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The End of the Commodity Super-Cycle


It was super-short. What's next?

Super-Short Super-Cycles

The commodity super-cycle proved to be super-short. The commodity boom is now officially a bust. So what happened?

The rise in commodity prices was driven by a number of factors. Debt-driven growth in major developed countries drove strong growth (both export and domestic) in emerging markets, such as China and India. This in turn fueled demand for resources. This fortuitous cycle drove demand in major commodity producers, such as Russia, the Gulf, Australia, Canada and South Africa, whose strongly growing economies fueled further growth globally by way of increased consumption and investment.

The effect of increased demand on prices was exacerbated by decades of significant under-investment in commodity infrastructure (mineral processing, refining, transport infrastructure, such as shipping, ports and pipelines) driven, in part, by low commodity prices.

The commodity boom was aided and abetted by investors, especially leveraged investors like hedge funds. Hedge funds used commodities to bet on strong global growth and catch the updraft in emerging markets indirectly reducing problems of direct investment. Commodities also provide significant leverage making them more attractive to hedge funds.

Traditional investors also embraced commodity investments. Commodities were seen as a separate investment class with low correlation to traditional investments enabling investors to improve investment returns and reduce risk simultaneously.

The last factor was inflation. Rising commodity prices and strong growth fuelled rising prices. This encouraged further investment in commodities as a hedge against inflation. The higher prices went the greater the threat of inflation and the increasing flow of funds into commodities. The momentum was irresistible.

Reverse Gear

In 2008, each one of these factors went sharply into reverse. The global financial crisis (or the GFC) resulted in reduced availability and higher cost debt, which in turn affected commodities via several channels. Leveraged investors were forced to liquidate their positions as leverage was reduced and investors redeemed capital. The reduction in debt also reduced global growth sharply and the demand for most resources.

The reversal was exacerbated by several factors. Rising prices and anticipation of higher demand had led to significant investment in certain commodities and infrastructure. The time needed to build capacity meant that this increase in supply coincided with reducing demand further pressuring prices.

The GFC also reduced cross-border capital flows and global trade. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than $165 billion - 36% of the $466 billion inflow in 2008, and only one fifth the record amount in 2007. The projected decline in capital flows is around 6 % of the combined gross domestic product of the emerging countries. This compares to a decline of approximately 3.5 % of combined GDP in the Asian financial crisis and 1.5% in the Latin American crisis.

Global trade is also declining. In late 2008, the World Bank forecast a fall in global trade volumes for the first time in over 25 years. The Baltic Dry Index, a measure of supply and demand for basic shipping materials, has fallen 90 % since mid 2008. Exports from Japan, Korea, Taiwan and China fell between 10% and 40% in late 2008 also signalling reduced demand for commodities.

Financing pressures also mean that it is increasingly difficult to finance trade. Some countries have had to resort to barter to obtain essential foodstuffs.
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