a whole raft of macro assumptions. We all agree gold is going up in price, as are all other commodities. We all believe China is the main driving force behind this boom. We all believe sectors that feed off commodities, such as shipping, will continue to boom, and we all believe trade will keep growing. On the other hand, we all believe that the US dollar and most first-world equities are too expensive, and should thus fall in price.

Unfortunately, one of the inconvenient things about financial markets is that whenever you're pretty sure everything finally looks predictable - and this is especially true if everyone agrees with you - everything will almost certainly change. The most obvious reason for this is that as long as everyone you know ends up being a reasonable proxy for the whole market, by the time they all agree, they've all placed their bets and there's no marginal buyer left.

And so it appears to be this time too. For the last couple of issues of MoneyWeek, I've been arguing that at least two parts of the China/commodities story have fundamentally turned the corner. The first is shipping, which is now facing a traditional cyclical downturn, triggered by new capacity coming on stream. Although share prices in this sector are still quite high, there is ample evidence that the tanker market specifically has already entered the downturn. Tanker rates from the Gulf to Japan are already a whopping 83% below their November highs.

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Then there's steel. Chinese demand for this once appeared to know no bounds. Net imports of the stuff rose from a long-run average of 500,000 tons a month to three million last year, but have now so savagely reversed that a couple of months ago China was briefly a net steel exporter. The Chinese have added new capacity since 2003, equivalent to the total production capacity of their mighty industrial neighbour, Japan. Now, rather than importing, they're threatening to flood the Asian markets. Japan's Tokyo Steel has just been forced to announce its first price cuts for steel sheet (of up to 14%) since 2001.

But dramatic turnarounds aren't restricted to steel and shipping. A central part of the global-commodity story is gold, which has been rising for the last few years. But even this has just suffered a nasty blow: this week it broke out of its four-year price uptrend. Historically, gold and the dollar have always moved in opposite directions, so the corollary of gold's break, even according to the gold bugs, must be that the US dollar is once more a buy - and sure enough, as the dollar index chart shows, the greenback is again on the hoof.

How, you might ask, is this possible, given the famous US deficits? The answer is that currencies are purely relative. Yes, the dollar might be an intrinsically lousy currency, but if the euro, sterling and a host of other currencies are too, then the dollar can easily go up. Don't forget that the euro has recently been described as fundamentally the worst currency in the world, and sterling suffers from every affliction that affects the dollar, but with the added burden of a consumer-confidence crisis.

Of course, it's not that the whole China and commodity story is suddenly finished, rather that it is making a generational change into the next stage. From now on, China will still absorb vast quantities of iron ore and coking coal, for example, but not so the basic steel products you make from them. For all these manufactured commodities, the China effect will be deflationary, not inflationary. This is certainly the message that the first world's bond markets seem to be conveying, with their recent sharp gains (and corresponding falls in yields) and deflation is the very opposite environment to the one that commodities thrive in. Think instead about a good, old-fashioned cyclical downturn, exacerbated by the fact that this one has been particularly good for all the basic hard-commodity and smoke-stack type sectors. From now on, a super-low p/e in a commodity-related stock should be seen as a warning sign (it suggests an earnings peak), debt gearing is to be avoided and investors should look at the historical earnings of firms before they buy: those that weren't earning money two years ago probably won't be earning anything much again by next year. Investors would be wiser to buy into some nice, safe, cheap defensives, such as pharmaceuticals.

As for commodities, the raw material ones are much more likely to hold up than the manufactured ones, but it's a benign storm indeed that only smashes your neighbour's boat. I feel they are all at risk of profit-taking for the time being, and the main reason I say that is that the gold-chart break, confirmed as it is by the dollar recovery, is giving us a double warning that markets aren't going to be so nice and easy to read this year as we'd all hoped.

Commodity markets are at the start of a long-term bullish trend, says Dan Denning. Stay in.

There are three serious arguments for selling commodities and gold and buying the dollar. The first is that China is becoming a producer of commodities (for example, steel) and not just a consumer, and that will have a deflationary effect on commodity prices in the same way it has on prices of textiles and consumer electronics. The second is that the recent commodities rally was merely a cyclical rally that has run its course. The third is that the dollar is "less bad" than other currencies, and as the dollar appreciates relative to the yen and the euro, commodities, which are priced in dollars, must necessarily cool.

But none of these factors go any way to overriding the bullish long-term dynamic in the market. The Goldman Sachs Commodity Index may have completed the first part of an "up leg" in a long-term bull market, but it is far from the last. Bull markets do not go up in straight lines, nor can China's economy grow at double digits without the occasional cooling off period. But even slower rates of global growth will not affect the fundamental reason to be bullish on commodity stocks: increased demand for resources without an increase in supply. There will be exceptions. As James Ferguson notes, China has added so much steel-producing capacity in the last three years that it may become a net steel exporter. But in other key raw materials, such as food and energy, it will be a net importer for years.

A recent Business Week article shows that China will consume over 2.2 billion tons of coal by 2010, running a coal deficit of 330 million tons. China is already the world's largest producer of coal. It just happens to be the world's largest consumer as well. It's hard to be a net exporter of a commodity you can't get enough of. Or, as Wang Xianzheng, the vice-director of the State Administration of Work Safety recently said, "The present size and scale of China's coal industry are far from being able to meet the country's futuremarket demand." This imbalance is symptomatic of the larger commodities conundrum the world faces, and is the best evidence that the current commodities rally is not merely cyclical but secular. As far as I can see, this means the dominant influence on share prices in the coming years will be the raw demand across the world for the basic materials of civilization. It will take trillions more in investment in energy, food and mining sectors and a great deal of time (you can't build nuclear power stations overnight) before new capacity begins to offset growing demand.

That brings us to the third argument for selling rather than buying commodity stocks: the dollar. The dollar bulls will have you believe that you can't keep a bad currency down. The greenback has risen 8% against the euro since the beginning of 2005, and according to global-currency traders the buck is back, and that means weak commodity prices. I doubt it. To my mind, there is a great deal less to the dollar-bull market than meets the eye. For each and every reason to "buy" the dollar, there's an opposite and more powerful reason to "sell" it. In the greater monetary scheme of things, the dollar is still what investor Doug Casey calls "the unbacked liability of a bankrupt government". America's deficits are not getting smaller and the willingness of foreign governments to finance them appears to be on the wane. Since last August, the Japanese have cut their holdings of US Treasury bonds by $19.4bn. That's not a huge fall, but the important point is that they are not increasing their buying of US bonds. The Chinese have increased their holdings, but not much, from $201.6bn in August to $223.5bn in March.

In fact, the only notable increase in purchases comes from Caribbean banking centres, or what I call off-shore hedge funds. Since August, the hedge funds have increased their Treasury holdings by 44%. But between August and December, their holdings actually declined to $71.4bn. So, since December, hedge funds have increased their Treasury holdings by a whopping 92%. And how long do you think this will last? Hedge funds, unlike Japan or China, have no interest in keeping the dollar strong. They are merely out to make money where they can, and right now they make a decent yield on dollar holdings. But we must not forget: hedge funds will sell when a better trade comes along. Then who'll pick up the slack?

All of which is to say that there is a lot less support for the dollar than meets the eye. US bonds are distressed debt, owned increasingly by fund managers desperate to eke out a few basis points here and there. This is not the bedrock of a solid currency. So, when the dollar next falls, it will fall against Asian currencies, gold, and commodities. If the dollar-rally story is shallow, the commodity-bull story is still deep and rich. A 25-year period of under-investment in productive capacity in commodities is not simply erased by an 18-month bull market in commodity stocks, nor a long-term bear market in the dollar reversed by a few months of hedge-fund buying.Dan Denning is editor of Strategic Investment and author of The Bull Hunter, which is released this month by John Wiley & Sons.