What does the year have in store for commodities?
Phenomenal gains have been recorded in 2010 for certain commodities, notably coffee, cotton and some precious metals, suggesting the much-heralded multi-year super-cycle remains intact.
But these gains have been supported by considerable economic momentum and their sensitivity to economic news may yet prove a problem as growth slows in 2011.
Almost all commodities saw double-digit returns in 2010. Particular areas of strength included precious metals, seen as a bulwark to weakened currencies, and anything in demand in developing markets, including China, such as coal. Agricultural commodities showed strong gains as adverse weather hit supply.
However, with a few exceptions, commodities remain at 2007 levels or below. In spite of strong growth in 2010, corn futures peaked at more than $700 in 2008 but now trade around $530. Copper only hit the highs it achieved in 2008 in November 2010.
Many key determinants of commodities' performance in 2011 are likely to remain the same - the strength of China and the outlook for inflation. Ian Henderson, manager of the JPM Natural Resources fund, says: "The commodities story is still very much one of China, and that is unlikely to change a great deal. The emerging world will continue to grow."
While China's growth is not disputed, the rate of growth is open to debate. But even if China slows, it is unlikely to stall. The same is true of the other large emerging markets. Henderson says: "Although there are concerns about the world financial system, emerging markets are unlikely to go into recession and now consume more than 55% of the world's commodities."
Developed markets are a different matter, with economic recovery precarious. It is impossible to ignore developed market demand altogether, but certain commodities are more affected by US demand, in particular, than others.
US consumers are an important determinant of the oil price, for example, whereas demand for steel in developing nations has a major influence on price.
A rise in inflation will also drive commodities upwards. They are traditionally seen as offering protection against inflation and there are signs of inflationary pressures building in the global financial system, particularly in developing markets but also in the UK.
While the trend in commodities appears to be largely one way, investors need to be prepared for significant volatility. Commodities attract speculative money, which can create extreme movements.
Richard Robinson, a European investment manager at Ashburton, says some speculation can be healthy: "It is healthy if you get speculators holding up prices because it means you have projects being passed.
"However, volatility needs to be controlled. The oil price has been more stable over the past two years, but other commodities have been more spiky."
Agricultural commodities saw strong gains in 2010. Cotton was up 66.81% on the previous year, corn up 41.16% and coffee up 54%.
Gert van der Geer, manager of Pictet Agriculture fund, says there are still constraints on supply: "Many agricultural commodities have stabilised at a high level and are now starting to rise again. This has been accelerated by some borders closing for international trade and some problems with the weather.
"Certain soft commodities still have very tight inventories. As soon as people start to worry, volatility creeps into prices."
Agricultural commodities also have a number of long-term drivers on the demand side. Van der Geer says general global population growth - currently running at around 1% per year - is helping demand, as is a change in dietary patterns, notably in Asia, as increased wealth drives the adoption of a more Westernised diet higher in meat and other protein.
"As people join the middle class, they begin to eat things from outside their region. Also, meat requires a lot of grain as an input," says van der Geer. As such, China, which has traditionally been a net exporter of agricultural commodities, is slowly becoming an importer.
The risks for agricultural commodities are less related to GDP growth than they are for other commodities. Pictet points out that during recessions, food prices have not tended to fall significantly. He is more concerned about governments erecting trade barriers, which could lead to a build up of agricultural stocks in certain areas and a lack of supply in others, distorting the overall price.
Temperamental weather conditions and water availability may also affect the agricultural market.
Henderson generally avoids the agricultural commodities market for this reason: its dependence on things ultimately outside his control.
Precious metals have seen the most significant gains in 2010, as investors have used them as a store of value in the face of weakness in the major currencies.
Although gold has been the most widely discussed, it is only up 18% over the year to 1 December. In comparison, palladium, which is used in catalytic converters, is up 163% over the same period. Even silver, which is often ignored by investors, is up 47%.
Henderson believes precious metals have further to run, and his fund is invested in gold, silver, palladium and platinum companies. He says: "We aren't outright gold bulls, but we think there is still plenty of demand, particularly in a zero interest rate environment."
And talk of 'competitive devaluation' between the major economies and the resumption of quantitative easing in the US continues to usher people to the safe haven of gold. However, Stephen Barber, head of research at stockbroker Selftrade, urges caution: "Everyone knows gold is going up and investors have to be careful of something that has no real utility."
To illustrate just how far the gold price has soared, a lump of gold the size of a pack of butter now costs the same as the average UK house.
COAL, OIL AND BASE METALS
China is the key determinant of the coal price. Ashburton's Robinson says: "China went into the previous cold snap with reserves to last two to three months. This time, it is closer to 14 days. This could produce a price spike in coal. The same is true for natural gas and fertiliser, where China has low reserves."
He is also bullish on oil, which lagged behind many other commodities in 2010. He believes non-OECD countries will continue to support demand at the same time as the productivity of individual wells falls. For instance, BP's problems in the Gulf of Mexico have held back projects, which has, of course, constrained supply.
It is just as difficult to find bears on base metals. The sector has been given a boost by news that providers are to launch physically backed ETFs in base metals, especially copper and aluminium. These launches have been credited with pushing up prices as the market anticipates a tightening in supply as stocks are diverted into these funds.
There are fundamental reasons to expect strength in this area, according to Bradley George, Investec's head of commodities and resources. He says: "In the base metals space, the copper supply out of Chile has been disrupted by strike action at some of the big mines and safety concerns after the recent mine disaster at the San Jose mine, near Copiapo. Supply is not improving, yet demand is high in China."
If anything, the biggest worry about commodities is that everyone is positive about them, which goes hand-in-hand with a belief in the growth of emerging markets.
But the shadow of weakening developed market demand lurks in the background. Investors are advised not to bet against the sector, but, as always, they need to be prepared for volatility.
How to take a punt on commodities
There are two main ways to invest in commodities: invest in the commodity itself or in a company that mines, distributes or services it. With the direct route, the main way to invest is via exchange traded funds or commodities (ETFs or ETCs).
Five-minute guide to exchange traded funds
There are physical ETFs and derivative-based ETFs. Non-physical ETFs will generally operate a rolling futures strategy, which means they never buy at the spot price and can have a higher tracking error than physical ETFs. But they avoid storage costs so can be cheaper to run.
As commodity prices can be extremely volatile, spreadbetting on commodities is a popular way to take bets on the rise or fall of commodity prices.
Spreadbetting groups allow bets on most major commodity markets. They also offer controlled risk features. This means investors can bet on a fall in the price of gold, for example, but cap their losses at, say, 10%.
Commodity markets have distinct trading characters. Agricultural commodities, for example, will have quiet and busy seasons and will be affected by weather conditions. Investors contemplating commodity spreadbetting should familiarise themselves with these trading patterns before entering the market.
The Organisation for Economic Cooperation and Development was established in 1961 to promote policies that will improve the economic and social wellbeing of people around the world. It uses a broad range of economic information and research to help governments foster prosperity and fight poverty through economic growth and financial stability and also ensure the environmental implications of economic and social development are taken into account. It can only make recommendations and has no powers of legislation; nor can it compel members to adopt any recommendation. Based in Paris, the OECD currently has 34 members, including the UK.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
A financial instrument where the price is “derived” from a security (share or bond), currency, commodity or index. The price of the derivative will move in direct relationship to the price of the underlying security. They often referred to as futures, options, warrants, interest rate swaps and contracts for difference (CFDs). They are mainly used for financial certainty – to protect against spikes in the prices of commodities – as a hedge, whereby investors can buy a derivative that bets the market will move against them so they protect themselves against potential losses. Derivatives are also a tool of speculation as they enable banks, traders or investors to bet on price movements without having buy the actual physical assets. As derivatives cost only a fraction of the underlying asset price, they are “geared” (leveraged in the USA) so if the price of the asset moves £1, the value of derivative could change by £10.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
The total money value of all the finished goods and services produced in an economy in one year. It includes all consumer and government consumption, government spending and borrowing, investments and exports (minus imports) and is taken as a guide to a nation’s economic health and financial well being. However, some economists feel GDP is inaccurate because it fails to measure the changes in a nation's standard of living, unpaid labour, savings and inflationary price changes (such as housing booms and stockmarket increases).