Technically, Commodities Are Building a Bottom

Guild Investment Management  |

The Thomson Reuters Continuous Commodity Index (CCI) bottomed at about 500 in July, and has gradually begun to build a base slightly above that point.  The index consists of 17 commodities that are continuously rebalanced: cocoa, coffee, copper, corn, cotton, crude oil, heating oil, live cattle, hogs, natural gas, orange juice, platinum, silver, soybeans, sugar, and wheat.

The fact that the CCI is bottoming and building a base is correlated with the demand for commodities in China.  The government’s brief tightening measures of a few months ago have ended.  China has made it clear that they will continue to tighten conditions for banks, and tighten the creation of credit by banks, with more frequency, but we expect it will be for short periods of time.  These periodic economic tightening exercises by China should last for 3 to 6 months, but will allow China to continue to grow their economy. 

We think that food prices may moderate in months to come; but in spite of that fact, we are bullish on global commodity prices for the long run.

What Will Drive Commodities?

1.  World economic growth is continuing and expanding.

First, China has been growing strongly for decades, and their continued and increased imports of minerals are not going to stop anytime soon.  They import minerals from Brazil and Australia.  They also continue to import energy, gold, timber, food grains, vegetables, and many other commodities from other countries.  Second, Europe’s economy is improving, and this leads to demand for goods which are exported by south and southeast Asian countries.  Third, the U.S. economy is improving (see below).  We expect global economic growth of about 5 percent in 2014.

2.  Liquidity is excessive in many countries.

This has been the case for several years.  Yet because bank loans have not increased in many countries, the multiplier and accelerator effects created by the fractional reserve lending system have not yet been able to turn this liquidity into faster economic growth.

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When the banking system gets back to lending, we will see more rapid economic growth and eventually we will see currency depreciation and price escalation.  But this is not happening yet.  Today, inflation is not a problem in the west, and it is moderating in the Asian world.  The excess liquidity that is being created in many countries is not going into bank loans and is not yet creating inflation in goods and services -- so the floating pools of money are seeking a place to earn a return, and real estate and stocks are where investment has been flowing.  This is causing a rise in the price of stocks and of real estate in the U.S., Asia, and much of Europe.  Investment is now beginning to move into commodities, and this will be bullish for commodity prices in years to come...  The commodity rally may not occur in 2013, but the seeds of a return to higher commodity prices are being sown.

3.  Cost-cutting and supply decreases in many minerals.

During the run-up in commodity prices through 2011, many commodity-producing firms made unwise decisions to go after high-cost new production, based on faulty assumptions that prices would remain high and would rapidly rise further.  Their subsequent cost-cutting efforts have resulted in reduced production capacity…and supply.

4.  A moderating influence mentioned above, food production is increasing in both the developed and developing world.

As we noted above, in the developing world, where food makes up a much larger percentage of the average family budget than in the developed world, production is up thanks to increased agricultural capital expenditure.  In the developed world, soybean, wheat, and corn production is up as well, and this means lower grain prices and more animals on feed -- these events should lead to reduced food price inflation in the developed world in 2014.

In the U.S., rationality is prevailing, and the support for the irrational corn ethanol mandate is waning.  Budget constraints are challenging the associated subsidies.  Gasoline consumers and taxpayers are penalized (1) when ethanol mandates create higher prices for gasoline, and (2) when they fund subsidies to produce ethanol which benefits farmers.  In spite of the removal of presure on food prices, we see higher demand for raw materials and energy as consumption by the developing world continues to take off.

5.  Energy companies are lowering their costs due to the implementaton of new technologies.

In the world of oil, there are many new technologies that we have discussed in past letters that will be utilized to continue the long-term technological revolution in energy production that has been running for decades.  The new technologies will decrease the cost of energy, but the increased demand -- especially for non-coal energy -- will create a supply/demand balance where higher prices are expected for years to come.

Final Message on Commodities

We believe that gold and silver are a good buy on dips over the next few months.  Gold and silver are building a bottom which may take some time to complete.  Our strategy is to buy on dips while this bottoming process continues.  Accumulating over the next few months will prove to be wise, in our opinion.

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