Jeremy Grantham thinks the worst is over for commodities.

Grantham is a “living legend” in the investment business. His quarterly letter is one of our few “must reads.” Grantham is the chief investment strategist at GMO, a firm that manages $118 billion.

Grantham wrote about commodities in his latest letter. Regular readers know commodities are the most beaten-down asset class in the world right now. As a group, commodities are the cheapest they’ve been since 2002.

•  Grantham says the current commodities bear market is a consequence of the record-breaking bull market that came before it…

Here’s Grantham:

After every historical major rally in commodity prices, there has been the predictable reaction whereby capacity is increased. Given the uncertainties of guessing other firms’ expansion plans, the usual result is a period of excess capacity and weaker prices as everyone expands simultaneously. The 2000 to 2008 price rally was the biggest in history, above even World War II. It was therefore not surprising that the reflex this time was the mother of all expansions and excess capacity.

Grantham then pointed out that China’s slowdown is the other half of a “double-whammy” that’s depressing commodity prices:

This was further exaggerated by a sustained slowdown in demand from China, which is still playing through. The most dramatic example of this was in China’s use of coal, which had grown from 4% of world use in 1970 to 8% in 1988 and to 50% in 2013, the world’s most remarkable expansion in the use of anything since time began. And yet this remarkable surge was followed in 2014 by a reduction in China’s use of coal! And that in a year in which China was still growing at over 6%.

Grantham went on to say that commodities are likely close to a bottom:

And now with a further sell-off in commodities following China’s recent mini stock bust, the reaction phase may be more or less complete: projects have been cancelled and capital spending plans in general have been savaged.

He also noted the extreme pessimism around commodities right now. He even pointed to a “Magazine Moment” as a sign of the bottom:

Investment attitudes are extremely negative, which is, as always, a requirement for change. Today’s Wall Street Journal (July 21, 2015) carries a headline: “Investors Flee Commodities.” Promising. From now on it seems likely that prices will be more mixed, with some rising as others continue to fall.

Yesterday, we showed you commodities are now the cheapest they’ve ever been compared to US stocks.

•  The crash of one commodity is hurting Canada most…

Canadian stocks are falling.

The S&P/TSX Composite, Canada’s main stock exchange, is down 3.5% in 2015. It’s declined 7.8% since hitting a yearly high in April. And it recently fell for seven straight days… its worst losing streak since 2011.

Oil prices are 52% lower than they were a year ago. This is a big problem for Canada. Canada is the world’s fifth-largest oil producer. Crude oil is its biggest export. It makes up 27% of Canada’s total exports.

The Financial Post explained, “(I)t has become increasingly clear that the collapse in oil prices is doing much more damage to the Canadian economy than initially predicted.”

Canada could be in an official recession by tomorrow. Its economy shrank by 0.6% during the first quarter, and it releases second quarter numbers tomorrow. The official definition of a recession is when an economy shrinks for two quarters in a row.

•  And Canada’s housing market looks wobbly…

Deutsche Bank recently called Canada “the most overpriced housing market in the world.” It said homes in Canada are overvalued by 63%.

Unlike US home prices, Canadian home prices never crashed during the financial crisis. Prices took a small dip, then kept on rising, as we’ll show you in the Chart of the Day. Canadian home prices have risen twice as much as US home prices since 2000.

Last month, the Bank of Canada said, “Canada’s overheated housing market represents a significant risk to the stability of its financial system.”

According to Reuters, the central bank is worried housing prices could fall as a result of “a large macroeconomic shock.”

Two weeks ago, the stock price of a Canadian subprime mortgage lender Home Capital Group (TSX: HCG) crashed 19% in one day when it announced bad results.

Subprime lenders give risky loans to people with bad credit. Defaults on subprime loans were a major cause of the US financial crisis in 2008. This could be a sign of more trouble for Canada.

•  As expected, the Federal Reserve decided not to raise rates yesterday…

The Federal Reserve cut interest rates to near zero in 2008 to fight the financial crisis. It has held rates near zero ever since.

The Wall Street Journal reports:

The Federal Reserve on Wednesday left its key interest rate near zero but cited progress in the US job market, a sign it remains on course to raise interest rates in September or later this year.

At the same time, the central bank flagged a nagging concern about low inflation, which is creating caution among officials and could convince them to delay the first interest rate increase in the benchmark federal funds interest rate in nearly a decade.

The Fed has been saying the same thing for years now. It’s not raising rates yet, but it might raise rates soon.

Many analysts think the Fed will finally begin raising rates in September or December.

Here’s Bloomberg Business:

“The committee is keeping the door open for rate hikes later this year, not necessarily opening it further or closing it,” said Michael Gapen, chief US economist for Barclays plc in New York and former Fed Board section chief in charge of monetary and financial markets analysis. “Labor markets have improved further, and they need to see a little more improvement to be ready to go, so that says September or December is in play.”

It’s a guessing game to predict when the Fed will finally raise rates. We don’t know when it will happen. We can’t know. What we do know is how our investments will likely react when the Fed raises rates.

In case you missed it, yesterday we pointed out HSBC’s new study that shows rate hikes don’t hurt the price of gold.

It’s an important finding. Most investors assume that higher rates will hurt gold. The thinking goes that gold doesn’t generate income. So when interest rates rise, people prefer to own bonds and dividend-paying stocks instead of gold.

But the data prove that theory wrong. The price of gold actually went up the last four times the Fed began to hike rates.

Chart of the Day

Today’s chart compares the growth in Canadian home prices versus US home prices.

From 2000 to mid-2006, US home prices increased more quickly than Canadian home prices. US home prices crashed in 2007/8 during the financial crisis. But Canada’s housing market only took a small dip in 2008. Prices quickly recovered and have been setting new highs ever since.


Justin Spittler
Delray Beach, Florida
July 30, 2015