What ‘peak everything’ means for investors

“Nothing to see here, folks. Move along now.”

That was pretty much the message from Federal Reserve chief Ben Bernanke’s first big press conference last night. Inflation might be a bit higher than expected, but it’ll all go away: it’s just “a short-term increase”. And growth will be slower than previously expected too.

So in all, the Fed has no plan to raise interest rates any time in the near future. The latest batch of quantitative easing (QE2) will end as scheduled, at the end of June. But the proceeds from maturing mortgage-backed bonds will keep being recycled into US Treasuries. In other words, even with the end of QE2, the Fed won’t be tightening monetary policy.

Needless to say, gold went up, and the dollar went down. The markets are happy with the idea that money will remain cheap, but they don’t believe that inflation is just a short-term blip.

Indeed, if a new analysis by US fund manager Jeremy Grantham is right, a particularly nasty form of inflation could be a constant presence in our lives over the coming decades.

We’re running out of everything

Jeremy Grantham, of US fund group GMO, is one of the rare talking heads in the financial world who is always worth listening to. You may not always agree with what he has to say. But he had a very ‘good’ financial crisis – he predicted both the bust and then the rebound (almost to the day). So you’d be foolhardy to ignore him.

And his latest quarterly newsletter is a must-read. Grantham is exceptionally bullish on commodities in the long run. In fact, it’s no exaggeration to describe his latest piece as Malthusian. Grantham argues that we’re “running out of everything”.

For all that low interest rates haven’t helped, Grantham’s argument is that commodity prices are high mainly because the fundamentals say they should be. On the one hand, the world is close to or past “peak oil” – in other words, we’ve run out of the cheap stuff. And at the same time we’ve “had the explosion of demand from China and India and the rest of the developing world”.

It’s nothing that you haven’t heard before. In a nutshell, an expanding and increasingly wealthy population is coming up hard against the fact that the world only has a finite supply of the resources we currently depend upon.

But he backs up his view with some convincing data. Grantham argues that we’re facing a “great paradigm shift”. We’ve grown used to the cost of raw materials constantly falling. But now we’re going to have to adjust to them rising.

Now when any investor starts using that word ‘paradigm’, a contrarian’s ears should prick up. Because using the phrase ‘paradigm shift’ is pretty much the same as saying “this time it’s different”.

However, he points out that this has happened before. Since 1974, oil prices have broken with the general trend for commodity prices to fall. I’ve written about this in a previous Money Morning,  so I won’t go into the details here. Suffice to say that the path of the oil price demonstrates that a shift in the trend for commodity prices is certainly possible. And Grantham reckons we’re seeing the same thing happen across the commodity spectrum now.

Take copper. We often discuss how we’re running out of cheap-to-extract, high-quality oil. But the same thing is happening with the red metal. As Grantham puts it: “Copper… has an oil-like tendency for the quality of the resource to decline and the cost of production to rise… since 1994 one has to dig up an extra 50% of ore to get the same ton of copper”.

There are two big threats to commodity prices

So what’s the upshot? Buy commodities? Ah, not so fast.

For all the talk of paradigm shifts, Grantham’s not daft. There are two big threats to commodity prices in the short term. The weather, and China.

The weather for the past year has been particularly bad. If it gets better – which seems likely – then we could end up with record harvests this year. That would hit agricultural prices. More seriously, if “at least one wheel” comes off the Chinese economy in the next 12 months, that would batter commodity prices too.

If either event occurs (and Grantham puts the chances of this at 80%), “then commodity prices will decline a lot”. And if they both happen, “it will very probably break the commodity markets en masse”. That would lead to a massive buying opportunity. But it would be painful for anyone heavily exposed to commodities right now.

The sectors that will profit from resource scarcity

Is Grantham right? In the short term, I’d certainly be cautious about having a high level of exposure – particularly direct exposure – to commodities right now. As I’ve noted recently, there are a few too many red flags suggesting that we could be due a correction.

As for the longer term – at MoneyWeek magazine, we’ve been believers in the notion of the commodity ‘supercycle’ for quite some time. And you don’t have to take quite as pessimistic a view as Grantham to see that there are some investment sectors that are very likely to do well out of resource scarcity in the future.

These include investments in technology that helps us to make better use of the resources we have – so anything related to energy efficiency, or agricultural efficiency. Commodities that remain relatively cheap and can act as substitutes for more expensive ones – such as natural gas – will also be more in demand. And higher prices will give the renewable energy sector a boost – my colleague Paul Hill wrote about solar energy for example, earlier this week.

MoneyWeek