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Commodities and the Boom and Bust Cycle

by xyonent
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It’s always interesting when commodity prices rise. The market creates various stories to suggest why prices will continue to rise indefinitely. This is true for everything from oil to orange juice to cocoa beans. For example, Michael Hartnett of BofA recently said:

The 40 years from 1980 to 2020 were a denflationary period. Thanks to fiscal discipline, globalization, and peace, the markets saw “deflationary assets” (Treasuries, Corporate Bonds, S&P, Growth Stocks) outperform “inflationary assets” (Cash, Commodities, TIPS, EAFE, Banks, Value). As shown below, the 40 years of “deflation” was 10% per year while “inflation” was 8%.

But the regime change of the past four years has reversed the roles, and now the “great” inflationary assets are earning 11% per year while deflationary assets are earning 7% per year.”

To be clear, this is not the first time the market has gone “commodities crazy.” The most recent was in 2007. “Peak Oil” But it’s important to note that this time is no exception: As shown below, commodities periodically experience performance spikes, becoming the best performing asset class for a year or two, before suddenly reversing performance and becoming the worst performing asset class.

Its performance “Boom and Bust” This has been a trend since the 1970s. The chart below shows the performance of commodity indexes over the past 50 years. On a buy-and-hold basis, investors have seen a total return of 40% on their investment. This is because commodity prices have seen big spikes followed by big crashes.

So that raises a big question. Why do commodities periodically spike and crash?

Why do commodities rise and fall sharply?

The problem with the idea that there will be a structural shift towards commodities in the future, and why it hasn’t happened in the past, is because of the dynamics of commodity prices.

Here’s a simple example:

  • During the product cycle, The initial stage of commodity price increases is due to increasing demand outpacing existing supply.This is a common occurrence with orange juice, when drought or pest infestation wipes out the entire crop for that season. Suddenly, the existing demand for orange juice vastly exceeds the supply of oranges.
  • As the price of orange juice rises, speculators on Wall Street begin to inflate the price of orange juice futures contracts. When the price of orange juice rises, more speculators buy futures contracts, causing the price of orange juice to rise.
  • Farmers respond to the increase in the price of orange juice by canceling their planned production of lemons and increasing the supply of oranges. As orange production increases, the supply of oranges begins to exceed the demand for orange juice, leading to an orange overstock. With too much orange supply, farmers are forced to sell the oranges at a lower price or they will rot in warehouses.
  • As prices fall, Wall Street speculators begin selling futures contracts., As the price falls, more speculators abandon their contracts and sell orange futures contracts short, causing the price to fall further.
  • As the price of oranges crashed, farmers stopped cultivating orange trees and started growing lemons again.
  • This cycle repeats.

Moreover, rising commodity prices are a constant threat. “High prices are high prices for medicine.” If the price of orange juice becomes too high, consumers will consume less, leading to a decrease in demand and an increase in supply. The following graph comparing goods to nominal GDP shows the same thing: When commodity prices spike, economic growth slows. This is not surprising, considering that consumption accounts for about 70% of GDP.

There is also a high correlation between goods and inflation. It is self-evident that when commodity prices rise, the cost of goods and services also rises due to rising input costs. However, price increases are contained as consumers are unable to purchase those goods and services. As mentioned earlier, rising prices reduce demand. Less demand leads to lower prices, which in turn keeps inflation in check.

This is why tangible asset deals repeatedly fail, despite enthusiastic media coverage.

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Tangible asset deals tend to end badly

Commodities, and hard assets in general, can be exhilarating and profitable on the upside, but as the long-term chart above shows, their trades tend to end badly. Commodities have repeatedly caused market declines and recessions.

Will this time be different? We doubt it will be, for two reasons.

As discussed, high prices (inflation) It is the cure for high prices because it reduces demand. As mentioned above, if consumers save, demand will decrease, which will lead to lower inflation in the future.

Secondly, as the country moves in a more socialist direction, economic growth will likely be limited to below 2% and deflation will remain a long-term threat. Dr Lacey Hunt has also suggested the same.

JointContrary to conventional wisdom, disinflation is more likely than accelerating inflation. Annual inflation will be temporarily elevated due to the decline in prices in the second quarter of 2020. Once these base effects dissipate, cyclical, structural, and monetary considerations suggest that inflation will decline modestly by the end of the year, below the Fed’s 2% target. The inflation psychosis that has gripped the bond market will fade in the face of such sustained deinflation.

He concludes:

The two main structural impediments to traditional economic growth in the United States and around the world are massive debt overhang and adverse demographic trends, both of which have been exacerbated as a result of 2020.

That last point is crucial: when liquidity dries up from the system, income is diverted from productive activities to debt service, and excess debt puts a strain on consumption, weakening demand for goods.

Commodity trading is certainly “In bloom” Be aware that liquidity is surging and this could eventually lead to a reversal.

Deflation remains a problem for investors “A trap is being sprung.” In the case of tangible assets.

There is nothing wrong with owning goods. Don’t forget to take profits.

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2024/06/07

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