What Grantham Got Wrong About Commodities

A few readers commented that my objections to Jeremy Grantham’s thesis that the days of abundance are forever over didn’t really address the points that he brought up but merely his conclusion.

My objection was that at or near the top of every single major market move, we can find intelligent people who argue that we have said goodbye to the usual cycles of the past and are now embarking on a new period of linearity. If you were around the last equity market top in 1999 and 2000 you won’t have to strain hard to remember the arguments. Who could forget “Dow 36,000”?

Casting back a few more years to the infamous 1920 equity market bubble, we have the infamous words of Yale economist Irving Fisher, who said days before the crash, “Stock prices have reached what looks like a permanently high plateau.” And I’m sure you won’t have any difficulty in coming up with more examples.

While we may scoff at these past arguments with the perfect knowledge that hindsight provides us, at the time they were intelligently sourced and convinced many.

So that provides the biggest caveat emptor whenever we hear the words “it is different this time” or any variations thereof.

Here are three things which Grantham didn’t give their due attention in his long term analysis of commodity markets:

Consequences of China’s Real Estate Bubble
First, the role of Chinaas as a juggernaut in the commodities markets. Grantham does mention China, saying:

The primary cause of this change is not just the accelerated size and growth of China, but also its astonishingly high percentage of capital spending, which is over 50% of GDP, a level never before reached by any economy in history, and by a wide margin. Yes, it was aided and abetted by India and most other emerging countries, but still it is remarkable how large a percentage of some commodities China was taking by 2009. Exhibit 3 shows that among important non-agricultural commodities, China takes a relatively small fraction of the world’s oil, using a little over 10%, which is about in line with its share of GDP (adjusted for purchasing parity). The next lowest is nickel at 36%.The other eight, including cement, coal, and iron ore, rise to around an astonishing 50%! In agricultural commodities,the numbers are more varied and generally lower: 17% of the world’s wheat, 25% of the soybeans (thank Heaven for Brazil!) 28% of the rice, and 46% of the pigs. That’s a lot of pigs!

China’s central bank and government has been able to prolong the inevitable for the past few years. But there is no arguing that their economy is running on fumes. They also have blown one of the largest credit induced real estate bubbles in the history of the world. Just as with previous real estate bubbles, a host of individual mechanisms has convened to push up prices to the breaking point.

Things are so out of control that the Chinese real estate bubble is spilling over into the Vancouver real estate market, pushing price to rent ratios out of whack. The inflow of hot money from Chinese investors is also pricing out domestic demand from Canadians, leaving many double income families without the ability to purchase a home.

So it is surprising that Grantham doesn’t connect the dots and conclude that when China’s real estate bubble implodes, it will take down their economy. That in turn will result in the total price devastation of commodities. The shockwaves would then spread through commodity markets as demand collapses.

Bona-Fide Loophole
The second point Grantham misses is the structural and regulatory changes that have occurred in commodity markets in the past 40 years. The crippling of the regulation that had been in effect since 1936 allowed unchecked speculation in commodities. The effect was an astonishing inflow of money into the commodities markets as long only bets. From 2003 to 2008, speculative funds in commodities went from $13 billion to $317 billion. This completely skewed the price discovery effect and resulted in a hyper-reflexive market.

Prices go up because hedge funds and institutional funds are buying and stuffing their portfolios with long only contracts. This buying itself pushes prices higher. In response to the higher prices, the investment is profitable and more positions are added. And on and on.

I’ve already mentioned this several times for specific markets:

Impact of Speculative Activity on Commodity Markets
How Speculators Are Crippling the Copper Industry
2008 Crude Oil Bubble Top

Speculators have always have always been welcome at the commodity trading tables. They provide the much needed liquidity and risk distribution for an orderly market to match demand with supply. However, what we are seeing now is a perversion of the normal functioning of the market for pure profit without any underlying benefit or productive activity.

Federal Reserve’s ZIRP Party
The third thing that Grantham misses is the real reason why prices have gone out of whack. As hedge fund Michael Masters said in his testimony in 2008, “What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets.” This is very important because otherwise we may think incorrectly that prices are rising because of a supply shock or other structural issues. That is not the case.

So why are these new participants flooding into the commodities markets? Obviously the first reason is because they can. As regulation is weakened and anyone is now “a bona-fide hedge” even if they aren’t, there are no limits.

But the real reason is the Federal Reserve’s zero rate policy. In reaction to the financial crisis, the Federal Reserve lowered interest rates to zero and handed out money like it was going out of style. Almost anyone and any institution got free money. For a scathing expose of the more sordid details, see Taibbi’s recent article, The Real Housewives of Wall Street.

The Federal Reserve is holding rates at zero to motivate everyone to take risks as much as possible. Part of that liquidity has spilled into the equity market and we’ve seen a stunning rise from the March 2009 lows. Part of that has been funneled to the commodities markets where it was heading anyway even before the credit crisis. The only effect of the financial crisis was to intensify the inflow because until recently, the equity markets were collapsing and two, the Fed was basically giving away money.

As this article explains, the change in the structural dynamics of the commodity markets occurred in 1999 as regulation that had been in place was removed. This has wreaked havoc in the markets and resulted in real pain, especially in the food markets.

Right now, speculative participants in the wheat market out number genuine hedgers by a factor of four. This was bound to happen as regulation was weakened or destroyed. But coupled with the zero interest rate and easy money policy of the Fed, it was like dumping a truckload of gasoline on a fire.

One Scenario for Total Commodity Price Collapse
Putting all that together, here is one scenario that would result in the complete collapse of commodity prices:

China’s real estate market reaches its zenith and implodes under its own weight. The Chinese economy follows as bureaucrats who were thought to be masterminds of prosperity are powerless to stop the natural progression of a bursting bubble.

Commodity markets react to the collapse of China’s demand (see above for the significance of this demand).

The speculative participants in the commodities markets, who up to now regarded this as a one way, guaranteed bet, start to lose money for the first time. The leverage that multiplied their profits up to now results in growing losses.

As they react to the hemorrhage and unwind positions, their selling pushes down prices even more, amplifying the demand destruction. Selling motivated by speculative losses and selling from the demand decline race for the bottom. New opportunistic speculators, seeing this, push on the short side feeding off the desperate sell orders.

When the dust settles, commodities have entered a new downward cycle. We see multiple peaks on charts that will last years, if not decades. Several institutions either go bankrupt or be bailed out by the Federal Reserve as a result of the losses they sustain from their commodity operations.

The new lower prices in raw materials acts as stimulant for the world economy eclipsing by several orders the magnitude of the stimulus funds we saw injected by central banks in an orchestrated rescue operation in 2008.

A new secular equity bull market is born.

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8 Responses to What Grantham Got Wrong About Commodities

  1. Don Riley says:

    He also didn’t elude to the fact that 10 year rolling returns of commodities are now at or above all of the prior peaks of the last 200 years. All which saw major declines in years to follow. Time will tell.

  2. Bo says:

    Good analyasis.BaBak.
    I only want to add one more point. The collapse of fiat money system or the return of gold standard can be a triggers of commodity secular bear market.

    • Kevin says:


      Ummm, if paper money collapses, then so-called hard assets must go up in price. So not sure I follow your reasoning….

      You may be interested in reading Paul Brodsky’s “Apropos of Everything” for a thorough, well thought-out analysis of the fatal flaws of the fiat money system, and how it may all unwind.

  3. Bo says:

    My resaoning is collapse of paper money (leading to ultimately parabolic rally of commodity) >>> to restore gold standard >>> contraction of liquidity and funding >>> secular commodity bear market.

  4. JP says:

    What I got out of Grantham’s report was that the underlying downtrend has changed into something else.

    We don’t know what the something else *is* yet, just that something *very bad* has happened in the sphere of *irreplacable* commodities.

    And it had to do with his bubble analysis. Meaning that he’s *absolutely sure* they are *not* normal bubbles. Of course commodities are going to decline again. You can look at his charts and see that oil is going to mean revert to below $75. That’s *not* the issue.

    The problem is that the trend has changed due to two factors:

    1) The emerging markets coming online in a big way
    2) 7 billion people (and increasing) using commodities.

    He’s making what essentially amounts to a mathematical analysis.

    We will still get a secular bear in commodities. But that secular bear is going to hit a higher low this time.

  5. OntheMoney says:

    Excellent analysis.

    It’s odd (and uncharacteristic) for him to skip so lightly over the effects of speculation on the commodities market – but then that would cast doubt over his whole thesis, to which I get the feeling he is emotionally attached.

    Still, to his credit Grantham is fully aware of the likely effect of a Chinese meltdown on commodities, whereas those bulls who have seized on his words in self-justification prefer to ignore that rather inconvenient and ugly-looking growth on the face of their argument.

    If Grantham is to be ultimately proved right and this time really is different, the moment to bet on it is certainly not now, with euphoria rampant and parabolic moves all over the charts.

    There will be – at the very least – a strong pullback and a period of consolidation. If no crash materializes and China stages a miraculous escape, then we’ll have plenty of opportunity to establish long positions as the over-exuberance subsides.

    • JP says:

      Grantham is emotionally attached to his climate change position.

      He’s not so emotionally attached to bubbles. He’s arguing that the massive run-ups in commodities are not normal bubbles because they are so far outside what you expect from bubbles. Considering that he makes his money finding bubbles and using them, I will give him the benefit of the doubt until I see more data to confirm or discredit Babak’s response.

      If you look at his oil chart, he’s arguing that we are going to have severe volatility with $75 as the point for regression to the mean. His lower limit on a reasonable trading range is below that.

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