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Commodity super cycle
August 19, 2008
The commodity super cycle theory is based on the work of 20th century economists who studied the result of demographic shifts in populations and the resultant affect on demand for basic commodities. Economist Simon Kuznets, the 1971 Nobel Prize winner, did research on emerging markets that led him to define the “Kuznets Cycle.” That 20-year cycle arises in countries with policies to expand infrastructure and the tremendous demand for resources that results. As an example of the cycle, Kuznets pointed to the creation of the U. S. interstate highway system in the 1950’s. A Kuznets cycle can currently be seen in China, India, Brazil, Russia and emerging markets in general. These emerging markets are increasing infrastructure spending at about 10% annually as population growth and desire for improved standards of living are fulfilled. According to the United Nations, the world had 6.5 billion inhabitants in 2005, 380 million more that in 2000, or a gain of 76 million persons annually. By 2050, the world is expected to house 9.1 billion persons, assuming declining fertility rates. A world of finite raw materials, along with an increasing population base, translates into higher prices. We have seen the prices of most commodities rise significantly over the past few years. They may take a pause, as they have recently done, but will ultimately be driven higher by increasing demand.
The impact of the commodity super cycle on gold is a tendency for gold, precious metals and other tangible assets such as rare coins to rise as demand for commodities rises. We have seen this over the past few years, as gold has risen from about $300 in 2002 to over $1,000 before weakening in sympathy with oil and other commodities. The principal drivers propelling gold higher are produced below:
- Growth in World Money Supply – easy money supply by world central bankers has created a global cash glut and credit bubble. Excess cash in the marketplace tends to bid up prices for goods and services and causes declining confidence in paper money. Investors have bought gold and rarities as a store of value as compared to fiat currencies. The fiscal deficit in the U.S. is expected to grow at an alarming rate as boomers retire, putting more pressure on the dollar and providing an additional impetus for gold to rise.
- The growing need for oil has driven up prices and filled the financial coffers of oil exporting nations. The dollar is the primary currency used in the oil trade, so the oil exporting nations are accumulating vast quantities of dollars. OPEC members are diversifying from dollars by using more of their foreign reserves to buy gold. The central bank of Russia now has $422 billion in reserves and could be the next candidate for diversification into gold or non-dollar currencies.
- Gold has long been prized in China, which has been one of its largest consumers. China’s gold market has become more liberalized. In 2002, the Shanghai Gold Exchange opened, ending over 50 years of government regulation and moving China closer to becoming a market economy. China has a huge trade surplus with the U.S. and Europe that continues to grow wider. China has one of the world’s highest savings rates, but inflation has picked up and real rates are now negative. While China still buys large amounts of U.S. debt, it is increasingly diversifying its large reserves into resource investments, including gold.
- Low gold prices in the 1990’s combined with environmental controls discouraged mining companies from exploration for new sources of gold. No new major gold finds are expected in the coming years. The lack of investment during the previous decade means that supply has not kept pace with rocketing global demand.
- When real interest rates, after accounting for inflation, are low, investors turn away from paper assets with declining value and towards real assets with real value, like gold. Low interest rates provide little incentive for hedging by gold producers. A decline in hedging shrinks gold supply, creating a market imbalance during a time of escalating demand.
- The U.S. economy has been hurt by tighter liquidity due to heavy sub-prime losses in the key financial and housing sectors. The Fed has attempted to inflate the economy by massive rate cuts and other measures. The low interest rates have driven investors into real wealth such as gold. Both the Bank Credit Analyst and Merrill Lynch have forecasted that housing has not reached bottom and it is very unlikely that the Fed will tighten credit for the foreseeable future. Thus the dollar will remain weak and, according to the Bank Credit Analyst, is in a long-term decline, providing further momentum for gold, precious metals and rarities.
- The wealthy individuals that make up a substantial portion of our client base are directing an increasing portion of their portfolios towards alternative assets, according to the Capgemini “World Wealth Report”, alternative investments have increased from about 10% of high net worth portfolios to more than 20% in 2007. These investments include what Capgemini terms “investments of passion,” such as rare coins.
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