In a specialreport on Signposts for a Commodity Mania, the Bank Credit Analyst has foundthat its mania roadmap for commodity prices and related assets is on trackand not yet at a late stage. The research outfit says that one possible catalystfor the next upleg would be the end of US deflation ata time when the rest of the world has not slowed much.
This, BCAResearch argues, would spur a further shift from crisis hedges like preciousmetals to growth-sensitive commodities like industrial metals. The special reportintroduces five indicators to gauge whether the roadmap has reached adangerous, bubbly phase, and finds that none of these indicators are flashingred.
In anothermajor finding, BCA Research states that resource-sensitive stocks probablywill be rerated upwards before the mania has run its course. The researchers,who have long believed that the commodity universe will eventually enter aviolent boom/bust cycle, argue that the mania roadmap is at an early stage.
The special reportisolates what is necessary for the commodity bull market to persist in light ofthe history of the past two centuries; applies the methodology of CharlesKindleberger to the commodity backdrop, and finds few warning signs thatcommodity prices have reached the danger phase. Charles Kindleberger and RobertAliber wrote Manias, Panics, and Crashes: A History of Financial Crises,published by John Wiley & Sons Inc., in 2005.
Qualitatively,BCA Research notes that while the commodity space has bubbly pockets, it doesnot feel like Nikkei 1989/90 or NASDAQ 1999/2000. Consistent with this,concrete indicators such as physical premia, fair value trends, exploration activity,emerging markets (EM) infrastructure demand and commodity play valuations arenot flashing red.
To sustainthe bull market much longer, BCA Research argues that something must bedifferent this time. Three possibilities are considered. First, inflationcould spur the demand for commodities as a hedge, as was the case in the1970s, or during wars prior to that. This is possible, the researchers state, butwill take several years to emerge given the high-productivity supply booms inmany emerging countries.
In addition,there could be a slow supply response after a 20-year bear market, even thoughmany resource prices are well above cash cost of production. The cost inflationand continued bottlenecks in many resource industries support this view, at leastfor the next few years.
Third, the China factorcould overwhelm the typical demand and substitution responses to highercommodity prices. Eventually, commodity prices could mean-revert, but they willstay stronger for longer in the interim. BCA Research also believes that India's resourceneeds could attain critical mass beyond the next few years.
Arguing thatit is foolish to ignore the lessons of history the researchers argue thatit's too soon to expect traditionally bearish long-term commodity trends toassert themselves. But what's next, now that a synchronized global recovery,structural China bull storyand US dollar bear market have been discounted in just five years?
It isconceivable, BCA Research argues, that commodities will correct after the runup of the past year as the Federal Reserve, the US central bank, goes into waitand see mode and China slows moderately. In addition, it could be argued thatthings can only get worse because global decoupling in the second half of2007 was the perfect environment for commodities.
China, the marginalbuyer of many of the world's primary products, was growing rapidly, BCAResearch notes, and at the same time, it became clear that the monetaryauthorities in the US would haveto flood their economy with liquidity, resulting in prolonged weakness in thedollar, the main pricing unit for commodities.
Even so, thebigger picture is seen as remaining fundamentally supportive. Monetaryconditions will stay generous, especially in the US. Supplybottlenecks for many resources will persist. Emerging markets commodity demandhas 'survived' US economic weakness.
Of the fourmain commodity sectors (energy, mining, grains and precious metals), BCAResearch notes that only base metals have not gone vertical this year: Acorrection is likely and already has begun for precious metals. Still, this ismore a recipe for buying dips than a major cyclical decline.
PRECONDITIONSFOR A MANIA
BCA Researchargues that the benign environment and the incentive to buy on dips come at atime when commodities satisfy Kindleberger's three preconditions for a mania.First, displacement, here, in the form of China's rapidindustrialization: this is a swift, powerful development that creates bigwinners (and losers).
Second, liquidity,where the current environment of low real interest rates and plentiful moneygrowth is a precondition for asset price overshoots. Particularly important,the researchers argue, is the subdued nature of core price inflation and unitlabor costs in the developed world, despite strong increases in food and energyprices. This allows central banks, especially the Fed, to respond to financialstress and burst housing bubbles.
Third, thepotential for continued investor flows even as prices overshoot traditional valuationmetrics: commodities are increasingly viewed as a hedge against everything. Thebottom line here is that mania preconditions are in place: Periods of weaknesswill increasingly be viewed by investors and speculators as buyingopportunities.
WARNING SIGNSTO MONITOR
BCA Researchasks how to know when the mania has entered the dangerous terminal phase, andpoints to five of its favorite signposts, none of which are worrisome.
First, physical premia. Thismeasure reflects underlying physical demand for commodities, unaffected bypaper demand or manipulation. Widespread declines in, or low levels of,physical premia would be worrisome. Instead, they are either rising or abovetheir lows of the past three years for key metals in all the major consuming regions.
Second, fair value. BCA Research's long-term,macro-driven Fair Value Models for oil, copper and Commodities Research Bureau Industrialsshow a common picture. Prices have overshot but it is encouraging that theunderlying trend is rising.
Third, supply response. Explorationactivity has been slow to respond even though operating margins have surged. Explorationbudgets have increased, but part of the rise reflects massive cost inflation.For example, the global oil and gas rig count has gone flat after rising by 46%from 2003 to 2005. Caution after a two-decade commodity bear market plays arole, but so does the threat of nationalization or royalty increases in manycountries.
Fourth, the BRICs infrastructure story: Brazil, Russia, India and China are large playersin the infrastructure boom, which spurs a relatively price-insensitive demandfor raw materials.
Fifth, commodity play rerating. Resourcesstock prices have risen dramatically, but their earnings multiples have stayedlow. Investors still consider these companies to be heavily cyclical andcommodity prices to be mean-reverting.
BCA Researchargues that the tech bubble of the late 1990s and the housing/finance bubble ofthe early 2000s provide benchmarks for comparison. It is possible that resourcesstocks will never be rerated the researchers state, as was the case forhomebuilders and investment banks during their bubble.
The lack ofproprietary technology or differentiated products in the energy and miningspace make multiple expansion less likely, but 'China displacement'is seen as possibly encouraging a mini-version of the tech bubble as the maniaruns its course. So far, the researchers say, no sign: Mania has not yetentered the terminal phase.