When prices in certain financial assets have already fallen a long way, it’s tempting to believe that the worst may be over. We all love a bargain after all. But buying something that is continuing to fall is described as like “catching a falling knife”.
It can hurt.
As present, this challenge is no more evident than in the commodities complex. Commodity prices, the Australia dollar, and resource stocks have already fallen a long way since their peaks and some adventurous analysts are prepared to speculate that they now represent value.
The Reserve Bank of Australia’s bulk commodity price index in $US terms, for example, has already fallen by 70% from its peak in May 2011. The $A is down almost 40% from its $1.10 peak. The S&P/ASX 300 metals and mining index is down 62% from its peak in May 2008.
Is it time to buy? I’m not so sure. What’s more, it seems even the Reserve Bank of Australia is on my side.
The first point to note is that, from a longer-run perspective, commodity prices and the Australian dollar are still reasonably high. As seen in the chart above, the RBA’s bulk commodity index (which covers world prices for key commodities such as coal and iron ore) is still twice that average in the pre-China boom years from the early 1980s to early 2004.
Equally, the real Australian dollar trade-weighted index is actually still a little above its long-run average – it is hardly cheap. In a commodity down cycle, it’s likely to spend a period in below-average territory.
The next issue to note is that the short-run dynamics of supply and demand still favour price weakness rather than strength. After all, the supply of iron ore especially is still rising – as evident with Gina Rinehart’s Roy Hill mine – while Chinese demand is weakening.
Indeed, the Chinese demand outlook could get weaker still once there is greater rationalisation among the many loss making steel producers littered across the country. So far at least, Chinese steel production has held up relative to weakening local demand – but only by flooding export markets with their surplus.
Economists describe commodities as following a classic “cob-web” model, whereby supply adjusts only slowly to demand and prices. The commodity price surge earlier last decade was because supply could not keep up in the short-term as Chinese demand exploded. After years of investing in new mining capacity, supply is finally responding just as demand and prices have turned down. It will take a long time to again wring excess productive capacity from the slow-moving resource sector – which will only take place via an extended period of unprofitably low prices.
Even China is still producing more iron ore than it should. As the Department of Energy’s Resources and Energy Quarterly noted back in September “China’s domestic iron ore production has proven to be far more resilient than expected in the wake of lower prices.”
The Department forecast that global iron ore exports will rise a further 3% in 2016. Australian iron ore exports are expected to rise by 8%.
The RBA also is not holding out hope for a commodity price recovery anytime soon. In its latest quarterly report it noted “the volume of global low-cost iron ore production, including from Australia, is expected to increase further. In the absence of a pick-up in the growth of global demand, this will place further downward pressure on the iron ore price for some time.”
As for the local resources sector, the RBA is still counting on a further decline in mining investment has a share of GDP. Having already fallen from 8% to 5% of nominal GDP in the past three years, the RBA expects mining investment to decline “to below 3 per cent” over the next two years.
All up, it hard to see much light at the end of the tunnel just yet. One potential positive – and something investors need to look for – is that resource stocks at least tend to lead developments in commodity prices. At some point, resource stock price will form a base and inevitably start to rise – and a sustained rise will likely imply a bottom and eventual lift in commodity prices could be one to two years away.