BIG PICTURE – The past couple of quarters were traumatic for the commodities investor. After a huge advance, the natural resources’ bull came to a grinding halt before falling off the proverbial cliff! The carnage that followed yet again reminded investors not to chase “hot” assets after a big rally. So, what caused this sudden reversal and is the commodities bull dead?

In my view, the recent decline was a classic correction or consolidation within the context of the primary bull-market and was caused by fears of monetary tightening. Back in May, everyone was worried about rising interest-rates; even the Bank of Japan had joined in the party by declaring an end to its zero-interest rate policy. As fear grew amongst the investment community, leveraged positions got unwound, causing a sharp reversal in commodities prices.

So, what will the future bring? In order to examine the commodities market, let’s review the following fundamental factors –

Rapid industrialisation and urbanisation of Asia (led by China & India)

Whether you like it or not, the next century will belong to China. Apart from a major war, natural disaster, not much else can stop the world’s oldest civilisation from replacing the US as the world’s most significant economy. The Chinese economy (GDP) continues to grow at an annualised rate of 10.4%, industrial production is surging by 16.1% and its foreign exchange reserves are set to cross US$1 trillion within a matter of days, representing more than 20% of global reserves.

Sure, there is a lot of talk about the coming slowdown in China but I suspect these fears are overblown. Even if its economy was to slow down considerably to say 7-8% of GDP growth, what difference will it make? Do you really think that the millions of Chinese would then park their cars, abandon their urban homes and move back to their communal villages? Somehow, I just don’t see this scenario unfolding. Even if the Chinese economy slowed down to 5% of GDP growth (50% decline from current level), it would still be far superior to the current economic growth-rates in the US (3.5%), Australia (1.9%), Britain (2.8%) or Euro zone (2.7%). So, as far as the eye can see, I expect China to remain a major consumer of natural resources.

Moreover, if my assessment is correct, I anticipate India to become a major player in the commodities’ markets over the coming years. In tandem with China, India is developing at a rapid pace and its “modernisation” will also require an immense amount of raw materials. The Indian economy is growing at 8.9%, industrial production is chugging along nicely at 9.7% and its foreign exchange reserves have soared to US$160 billion. Furthermore, the Indian government has recently unleashed plans to improve infra-structure (roadways, airports and shipping ports) by agreeing to build “special economic zones” within the country – great news for the commodities investor.

According to the Asian Development Bank, while the population in Asia as a whole grew by roughly 125% over the past 40 years (2.1% per annum growth), its urban population grew by 365% over the same period to a level almost five times of the US. Should current trends remain intact, the urban population in the region will rise by another 500 million by 2015 (Figure 1).

Figure 1: ADB estimates of Asian population

Source: Diapason Commodities Management

In summary, over the coming decade, millions of Chinese, Indians and other Asians are likely to migrate to urban areas in search of a better life. People in cities consume more goods and (fortunately for the commodities investor) this additional demand will generate gigantic profits over the years ahead.

Consumption-growth in Asia

During the past 5 years the real driver of the world economy has been Asia, accounting for over half of the world’s growth since 2001. On the other hand, during the same period, the US accounted for only 13% of global real GDP growth, using purchasing-power-parity (PPP). Even in current dollar terms, Asia’s 21% contribution to the increase in world GDP growth exceeded the 19% contribution from the US.

Contrary to the consensus view, the bulk of Asia’s economic-growth has been driven not by exports to the US but by domestic demand. Figure 2 highlights that Asian domestic demand (consumption and investment) has been responsible for a big chunk of the region’s economic growth in the past year. This holds especially true in China, India, Malaysia, Japan and Indonesia (Figure 2). In direct contrast, growth in Taiwan, Hong Kong and Singapore has been largely export-driven, so an economic slowdown in the US is likely to affect these economies a lot more than the rest of Asia.

Figure 2: Booming Asian demand

Source: The Economist

For some bizarre reason, the majority of “experts” interviewed on the financial media often blame the Chinese for being too frugal and not spending enough. However, closer inspection reveals robust domestic demand (Figure 2).

In China, over the past decade, real consumer spending has been growing at a blistering pace of 10% per annum – the fastest in the world and much faster than in the US. Moreover, the savings of Chinese households have in fact fallen from 20% to 16% of GDP over the past decade. Despite rapid consumption-growth, the reason why the Chinese savings rate is so high (close to 50%) is due to the fact that the Chinese companies have been hoarding a big slice of their corporate profits.

Furthermore, it is not only the Chinese who have increased their consumption. Excluding China and India, Asian household savings have fallen sharply, from 15% of GDP in the late 1980’s to 8% today.

Today, several economists believe that a slowdown in US consumer spending will de-stabilise the global economy and cause the prices of commodities to crash. I tend to disagree with this view since there is sufficient evidence that America’s importance in the global economy is diminishing. Over the past 5 years, America’s share of Asia’s total exports has fallen from 25% to 20% as regional trade has boomed and supported the economy. It is interesting to note that both South Korea and Japan already export more to Greater China (China, Taiwan and Hong Kong) than they do to the US.

At present, household debt levels in China and India are extremely low compared to the developed nations and this is another reason to be optimistic about commodities. Figure 3 shows that in China, consumer debt represents only 12% of GDP which is miniscule when compared to the more developed nations in Asia. In the future, when the Chinese banking system matures and credit becomes more easily available, I expect a big surge in Chinese consumption.

Figure 3: Chinese households in great shape!

Source: Gavekal Research

Today, per-capita consumption levels in emerging-Asia are extremely low and expected to rise significantly in the years ahead. This transformation will continue to have a profound impact on the prices of commodities.

Furthermore, on the monetary front, central banks continue to create inflation through money-supply and credit growth. As long as paper currencies are inflated, their value will continue to diminish against hard, tangible assets whose supply can’t be increased at the same blistering pace: thereby causing the prices of commodities to appreciate.

Based on the above factors and considering that the public hasn’t even really started investing in commodities, I conclude that the natural resources bull is alive and well! The recent correction in this sector seems to be over and now is the time to load up on precious metals, base metals and energy.

© 2006 Puru Saxena
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