May 12, 2017

Why Commodities is in a Sweet Spot to Invest in

The idea of business cycle investing is simple. Allocate more of your resource based on the different stages of the economy cycle. Invest in stock and property during the recession and early recovery of an economic cycle. Invest in commodities and financial related stock during the growth to stagnancy stage of the economic cycle as inflation and interest rates start to accelerate. The last stage whereby the economy swings back into recession is the time to hold on to cash and bonds.

This simplistic assumption held true for the past century when United States is the sole super economic superpower and the health of the global economy rests on the rise and fall of US. However, the picture gets muddled in recent years due to the rise of commodities hungry powerhouse: China.

The commodities market in the past decade seems to be aligned more closely to the economic cycle of China, rather than US with the rise and fall of commodities prices in conjunction with the health of the Chinese market. In the past few years, the Chinese economy has been growing at a much slowing pace moving from the Stagnancy phase into a soft/hard landing scenario which should be considered as a form of short term recessionary phase in the economic cycle, leading to a commodities market crash from 2011 to 2016. Many investor has been asking me: US is seems to be recovery/growth phase of the economy. Why isn't it supporting the prices of commodities?

The main reason why is due to strong deflationary pressures within US as the result of the after effect of the 2007 global financial crisis. The recovery stage took a longer than average 5 to 6 years, before swinging into the growth cycle in which inflationary pressures started to build up again and the US central bank began to raise interest rates in anticipation of more inflationary pressure. Simply put, the commodities rally of 2008 to 2011 rested mainly on the shoulders of China, which was bolstered by a shot of money printing, to offset the effects of the global financial crisis.

The question right now is that China will probably go through a period of prolonged slow-down, with the gradual popping of more asset bubbles within some of its more overbloated industry, is there room for commodities to rally back to its precious glory days.

The Story of US and Europe

Meanwhile in US and Europe, growth is starting to creep back into these developed nation with the unemployment rate at US at a low and Europe economic data picking up. Unlike China, which went on an infrastructure building spree during its developing years, developed countries have relatively less infrastructure needs and hence will be a lesser drivers for commodities demand as compared to the needs of China. Having said that, US is still one of the largest consumer of commodities product in the world and its oil consumption in 2015 is that of China, India and Japan combined. The recovery of its economy will no doubt bring a new spurt of demand in the commodities market. Other positive developments for the commodities market includes  China's one belt one route initiative, which can potentially spur an infrastructure building spree in other parts of Asia. What is also interesting is also the divergence between the stock market and the commodities market occurred during the 1990s period whereby the crash of the commodities market coincided with the Asian financial crisis whereby the miraculous growth of Asian economies came to an erupt stop and its demand for commodities shrank. The commodities market rallied strongly until the economic cycle of the US also went back into the recession mode due to the crash.

Breaking it down

While the story behind commodities is not as strong as the China story, the advancement of the economic cycle of developed nations from recovery to growth will stabilize and spur the prices of commodities in the next few years. The commodities crash has also put many commodities reliant countries and corporations into recession and bankruptcy. As the crisis deepens for many of these companies, the global supply of commodities will start to shrink while the demand will increase at a lower, abit gradual pace thanks to the rebalancing of needs from China to Developed Nations.

With so many other asset classes at relatively high valuation, the crisis beaten commodities sector seems like a sweet spot to invest in.

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