Investors should pick a reason for commodities' run
Thursday, 13 March 2008
John Authers
WE are on the horns of a commodity dilemma. If we believe the judgement of the credit and stock markets, then the US financial services industry, the engine of the world's markets, is in a critical state. Meanwhile, the bond and currency markets show that confidence in the US economy has collapsed.
But this bleak assessment co-exists with a historic rally in the commodities markets. Oil, gold and corn set all-time records early this month. Industrial metals also logged impressive rises. The rise has been inverse to the panic in other markets.
Why are commodities behaving like this and can we possibly expect this rally to continue? Let us break the arguments into supply and demand.
Traditionally, demand for commodities will overlap levels of economic activity. Société Générale research shows that, since 1981, moves in the CRB index, the longest-established commodity index, and the Organisation for Economic Co-operation and Development's leading indicators, have moved almost in alignment with each other.
In the past few months, that relationship has broken down completely. The commodity surge has co-existed with an unmistakeable economic slowdown.
There are two demand-based explanations for this. The first centres on demand from outside the OECD. The huge and growing demand for raw materials from the emerging world, on this argument, has pushed commodities forward, in spite of the evidence of a slowdown in the US.
This is a variant on the "decoupling" thesis -- that emerging markets have reached the point where they can grow internally, even if exports to the developed world slacken off. It is a real phenomenon, but to push it to the extremes on the present commodities market looks a little hopeful.
The second source of demand we can label "investment demand". It is not just industrial and agricultural producers or jewellers demanding these commodities; increasingly, they are seen purely as an investment in their own right.
The introduction of exchange-traded funds alone, which makes it as easy and as cheap to trade commodity futures as it is to trade stocks, has opened the world of commodities to more investors.
Commodities provide returns that are not correlated with stocks or bonds. This makes them very valuable for asset allocators looking to improve their risk-adjusted return.
This new investment demand has pushed prices upwards. The remarkable upward increase since last August also suggests that commodities do have a relationship with other assets.
Tim Lee, of pi Economics, dismisses the commodities "bubble" as "simply a reflection of a speculative shift of funds". Implicitly, investors are betting on stagflation -- recession in the US and rising commodity prices.
This might explain the breakdown in the correlation between prices and economic activity that has held good since 1980 -- we have not suffered stagflation in that period. In the stagflationary 1970s, high commodity prices co-existed with a recession.
Apart from demand, there is supply. When the commodities boom began to gather force in 2002, it was a demand-led phenomenon. Opec's production of crude oil, for example, rose from 25m to more than 32m barrels a day from 2002 to 2006, even as its price quadrupled. Further, a fall in prices in 2006 coincided with a dip in supply.
What has happened since the beginning of last year is more ambiguous. The oil price has more than doubled, but production has only increased slightly and remains below the peak levels recorded in 2005. Production from non-Opec producers such as the US, the UK, Norway and Mexico has fallen markedly.
Tim Bond, head of global asset allocation at Barclays Capital, says that "natural resource markets are delivering a supply shock of dimensions unseen since the 1970s". Wheat and corn stocks are at their lowest levels, as a proportion of annual consumption, since the early 1970s. Copper stocks, judged this way, are at their lowest since 1990.
If this argument is right, then the logical conclusion is stagflation. Prices will go up, because supply constraints will force them up and the world will have to pay them. Apart from raising inflation, that will put a brake on economic activity. Cutting interest rates in this environment will merely exacerbate inflation.
These explanations all have some truth. But their implications for investment, and for the fate of and the world economy are very divergent.
If the "consumer demand" explanation is right, then you should not necessarily sell commodities, as the emerging markets may "decouple". But it also suggests inflation is a real threat to the emerging markets' growth, so this still is not a safe investment for the long term.
If the "investor demand" explanation is right, then commodities are a bubble. You should get out now.
If the "supply" explanation is right, then the economy is in deep trouble and pace the 1970s, commodities offer almost the only protection against what is going to hit us.
.......................................
FT Syndication Service
WE are on the horns of a commodity dilemma. If we believe the judgement of the credit and stock markets, then the US financial services industry, the engine of the world's markets, is in a critical state. Meanwhile, the bond and currency markets show that confidence in the US economy has collapsed.
But this bleak assessment co-exists with a historic rally in the commodities markets. Oil, gold and corn set all-time records early this month. Industrial metals also logged impressive rises. The rise has been inverse to the panic in other markets.
Why are commodities behaving like this and can we possibly expect this rally to continue? Let us break the arguments into supply and demand.
Traditionally, demand for commodities will overlap levels of economic activity. Société Générale research shows that, since 1981, moves in the CRB index, the longest-established commodity index, and the Organisation for Economic Co-operation and Development's leading indicators, have moved almost in alignment with each other.
In the past few months, that relationship has broken down completely. The commodity surge has co-existed with an unmistakeable economic slowdown.
There are two demand-based explanations for this. The first centres on demand from outside the OECD. The huge and growing demand for raw materials from the emerging world, on this argument, has pushed commodities forward, in spite of the evidence of a slowdown in the US.
This is a variant on the "decoupling" thesis -- that emerging markets have reached the point where they can grow internally, even if exports to the developed world slacken off. It is a real phenomenon, but to push it to the extremes on the present commodities market looks a little hopeful.
The second source of demand we can label "investment demand". It is not just industrial and agricultural producers or jewellers demanding these commodities; increasingly, they are seen purely as an investment in their own right.
The introduction of exchange-traded funds alone, which makes it as easy and as cheap to trade commodity futures as it is to trade stocks, has opened the world of commodities to more investors.
Commodities provide returns that are not correlated with stocks or bonds. This makes them very valuable for asset allocators looking to improve their risk-adjusted return.
This new investment demand has pushed prices upwards. The remarkable upward increase since last August also suggests that commodities do have a relationship with other assets.
Tim Lee, of pi Economics, dismisses the commodities "bubble" as "simply a reflection of a speculative shift of funds". Implicitly, investors are betting on stagflation -- recession in the US and rising commodity prices.
This might explain the breakdown in the correlation between prices and economic activity that has held good since 1980 -- we have not suffered stagflation in that period. In the stagflationary 1970s, high commodity prices co-existed with a recession.
Apart from demand, there is supply. When the commodities boom began to gather force in 2002, it was a demand-led phenomenon. Opec's production of crude oil, for example, rose from 25m to more than 32m barrels a day from 2002 to 2006, even as its price quadrupled. Further, a fall in prices in 2006 coincided with a dip in supply.
What has happened since the beginning of last year is more ambiguous. The oil price has more than doubled, but production has only increased slightly and remains below the peak levels recorded in 2005. Production from non-Opec producers such as the US, the UK, Norway and Mexico has fallen markedly.
Tim Bond, head of global asset allocation at Barclays Capital, says that "natural resource markets are delivering a supply shock of dimensions unseen since the 1970s". Wheat and corn stocks are at their lowest levels, as a proportion of annual consumption, since the early 1970s. Copper stocks, judged this way, are at their lowest since 1990.
If this argument is right, then the logical conclusion is stagflation. Prices will go up, because supply constraints will force them up and the world will have to pay them. Apart from raising inflation, that will put a brake on economic activity. Cutting interest rates in this environment will merely exacerbate inflation.
These explanations all have some truth. But their implications for investment, and for the fate of and the world economy are very divergent.
If the "consumer demand" explanation is right, then you should not necessarily sell commodities, as the emerging markets may "decouple". But it also suggests inflation is a real threat to the emerging markets' growth, so this still is not a safe investment for the long term.
If the "investor demand" explanation is right, then commodities are a bubble. You should get out now.
If the "supply" explanation is right, then the economy is in deep trouble and pace the 1970s, commodities offer almost the only protection against what is going to hit us.
.......................................
FT Syndication Service