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Grantham's Mega-Bullish Call on Commodities

Signs that commodity prices will continue to rise and remain high are becoming more apparent, Jeremy Grantham warns in his latest quarterly letter to investors, and it's more than just the signs at gas pumps that start with "$4" that have led him to this conclusion. Grantham, chief investment strategist of the fund manager GMO, sees reasons to believe that a fundamental - and for all intents and purposes permanent - shift in the price trends of many commodities has occurred. Here's the harsh new reality, as he sees it:

"The purpose of this . . . piece on resource limitations is to persuade investors with an interest in the long term to change their whole frame of reference: to recognize that we now live in a different, more constrained, world in which prices of raw materials will rise and shortages will be common. . . . Accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources: after 100 hundred years or more of price declines, they are now rising and in the last eight years have undone, remarkably, the effects of the last 100-year decline. Statistically, also, the level of price rises makes it extremely unlikely that the old trend is still in place."

Grantham credits the last two centuries of accelerated economic and social progress to humanity's exploitation of fossil fuels. The cheap energy that they provided was a catalyst for the Industrial Revolution, the swelling of the population and the dramatic expansion in wealth, health and other sorts of progress.

The growth in prosperity was accompanied and supported by steadily declining commodity prices, Grantham writes. The price of a basket of 33 commodities, equally weighted, fell at a compounded annual rate of 1.2 percent a year, adjusted for inflation, between 1900 and 2002.

In just the last eight-plus years, that downtrend has been completely undone, Grantham says. Inflation-adjusted commodity prices are almost exactly where they were in 1900. That reversal is big and robust enough to convince him that the very long-term trend is up, and he identifies various implications for society, public policy and investment. Here are his thoughts on the first two:

"If I am right, we are now entering a period in which, like it or not, we must finally follow President Carter's advice to develop a thoughtful energy policy and give up our carefree and careless ways with resources. The quicker we do this, the lower the cost will be. Any improvement at all in lifestyle for our grandchildren will take much more thoughtful behavior from political leaders and more restraint from everyone. Rapid growth is not ours by divine right; it is not even mathematically possible over a sustained period. . . . Because we have way overstepped sustainable levels, the greatest challenge will be in redesigning lifestyles to emphasize quality of life while quantitatively reducing our demand levels."

Among the long-term investment outcomes that Grantham foresees, resource-producing properties, such as farmland, oil and gas reserves and water and fertilizer sources, will rise in value - "in general, owners or controllers of all limited resources, certainly including water, will benefit." The losers will be just about everything else, he writes, as "a constrained-resource world will increase in affluence per capita more slowly than it would have otherwise, and more slowly than in the past." One bit of good news - so-so news, really - is that the United States should be a comparative winner because it has abundant supplies of key resources. It also has abundant demand, but that could work in the country's favor because there is plenty of scope to cut commodity use as prices rise.
Grantham advises anyone who might consider rushing out to load up on commodities that short-term developments could cause prices to run counter to their newly established trend. Speculation has been rife recently, perhaps pushing prices up too far, too fast, in his view; China's economy may be due for a significant retrenchment, and much of the gain in agricultural products has been weather related and therefore possibly unsustainable.

As with many long-term investment stories, the best way to get into commodities if you think Grantham makes sense may be to start now but start slow. As he puts it:

"How does an investor today handle the creative tension between brilliant long-term prospects and very high short-term risks? The frustrating but very accurate answer is: with great difficulty. . . . If prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced - 'left behind' - commodities. If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever. So, that's the story."

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