Inflation and the Base Metals
Below is an extract from a commentary originally posted at www.speculative-investor.com on 9th August 2007.
As explained in the past, when it comes to the "commodity supercycle" we are definitely sceptics. We concur with the view that commodity prices in general and metal prices in particular are in long-term upward trends, but we do not think these trends are being driven by the strong growth of "Chindia" or the global spread of capitalism or the industrialisation of Asia or the movement of billions of people to the ranks of the "middle class" or any of the other catchphrases routinely used to neatly explain the price action. In our opinion, these explanations rank alongside slogans such as "new economy" and "technology-driven productivity miracle" that were used to legitimise the price action of tech stocks during the boom of the late-1990s.
As we see it, inflation (money supply growth) is causing a rolling boom/bust cycle whereby the combination of relative valuation and scarcity determines which sectors will be the major beneficiaries of inflation during the current cycle and which sectors will be relegated to the investment 'scrap heap'.
The analysts who concoct simple explanations based on real (non-monetary) changes in the world and repeat these explanations in mantra-like fashion will look incredibly prescient for a long time, even though they largely ignore the monetary factors that are actually at the root of the price changes. Some of these analysts will even take-on the status of prophets due to their apparent abilities to see the future. But the inflation-fueled boom will eventually turn into a bust, even if the touted fundamental bases for the boom persist. For example, the growth of the internet and technological progress in general did not 'miss a beat' when the NASDAQ crashed. All that happened was that the primary focus of inflation shifted, causing the "new economy" prophets to fade away and bringing to the fore a new bunch of prophets who chant "commodity supercycle".
In any case, regardless of what's fueling it the base metals bull market will probably continue for at least a few more years. The main concern we have at this time isn't with the next few years, because there will almost certainly be a lot more inflation in the future and as far as we can tell the base metals are not yet over-valued relative to anything except gold. Our main concern at this time is with the next few months, because although the prices of most base metals held up fairly well during the stock market's initial decline the backdrop has recently become markedly less favourable for growth-oriented investments. To put it another way, the things that have recently made us more bullish on gold with respect to the short- and intermediate-terms have increased the downside risk in the base metals.
Current Market Situation
As evidenced by the following chart, copper is not far below its May-2006 peak. This doesn't tell us much about the future, though, because the price action since the May-2006 peak could just as reasonably be interpreted as a consolidation that is about to end via an upside breakout or as a consolidation that will require, as a minimum, a test of the early-2007 low ($2.50) before it comes to an end.
We favour the latter interpretation, mainly because the liquidity contraction catalysed by the problems in the US mortgage market will most likely have an adverse effect on global growth. Even if there isn't actually a significant change in copper consumption over the next few months, the financial markets always attempt to discount the future and the risk is that the copper market will discount a future growth slowdown.
We also note that the aluminium price chart included below looks considerably more bearish than the copper price chart shown above. This is potentially significant because aluminium can be substituted for copper in some applications.
The base metals that appear to have the least amount of downside risk in the short-term are nickel and zinc -- nickel because it has already tanked and zinc because LME warehouse stocks of the metal are very low and continuing to fall.