The problem with commodities
Despite the highly unusual economic conditions, the central arguments for a commodities super-cycle remain intact. Demand for commodities from major new industrial powers such as China continues to soar, while global supply is running down.
More than 90 million new middle-class consumers are joining the 21st century every year, at a time when many precious metals are disappearing fast.
Terbium, for example, which is used in fluorescent light bulbs, could be gone in two years, while indium, used in flat-screen televisions, and even silver could be exhausted in 10 years.
"We expect the bull market to continue due to increasingly constrained and limited supply, and greater demand from developing economies," says Christopher Wykes, commodities product manager at Schroder Investment Management.
"That is not to say there won't be volatility. But, historically, bull markets in commodities run for 20 years, and as demand recovers we expect this one to be longer than average."
However, super-cycle drivers alone don't account for the meteoric rise in many commodity prices in 2009. Quantitative easing and low interest rates, designed to avert recession, have debased the value of western cash and encouraged investors to borrow those currencies to purchase higher-yielding commodities.
Jamie Horvat, senior manager at Sprott Gold and Precious Minerals fund, who predicted gold's stellar rise in 2009, says commodities have risen because central banks in the US, the UK, Japan and the EU are destroying the wealth of savers by forcing money into the system.
"If they continue to print money and expand money supply, hard assets should double in value," he says. "Commodities and other assets in south-east Asia are acting as an inflation hedge and carry trade. This carry trade is creating an asset bubble that will burst as soon as the central banks show even a sign of reversing interest rates."
Horvat adds: "Once rate hikes begin they will come quickly, knocking the value out of commodities such as oil and gold that have been driven far beyond fundamentals." However, he believes this scenario is some way off and that gold will first hit $2,000 (£1,227).
On the demand side, there is uncertainty about inventory levels. China appears to have staged a remarkable recovery on the back of its stimulus programme, but just how much of its rising commodity inventories are being consumed and how much merely stockpiled is unclear.
This year, China has imported twice the 1.46 million tons of copper it imported last year, and molybdenum, which is used to strengthen stainless steel, is being stockpiled so massively that oversupply could dominate the market for years.
Jane Foley, research director at forex.com, says: "Some of the price rise in oil is warranted, but a year ago it was difficult to see where growth could come from in 2009, and while we've had more growth than expected, prices can't continue to rally, given that supplies are as high as they are.
While gold and oil could both go higher, at some stage they will fall back and long-term gold investors could get their fingers burned."
Foley believes that, although gold will rise in the near term, as soon as investors see that the much-hyped inflation threat will not materialise, it will "drop back to $1,000 very quickly".
She adds: "One year on from quantitative easing there are no signs of inflation. Weak sterling has not imported inflation - because manufacturers do not have enough pricing power. I worry that the significant price increases in oil, metals and other commodities will be short-lived."
Making money out of gold in the past year has been easy. The precious metal rose 60% in the first 11 months of 2009, from $750 per ounce to nearly $1,200. But the near-linear progression in gold can mask the volatility of some commodities and how difficult they are to call correctly.
Crude oil, for example, has been on a roller coaster ride, rising to $150 in July 2008 and plummeting to $30 in December 2008 before doubling in 2009.
While gold divides opinion, there is more confidence about industrial metals on the back of the putative recovery. "Base metals and energy could be more interesting in 2010, as they will profit from an increase in economic activities," says Peter Koenigbauer, senior commodities portfolio manager at Pioneer Investments.
"The demand for base metals will increase as a significant proportion of stimulus funds are placed in infrastructure projects. If a sustained recovery continues, we will also see an increase in the demand for energy for the transportation sector."
Some investors will respond to the diversity in this asset class by investing in a product that tracks a broad commodities index.
The S&P GSC (Goldman Sachs Commodity) and Dow Jones-UBS Commodity indices account for 85% of all commodity investment. However, these indices are 70% weighted to energy, which investors might choose to avoid.
Exchange traded funds (ETFs) continue to proliferate, providing investors with instant access to everything from lean hogs to lead. Exchange traded commodities are different because they hold large stockpiles of the underlying commodity.
These tend to be limited to gold and silver, and other expensive metals such as palladium and platinum.
Nik Bienkowski, chief operating officer at ETF Securities, where assets under management increased threefold in 2009, says the top three ETFs recently have been gold, natural gas and broad agricultural indices, with silver and platinum close behind..
Spreadbetting offers immediate and leveraged access, and is well suited to this volatile asset class. David Jones, chief market strategist at IG Index, thinks oil offers some good short-term trading opportunities because whenever it falls to $76 it bounces back over the next few days.
He would not be surprised to see oil back above $100 in the longer term.
Among funds, JPMorgan's Natural Resources fund is recovering after a catastrophic 2008, when it was too heavily weighted to smaller companies which were hit when many hedge funds were forced to sell.
Nearly half the portfolio is now made up of companies with a market capitalisation of more than $2 billion.
Among quoted resources shares, the key is to concentrate on the fundamental attractions of the business rather than the commodity price.
David Field, manager of Carmignac Commodities fund, favours the copper industry "given its more favourable higher demand versus more limited supply and lower inventory build-up compared with other metals". He likes Xstrata, Freeport and Equinox.
"With the right stockpicking, companies will be more profitable from the rise in prices. They will also prosper from good quality management and potentially more capital expenditure for development," says Field.
"Moreover, companies can trade at levels that, compared with gold, offer an interesting leverage. We like Randgold, GoldCorp and Yamana Gold."
This article was originally published in Money Observer - Moneywise's sister publication - in January 2010
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 way of valuing a company by the total value of its issued shares and calculated by multiplying the number of shares in issues by the market price. This means the market capitalisation fluctuates continually as the value of the shares change in the market. For example, HSBC has 17.82bn shares in issue at a price of 646.2p making a market capitalisation of £115.15bn.
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.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
Posh-sounding word for the FOReign EXchange market – the global market for trading currencies. The primary purpose of Forex is to assist international trade and investment by allowing businesses to convert one currency to another. The Forex market is one of the biggest markets in the world, and includes banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors.
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.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A bull market describes a market where the prevailing trend is upward moving or “bullish”. This is a prolonged period in which investment prices rise faster than their historical average. Bull markets are characterised by optimism, investor confidence and expectations that strong results will continue. Bull markets can happen as a result of an economic recovery, an economic boom, or investor irrationality. It is the opposite of a bear market.