Wednesday, 6 April 2011

Super cycle – third, fourth or none?

Are we experiencing  a super cycle for commodities that supersedes the ordinary business cycle? The answer is worth gold (or silver these days!)  – for central bankers fighting core inflation, for public finances of raw material exporters and importers alike to set tax and spending plans, for business using or exporting the stuff – and for investors.  

The mechanic often assumed to operate is based on rising demand resulting from a growing world population and structural changes in consumption patterns in developing countries combined with supply constraints in a range of sectors suggest that prices may need to rise rather steeply in order to incentivise higher supply.  Super cycles are extended periods of historically high global growth, lasting a generation or more, driven by increasing trade, high rates of investment, urbanisation and technological innovation, characterised by the emergence of large, new economies, first seen in high catch-up growth rates across the emerging world.

The world economy may now enjoy its third super cycle, after the first 1870-1913 and the second  1946 – 1972. Note that the first super cycle which coincided with America’s industrialisation and Germany’s Gründerjahre was stopped in the tracks on the eve of World War I. Note also the end to the second cycle which followed the World War II and coincided with Japan’s and the Asian NIEs rapid convergence was stopped by the oil price shock. So war and oil prices are potential party poopers.

          Super cycles and real world growth

None seems to get more excited about the prospect of a new super cycle than the financial industry, at times suitably packaged with a noted regret as to the cost of inflation, in particular for the poor. Commodities as an asset class can produce large diversification gains when added to portfolios with stocks and bonds – just as emerging-market stock market returns did in the past before their correlation rose to developed stock markets.

Take a recent heavy 145-pages report (one could pick many more but this is by far the best), issued in November 2010 by a team led by Gerard Lyons at Standard Chartered*. The report postulates that we have entered a new super cycle since the 2000s, not just in commodities but for world GDP growth. Lot of evidence is marshalled to support the hypothesis. As for commodities:
·         Large-scale urbanisation and growing middle classes will drive commodity demand, in particular for food.
·         Despite better energy efficiency, demand will drive energy prices much higher. Supply constraints in metals and coal will create dramatic price spikes.
·         Commodity producers should be big winners as consumers pay more.
·         Climate change will exacerbate pressure on food, energy and water resources.
·         Policy needs to address resources issues if super-cycle growth potential is to be realised.
·         Solutions lie in increased efficiency and technology, presenting investment opportunities.

This is convincing stuff, or is it? Academic economists are generally skeptical about the presence of long cycles, arguing that long cycles may be an statistical artefact. Cuddington and Jerrett (2008)*, however, identify four - not three! – super cycles over the past two centuries, after applying state-of-the-art (I must guess…) methods for detrending and causality directions, in order to extract super-cycle components. Their finding adds another earlier cycle than usually observed, roughly round 1860 - 75, with strong correlation across six industrial metals. They conclude that by 2005 we were in the early phase a fourth super cycle.
But do stay cool! In a widely underappreciated pamphlet, the Research Department of the Inter-American Development Bank (2008)* suggests that, even if the favorable external environment persists, one may expect GDP growth rates to slow down significantly in raw material producing countries, because some of the improvements in external variables may have level effects rather than growth effects. So even if raw commodity prices stay on the elevated levels we observe today, their impact would not necessarily lead to higher growth in commodity exporting countries, but just produce a short-term level effect. And did you say Resource Curse?

* Cuddington, J., Jerrett, D. (2008), Super Cycles in Real Metal Prices?, IMF Staff Paper, Vo. 55.4
   Inter-American Development Bank (2008), All that Glitters may not be Gold, Washington, D.C.
   Standard Chartered (2010), The Super Cycle Report, London.

1 comment:

  1. Negative real interest rates are fuelling an investment boom in many emerging markets. This will trigger the next crisis, and so growth will not be linear in these countries. China is different. There, the fundamental issue is a race against time to move hundreds of millions out of rural areas and into higher-productivity jobs, before old age - caused mainly by the one-child policy - stifles growth. How long is the window ? Fifteen years ? twenty ? Then price fever will subside.