Is the Commodity Supercycle Dead?

By Nicholas J. Johnson, Greg E. Sharenow of PIMPCO

The answer is YES.

Nicholas Johnson is a commodity portfolio manager where as Greg manages the real estate fund at PIMPCO. In this article the authors subtly agree that YES the supercycle for commodities might be over BUT argue that the asset class could still offer inflation beating returns and therefore be an important part of investor portfolio. 

Their line of argument goes as follows -

Whats happened and is happening to commodity prices

• Commodity supercycle is being referred to a period from 1998 to 2008 crisis when commodity prices grew exponentially delivering over 20% annual return. However since early 2011, most  of the commodity prices are in downward trend. 
• Inflation today, particularly, in US is unusually low and stable. In stable inflation conditions commodity prices are more driven by growth expectations. In the last decade, most of the incremental demand for commodities was primarily driven by China and other emerging markets. Since these economies have sharply slowed down over the last few years these growth expectations have petered out leading to fall in commodity prices.
• At the current prices Commodities are neither in bubble nor really overvalue. The authors derive this conclusion - from their analysis i suppose  (which they have not shared) - that for most commodities, prices are within 1 standard deviation of their marginal cost of production. In other words, since lower prices would not even recover marginal cost, there is lower probability that that prices could trend further down. 
• Commodity prices have also been impacted by strengthening US Dollar which is the denomination currency for the trade and futures. 

Delinking between commodity prices and returns on commodity funds

• Apart from spot commodity prices, investors can earn good part of returns from two more variables 
• roll yield 
• return on underlying collateral 
• Roll yield is the difference between spot prices and future prices. When the future prices are lower than spot prices or when the immediate future prices are lower higher than even deferred future contract there is a positive yield on rolling of these contracts. This situation would mainly occur when market anticipates lower spot prices in future, which is a case today and the authors believe the same would continue in foreseeable future.
• The third element which generates return for commodity investors is income earned on the collateral provided to support the commodity positions. This could T-bills or any other form of fixed income securities. 

Case for commodities as a part of investment portfolio 

• Commodity prices are positively correlated to inflation and hence provide a great hedge against inflation and are a great diversification tool for investors.
• Currently inflation is hovering around 2% and the authors expect the spot commodity prices to return 2-2.5% annually.
• Add to that returns from roll yield and income from collateral securities and you will have above inflation returns. 
• As an indicator the authors provide data that since 1970 commodities returns have averaged around 3.59%  and similar returns could be expected going ahead as well
• A bull case is presented if growth in emerging markets picks up sharply which then could see spot prices are rallying far higher then 2-3% inflation rate.

Below is the link for the original article -

http://www.pimco.com/EN/Insights/Pages/Is-the-Commodity-Supercycle-Dead.aspx

The authors do provide good insights in commodities investment and also make a solid case for hedge against inflation. 

However, the article falls short of -

a) explaining the impact of rising US Dollar on commodity prices 

b) impact of artificial boosted low cost liquidity 

c) examining the basic fundamentals like demand supply and inventory which would have a larger impact today (since higher dose of liquidity doesn't seem to adding fuel to the party) and which would also vary sharply for different commodities.