Commodities on the slide – the long run-up stops for a breather

Raw materials' prices hit the skids last week following a 25% rise over the past three months. Oil fell by almost 10% after hitting a new record peak of $111.80 a barrel on Monday, gold sank by 11% in three days and on Wednesday notched up its worst one-day fall in over 17 years.

Platinum lost 10% and wheat was down by 17%. Base metals also tumbled. The CRB index, tracking 19 commodities, slid by more than 8%, the worst week since its inception in 1956.

The immediate cause of the slide appears to have been a rebound in the dollar following a smaller-than-anticipated cut in US interest rates by the Fed. There had been a "frenzied money flow" into greenback-denominated raw materials, says Paul Touradji of Touradji Capital management; a slumping dollar, fears of inflation, and tanking equities has boosted commodities' appeal.

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Relatively low margin requirements for commodity traders had meant that "they could leverage their bets to the hilt", says Edward Hadas on Breakingviews. Now funds are reducing their exposure and locking in profits, while some have been selling to cover losses in other markets. But this isn't just about speculators deleveraging. Investors seem to be worrying that the commodities rally may be ending as the world's largest economy slips into recession, hampering global growth and demand for raw materials.

A US recession will affect the requirement for oil note that American demand for oil products over the past four weeks has been 3.2% lower than a year ago and will prove a "headwind" for industrial metals. As Brian Hicks of US Global Investors notes, "we could see a lot of pressure on copper and the other metals".

Investors have been focusing on tight markets and hitherto robust demand from the emerging world, but the notion that developing markets can "decouple" is far from proven. As we have pointed out before, despite higher intra-regional trade, 61% of Asian exports end up in the developed world, while China and India will have trouble filling the void created by the weak US consumer since the latter spent $9.5trn last year, while the former bought just $1.65trn, says Ash Kumar of Morningstar.

It's interesting to note in this context that annualised world growth in world trade of goods was just 0.2% in the three months to January, down from 6.9% in the previous quarter, says Malcolm Maiden in Australia's The Age "a bearish commodities pricing signal".

Even a relatively minor slowdown in Chinese growth bodes ill for commodities, says Maiden, as China has been the main source of new global demand in recent years: it has accounted for a third of the increase in oil demand since 2003 and 66% of additional copper and aluminium demand. About half of the commodities China consumes are used for processing into exports, according to David Roche of Independent Strategy, so its commodities demand is highly vulnerable to the global consumption cycle.

Moreover, China is set to tighten monetary policy to dampen inflation just as exports are set to slide. The bottom line is that a 3% drop in China's growth rate to 8% is likely to remove the supply deficit from energy markets and send most industrial metals into surplus. The latter could slide by 20%-30%. "The big fall is coming."

Meanwhile, the Chinese government's efforts to slow growth in order to tame inflation, along with global contagion from the slowing US economy, suggests that oil could soon fall to around $80 a barrel, reckons Bart Malek of BMO Capital Markets. As far as agricultural commodities are concerned, the recent heavy sell-off "has taken prices back to areas more reflective of the fundamentals", according to Michael Coleman of Aisling Analytics.

Still, given how much hot money has flowed into commodities, there is likely to be more liquidation by funds in the near future, as Sri Jegarajah notes on CNBC.com. The grains may be the most vulnerable, given their strong recent run-ups; lean hogs or live cattle, both down by up to 11% this year, may prove safer bets for now.

None of the above changes the fact that we are in a commodities supercycle that has many years left to run: "the earth is being stretched to the limit" as emerging economies join the "affluent society", as Ambrose Evans-Pritchard puts it in The Daily Telegraph. There will always be cycles within supercycles, and energy and base metals now look set for a downleg as global growth slows.

Gold remained under pressure early this week as the dollar continued to firm. But, as SeekingAlpha.com puts it, "nothing has changed". The fundamentals are tight, the credit crisis is far from over and the US is looking set for a nasty recession, which implies further rate cuts so demand for a safe haven against uncertainty and the prospect of higher inflation is hardly likely to abate. "Use the dip to strengthen your positions."