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Commodities: Back to the Future?


For five years, the global economy has been suffering from the terrible impact of the greed of major investment banks in the USA and Europe. First came the costs of a recession which became a near depression, the “Great Recession.” Then came the costs of bailouts, followed by the ongoing costs to national budgets of collapsing tax revenues and soaring social benefits for millions and millions of unemployed.

In the industrial world, national debts continue to climb faster than GDPs, and even the Asian tiger economies that continued to grow despite the Great Recessionare finally showing signs of strain.

Almost unnoticed within this tale has been the performance of commodities and commodity stocks. No companies we have owned ever needed a bailout, and none of them actually experienced serious financial difficulties. No major commodity except natural gas has experienced a price collapse to levels below those prevailing in 2007 when the entire world was experiencing strong economic growth – and commodity stocks were completing their sixth year of outperforming all major equity indices.

Commodity Producers vs. Indices
10 years: June 14, 2002 to June 14, 2013

Cox 7-19 Fig 1

Source: Factset

  10 year price increase Percent
Potash Corp. Fertilizer + 1147.40 %
Monsanto Seed and Crop chemicals 976.25
BHP Billiton Base Metal Mining & Energy 541.60
Suncor Integrated Oil (oil sands) 326.49
Goldcorp Gold Mining 232.66
S&P 500® Index   166.93
FTSE 100 Index   148.67

Commodity producers had been investing heavily to meet soaring demand when the bankers went bust, and therefore, have continued to expand their output of what the world needs, although the ravaged industrial economies (apart from Canada) have collectively reduced their demands for raw materials. The result: lower commodity prices. It’s called supply and demand, a concept that has been out of fashion in elitist circles for years.

However, commodity prices remain at profitable levels (in many cases highly profitable) for most farmers, miners, and oil producers. (Natural gas is, of course, the victim of the oil industry’s startling success in producing shale gas, benefiting American industries and consumers while continuing to attract the wrath of prominent tax-exempt lobbying foundations.)

In particular, agriculture stocks have been strong because farmers keep increasing their expenditures for increasing production of basic foods.

Until recently, basic materials stocks had been the worst-performing group in the S&P 500. They have been holding up well on a relative basis since traders and investors began to contemplate the awful possibility that they would not be recipients of zero-interest rate funding from the Fed forever.

Commodity companies as a group are almost the exact opposite of big banks in terms of the conservatism of their balance sheets, so they have little to fear from tighter money. If that tighter money comes from a strengthening global economy, then commodity producers will be ecstatic.

Gold miners don’t need cheap money to finance their operations, but they do need the perception of the continuous cheapening of paper money’s value to generate high prices for their output. Until recent months, the price of gold rose almost lockstep with the rise in the Fed’s balance sheet, which is precisely what classical economics decrees. That relationship has recently been torn apart with emergence of a new consensus that inflation had been banished forever, meaning that central bankers can painlessly print money forever.

As a strategy, this is as perilous as the enthusiasm that spread in semi-arid parts of rural India and Pakistan to embrace new drilling techniques for finding underground water so they could grow profitable (and thirsty) crops such as corn and soybeans. Far too often, they learned the groundwater was scanty and not self-regenerating, and what they were doing was unleashing desertification, with predictably disastrous results.

In our view, if the five fat years for borrowers are to be replaced by a few lean years because the economies of the industrial world have begun a true recovery, then commodity producers will collectively be among the biggest winners.

The only thing dragging down local demand in previously robust Asian economies, which are collectively crucial for global commodity prices, is the industrial world’s pitiful performance. Astonishingly, we are now told by those who want us to buy bank stocks and consumer stocks that commodity stocks are even worse investments than they had previously counseled, because it’s only Asian demand that props up prices for raw materials.

If – and it’s a big if – the U.S. and European economies are on the road to sustainable recovery, then a big-time boom will be back in China and India, whose collective middle classes are now approaching U.S. numbers. The IMF says[1] that by 2016, China’s economy, on a purchasing power parity basis (which is how global economies are ranked for comparative purposes) will be greater than America’s. The OECD concurs: “The United States is expected to cede its place as the world's largest economy to China, as early as 2016. India’s GDP is also expected to pass that of the United States over the long term. Combined, the two Asian giants will soon surpass the collective economy of the G7 nations.[2]” By 2025, the forecasters predict that China and India will together have a bigger share of the global economy than the entire industrial world.

To get there they will have to continue to buy more commodities per capita than we do, and that means long-term investors in commodity stocks will be sustained winners – as they were in this century until big bankers blew their wads and got their bailouts. The “commodity crash” wasn’t a crash because of excesses in commodities, but excesses in Wall Street, London, Paris, and Frankfurt.

One can hope that they will not be allowed to do it again, the Fed’s sustained subsidies to them will not continue, and the economy will grow the right way – from hard work, ingenuity, and prudent investing. If so, the raw materials that are the stuff of progress will soon be back in vogue, and commodity stocks will be (almost) sexy again.

[1]China: 18,442  United States: 17,588; International Monetary Fund (IMF) GDP Forecast (2011-2018), PPP adjusted (USD Billions)

[2]Johansson, Å., et al. (2012), "Looking to 2060: Long-Term Global Growth Prospects: A Going for Growth Report", OECD Economic Policy Papers, No. 3, Organisation for Economic Co-operation and Development Publishing.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.