What is a Supercycle?
Since the turn of the century we have seen a surge in commodity prices, enough so that economists believe that we are in the midst of a commodity supercycle.
The idea of a supercycle comes from the work of Nikolai Kondratiev from Russia and Joseph Schumpeter from the U.S. Kondratiev in particular described economic activity as occurring in long waves, or cycles, spanning 40 to 60 years. A Kondratiev wave is similar to a business cycle, with alternating high and low growth, just on a larger time frame.
Countries need increasing amounts of raw materials as they industrialize, followed by decreasing amounts as they transition from a manufacturing-based economy to a service-based economy.
If we apply the idea of a supercycle to commodities, the movement of commodity prices takes the form of a business cycle, with alternating periods of low and high growth.
What Kind of Commodities?
The products we use on a daily basis – from the clothes on our backs, to the food we eat, and the cars we drive – are made using the world’s natural resources. We depend on these commodities and as the world’s population increases, we require increasing amounts of industrial and agricultural raw materials.
People have been trading goods for millennia in marketplaces across the globe. Today, some of the most commonly traded commodities include:
The stuff used to make your clothes! Cotton is one of the oldest known fibres and the leading producers of the soft fibre are China, India and the United States.
The most abundant metallic element in the Earth’s crust, this commodity is used in electronics, transport, construction, cooking utensils and food packaging. It is mined primarily in tropical parts of the world, with the largest known reserves located in the African country of Guinea.
Fun Fact: Coffee beans aren’t beans at all; rather they are the seeds inside the fruit borne by coffee trees. This cash crop only grows in latitudes between the Tropic of Cancer and Capricorn, and Brazil is by far the world’s largest coffee exporter, responsible for a third of global coffee exports!
In the chart below you can see the movement in the price of a basket of commodities going as far back as 1900. Clearly there are periods of low growth and periods of high growth. While the overwhelming trend for commodity prices is negative, i.e. commodities get cheaper over time; it is clear that since 2000 commodities have done very well. This strong rise in prices for everything from oil to cotton to iron ore is what prompted economists and investment analysts to dub this period a commodity supercycle.
A Great Shift Coming to an End
Within a supercycle there is always short term unpredictability, often due to unforeseen factors like war or technological advancement.
For commodities, a war or some improvement in shipping/transportation would lead to a rise in demand for natural resources. At the same time, commodity supply tends to lag behind demand. For goods such as industrial metals, which have to be pulled out of the Earth, it can take years for new sources of supply to be realized. As a result, supply fails to meet increased demand and prices rise.
So a 100 year trend of falling commodity prices has given way to a trend of rising prices or “The Great Paradigm Shift” as GMO, a financial asset management firm, calls it. What’s the problem?
While most investors’ have been focused on what stocks are doing, commodities have quietly taken a tumble. Oil and natural gas prices have plunged, as have prices for basic materials such as copper, nickel and iron ore. What everyone wants to know is…is this the end of the commodity supercyle?
Since the beginning of the 21st century, emerging market demand for commodities has been driving prices higher. China’s rapid industrialization overwhelmed the market, their demand sending a shock through the market that may have caused prices to surge higher and higher. Since it can take a decade to develop a mine, commodity demand and supply can remain out of equilibrium for a long time.
The Great Fall of China
As a big player on the scene, the recent slowdown in Chinese economic activity likely contributed to the decline in commodity prices. The Chinese economy slowed from 11% to about 7%. Growth is also faltering elsewhere, Japan is in recession, India’s economy is shaky and Russia is being squeezed tighter and tighter through a combination of economic sanctions and the repercussions of falling oil prices.
The answer to whether or not the commodity supercycle depends on who you ask. Some say it is over, and others, who are more bullish on commodities, say prices can and will continue to rise.
It seems unlikely that prices will surge much higher. With global growth so uncertain it is hard to see where the upward impetus will come from. The euro area is scared to death of deflation and energy prices are at record lows. With such soggy growth prospects one wouldn’t bet on the supercycle continuing in the near future.
It is conceivable that commodities could experience another up-leg if conditions change. Whatever you believe, if you want to invest in commodities it’s best to go for the lowest cost, least-leveraged producers. They have the ability to make big profits when times are good and manageable debt means they can better weather lean times. You never know, it might be a decade before the next up-leg. Hang in there!