Waltzing Matilda

While there remains a lot of academic controversy about the length of and reasons for commodity price cycles, to most of us in the real world - and certainly the market - it is an obvious truth that everything moves in cycles.

According to a paper published in February 2012 by the United Nations Department of Economic and Social Affairs (DESA Working Paper No. 110ST/ESA/2012/DWP/110), there have been three cycles in real (i.e., inflation-adjusted) non-oil commodity prices between 1894 and 1999. The average upswing in prices in each was 54 per cent and lasted 15 years (although the last cycle was anomalous in that the upswing lasted only two years). The average downswing was interestingly enough about the same - 50 per cent - although it is important to note that a 50 per cent rise followed by a 50 per cent decline leaves prices lower than they were at the start. The average length of the downswing was 20 years - substantially longer than the upswing, and this is the primary reason for this academic diversion.
 

Because it seems quite clear - to me and many others - that the current cycle (that began in 1999) has turned. With the usual 20/20 hindsight, the turning point can be determined as February 2011 or thereabouts. This means that the upswing lasted only 12 years, just below the average. However, the price rise in this upswing was a humongous 81 per cent, higher than even the 1932 to 1971 commodity price boom (which put on 72 per cent over a much longer period).

Assuming - and it's a big assumption - that this cycle follows the average performance of the previous three, it would suggest that commodity prices will continue to fall for another 15 years or so, and when the dust clears real prices will be some 50 per cent lower than their peak.

This will take gold to a bit below $1,000 an ounce - allahoakbar! Oil runs in much more volatile cycles, with the increase in prices overwhelming the downswing (which, oddly enough, averages about 50 per cent again). Thus, in another 15 years, oil should be down around $50 to $60 a barrel, which sounds completely insane - till you think about the new shale gas technologies as well as the rapidly accelerating shift to electric cars and the (hopefully) increasing clout of the environmental lobby. If this pans out, double allahoakbar!!

Of course, the flip side of this joy is that at these commodity price levels, global GDP growth will be strained. Statistically, there is a 60 per cent correlation between world GDP growth and commodity prices, which suggests that the steady drag on growth that we are currently facing will likely persist.

Obviously, there will be a whole new range of winners and losers, if this analysis is even partly correct. India can well be a big winner, since its numero uno problem today - the current account deficit - will be much easier to manage with substantially lower commodity prices, even though exports will remain difficult. More importantly, our domestic market will be our greatest strength. Perhaps, the planners need to be looking at weaning our policy away from export promotion to domestic market development. I recognise this is heretical and hardly advisable in these high CAD times; however, we do need to start thinking about it.

The developed countries, particularly the US and Japan, will do very well since, when commodity prices are low and/or declining, capital will seek returns in technology and productivity, which are their strong suit. Indeed, the modest resurgence we are seeing in these economies today may be a sign of things to come. More significantly, this will also play to Europe's strength, and if the bulk of the upcoming decline in commodity prices was front-ended, we could see the ongoing crisis ease quite quickly - fingers crossed on that.

One big loser will be Australia, which has become rich beyond its dreams as prices of its huge reserves of resources - iron ore, copper, coal - rose to stratospheric levels over the past 15 years. This created a structural problem - called a "hollowing out" - with the rest of the economy, as the corresponding rise in the Australian dollar rendered the non-commodity parts of the economy hugely uncompetitive. This explains the recent sharp increase in Australia's fiscal deficit.

The Aussie dollar has already started sliding - short Aussie (sometimes long real exotics like the Mexican peso) is reportedly one of the most popular trades in a segment of the market. It is likely to grind its way down below its long term average of 85 US cents.

Fortunately, Austraylians are easygoing, fun-loving folk, who are - with a few exceptions - less interested in making billions and more into cricket, Australian-rules football and Waltzing Matilda, waltzing Matilda, who'll come a-waltzing Matilda with me…