Despite last week's selloff on US Q4 GDP data, commodities as represented by the CRB index have sharply outperformed the S&P since mid December, and stand at a new relative high, surpassing even the levels seen at the peak of the commodity bubble last July. Why, when equities are panicked by depression and deflation, should economically sensitive commodities (and also credit markets) be diverging so markedly? Even more remarkable is to see this performance while the dollar is hitting 3 year highs on a trade weighted basis, against the bearish consensus. Having called the bubble last Summer, I've been advocating the accumulation of long-term resource positions this year, and in December took a contrarian stance on oil, where I saw a bottoming process supported by the steep contango structure encouraging OPEC quota discipline (although that same price curve makes ETF investing perilous).

On Jan 30th, I noted that strategic stockpiling by China (and indeed Korea), partly to protect domestic industry margins, would be supportive of base metal prices and had fuelled a radical turnaround in the scrap market. Copper is at a one month high, oil is holding a floor at about $40 rising to $55-60 by year-end (and recent evidence that US gasoline demand has bottomed is very supportive), but even agricultural commodities like corn are catching a bid despite ample short-term supplies as ethanol production slumps. After undershooting amid fund liquidation in the Autumn, the commodity complex is now steadying based on supply fundamentals and a quite different take on the economic outlook to equities. Is the CRB index now the leading economic indicator that equities used to be, discounting an incipient economic recovery within 12 months? From an investment standpoint, is the stunning disparity between those markets telling us that commodities are overbought or equities oversold?

The pattern evident in most constituents of the CRB is certainly one of relative consolidation rather than outright bullishness at this stage, but compared to the recent rout in equities, currencies and sovereign bond spreads, this calm is quite an achievement.The CRB is bouncing around the key 200 level, where it stood in early December, well off a peak of 244 in early January. The worst performing commodity YTD is lumber down 27%, reflecting the continued plight of the US housing market, but still barely matching equity indices. Many commodities from soybeans to copper are evidently more directly influenced by the China story than are US equity earnings, and the market is minded to take at face value Chinese officials who keep re-iterating that magical 8% growth target, and launch ever more stimulus plans to achieve it. 

The Jeffries CRB Index I use above has a much lower exposure to crude prices (with a 23% exposure overall) than the GSCI or Rogers Commodity Index and so captures a broader representation underlying sentiment in the commodity universe. It has 19 components, though it has to be said it is slightly lighter in metals than it should be, making up 20% of the overall index, with Gold only accounting for 7% and non-ferrous aluminum, copper and nickel making up the remaining 13%. Unlike commodities, equities suffer from direct exposure to the imploding financial sector, and deteriorating supply fundamentals, in the sense that the share buybacks that supported the bull market are over, while enormous equity refinancing will be necessary to shore up battered balance sheets worldwide, absorbing investor cashflow that would have otherwise provided upward momentum. Nonetheless, equities are now cheaper than for several decades on a cyclically adjusted earnings basis (and versus bonds) and stand at an extreme oversold level only seen a few times in the last century.

The key medium term issue with most commodity markets from sugar to oil is the extent to which supply disruption related to the financial crisis will offset near-term demand destruction.For instance, there is maybe 80m barrels of oil moored offshore right now and onshore crude stockpiles have surged in response to the arbitrage opportunity offered by the contango structure (which as a result will surely flatten further). But we have also seen OPEC cut 4.2m bpd in production and a slew of non-OPEC projects postponed in recent months, leaving the cartel with a stronger stranglehold into any recovery in demand. Assuming an IRR of 15% for major oil infrastructure investments, and even allowing for a slight drop of $5-10 in the marginal cost of new developments as construction costs have slumped, much below $75-85 the next generation of large fields offshore West Africa and Brazil just don't make sense. There is little doubt that as the cycle turns, developed nations will again be competing with the growing emerging market middle-class for scare resources, and I suspect food and energy prices in particular will reflect the focus of that competition.

My overall view is that fears of economic Armageddon have been grossly exaggerated (and consequently equities grossly oversold), and that the unprecedented global fiscal and monetary stimulus will gain traction in the next few months, and generate a sub-par but real recovery, led by the US by early 2010. Depression talk, in the sense of a repeat of the economic extremes experienced in the 1930's is hysterical nonsense. The freefall sensation reflected in recent global statistics from trade to capital flows will soon begin to level out and I I doubt we will even approach the 1974 experience at the nadir of this cycle, which looks imminent.

In fact, the real concern on a 2-3 year view should be inflation , and the hedge real assets (and index linked bonds) can offer in the context of a muted economic recovery, capped by a lengthy deleveraging cycle and more conservative business and consumer culture. The risk is that this modest scenario of maybe 1.5-2% US growth coincides with mid-single digit inflation, as both supply-side issues in many commodities and excess money supply as the credit markets steadily normalize combine to end the secular disinflation trend in place in the US since the mid 1980's. The Law of Unintended Consequences is the most powerful in economics, and the least heeded.