The Investment Case for Commodities
This month I wanted to write about one of the major alternative asset classes – commodities. I’m sure most of you are familiar with the spectacular run commodities have had for the last ten years and I’m sure many of you and many of your clients are wondering whether now is a good time to buy, sell or continue to hold commodities. In this month’s column I’ll outline the arguments for and against investing in commodities and give you some ideas for adding commodity style investments into your offering to your clients.
Commodities: The Commodity “Super-Cycle”
I expect many agents are aware of the so called commodity “Super-Cycle”. This is the idea that we are in a once-in-a-generation commodity boom as first China and then India industrialise. Their demand for raw materials to fuel their growth far outstrips our current supply and as a consequence we see dramatic rises in the price of commodities such as copper and oil. Supporters of this case argue that we’ve seen it twice before: once in the in the early 20th century as America industrialised and once following the Second World War, with the rebuilding of Europe and growth of Japan.
The evidence to back this up is compelling. Since 1999 Copper is up seven-fold and Oil is up nine-fold. Other commodities such as lead, aluminium and gold have followed suit.
“Peak Everything”
No doubt you have come across the peak oil theory. The premise is that global oil production will peak and then decline, leading to rising oil prices. Optimistic estimations of peak production forecast the global decline will begin by 2020.
More pessimistic commentators believe we are about to enter an era of “peak everything”. There are 1.3billion people in China and 1billion in India. Between them they have 40% of the global population. The peak everything theory suggests that as these countries and their neighbours grow richer and more populous, demand for commodities of all kinds will exceed the planet’s capacity to supply them. This encompasses everything from energy, metals, ores, crops, land, water… For a depressing read, check out Jeremy Grantham’s paper “Time to Wake UP: Days of Abundant Resources and Falling Prices Are Over Forever” available on GMO.com. The point he makes is that we are not in a commodity bubble, or even a cyclical bear market, but instead we are witnessing a genuine paradigm shift and rising commodity prices are a fact of life now.
However, recent sharp falls in copper, silver and even oil (down nearly 10% after the IEA announced it was releasing strategic reserves) have triggered concerns that the commodity Bull Run could be at an end
China Slow Down
You only have to look at the copper price chart above to see that most commodities capitulated along with everything else in 2008. This suggests that they are still very much tied to the global economic cycle and that they have not made a paradigm shift into a super-cycle. Commodity bears argue that when China’s growth inevitably slows, so will the demand for commodities. And there have been signs that China’s economy is slowing down recently. Wages have been rising, debt levels have grown, there is a property bubble in certain parts of China and many commentators believe the level of central government spending can’t be sustained. The “A” share stock market in Shanghai has dropped 11.7% from its high on April 18th and Goldman Sachs cut its forecast for economic growth in China during the second quarter. The Chinese government has also been taking steps to try and cool the economy and control inflation by hiking benchmark deposit and lending rates. All of this could signal a “hard” landing for the Chinese economy and an abrupt end to the commodity Bull Run.
Increased Supply
Of course, demand is only half the story. As the commodity bulls state, the limited supply of commodities contributes to the cycle. However, commodity bears argue that this is nothing new and is just part of the cycle. As prices rise, producers invest in new infrastructure and new operations to increase their capacity and meet demand. For example, oil majors are now undertaking deep water drilling, extracting oil from tar sands and developing operations in new locations such as Russia and Alaska. Naturally, once demand is met, prices will cool off again. And we shouldn’t forget that high prices also force consumers of commodities to look at substitution and innovation as they seek cheaper and alternatives. As more of these become viable, demand for traditional commodities will fall.
An End to Speculation
It’s also becoming clearer that investors cannot necessarily rely on central governments to embark on another bout of quantitative easing (money printing) to prop up the markets. QE has flooded the markets with liquidity in an attempt to stimulate growth after the financial crash of 2008, and a lot of this money has found its way into commodities as investors speculate on rising prices. Tighter global monetary policy could spell an end to this kind of speculation and kick away another support for commodity prices.
Conclusions
Personally I am a commodity bull. Many commodities did take a hit in 2008 along with other more traditional assets, but they recovered fast and are have made new highs, outperforming stocks, bonds and property. I am certain that we will see short term volatility as speculative money is taken off the table and as China’s growth slows, but long term I do not think it will be possible to grow the global economy – even at a slower pace – without using lots of raw materials. I am also keen to protect my investments from the impact of inflation and debased currencies as Western governments try and get out of debt. This means holding ‘real’ assets.
With this in mind, it’s important to take a long term view and pick investments carefully. Physical gold is the obvious choice to protect wealth against inflation and market uncertainty. Farmland is compelling, but crops are probably not – investing in crops such as wheat and corn feels took much like short term speculation to me. Owning a piece of productive farmland over the next 5 -10 years is a much more conservative play on rising food prices. Forestry and bamboo look favourable for similar reasons – the demand for timber looks set to rise and owning these assets will be a good inflation hedge. And the right investments into energy make sense, with alternative energy being the most exciting sector.
There are products in all of these sectors that agents who are prepared to diversify a little can sell to clients who are also convinced by the commodity story and are looking for the right investments.