Commodities are the hottest game in town. Since 2003, the Commodities Research Bureau (CRB) spot index has risen by 87 per cent, while the MSCI world equity index has gone up by just 35 per cent. As a result, investors are rapidly wising up to the idea that raw metals, fuel and crops can help build their wealth just as effectively as shares, bonds and property.
Despite the increasing enthusiasm for commodities, investors are still much less well informed about the what, where and how of this asset class. Good information and analysis about gold, oil, wheat and palladium is not nearly as widely available as research on shares in Vodafone or US government bonds. Without a good idea about what's happening and why, investors not only risk missing out on great opportunities, but can also incur painful losses.
To help you decide what role copper, soybeans and natural gas might play in your investment strategy, we're going to explore some of the key issues facing investors in the commodities industry today. From the most efficient way to exploit rising prices to a discussion on whether it's all getting out of hand, the following guide should give you some raw material for thought.
What is the best way to buy and sell commodities?
There have never been more ways for investors to get exposure to commodities. The last time that commodities were booming – in the 1970s – private investors had few opportunities, owing to a lack of products, tight regulations and currency controls. Nowadays, though, even those with very modest means can access a wide range of commodities instantly and cheaply.
The main issue here is how long you want to hold a position in commodities. If you're a long-term investor seeking diversification for your portfolio, exchange-traded funds or physical ownership may be the best way to go – see '' and '' for a full explanation of these alternatives. But if you're only interested in riding the wave for a few hours or weeks, spread bets and covered warrants make sense. Also, some products can be used over both the shorter and longer term, including futures and options.
Can commodities thrive in a global slump?
With the world economy slowing rapidly, this is a key question. The downturn originated in the US and is spreading to other developed countries including the UK and the eurozone nations. By contrast, emerging economies – in Asia, the Middle East and South America – continue to prosper, at least for now. But for all the talk of emerging economies 'de-coupling' from the developed world, the links between the two are tighter than ever.
A recession in the US and Europe would slash demand for many of the consumer goods that countries such as China now produce. This, in turn, would reduce the need for raw metals and fuels used in the production process, putting downward pressure on commodity prices. If this reduction in demand coincided with a rise in supply resulting from the increased investment in mining and drilling facilities over recent years, the effect could be exaggerated.
History tells us that global economic growth and commodity price changes are closely related. After reaching almost 7 per cent in the early 1970s, GDP growth plunged to below 2 per cent around 1974, causing the CRB index to decline 20 per cent year on year.
Still, for the turbulent 1970s as a whole, commodities trounced equities as an investment. The CRB index rose by 150 per cent over the decade, while the MSCI world index recorded a gain of just 15 per cent. So, while there were sharp sell-offs in commodities during this period, the long-term trend remains upward.
Although inflation is one of the main themes for investors today, there are fears that the coming economic slowdown could trigger the opposite phenomenon: deflation. The time deflation was a major problem internationally was the 1930s. There is evidence to suggest that commodities did well during that period, so it might not necessarily be the scrapheap for basic materials were we to experience another era of persistently falling general prices.
What's a 'super-cycle'?
The 'super-cycle' is an argument favoured by commodity bulls to explain why the prices of natural resources have gone up as much as they have and also why they may continue to do so. As we saw earlier, commodity prices move in patterns of boom and bust. When the world economy is expanding, they often tend to increase, while they pull back when it eases off. The CRB spot index has gone up five years in a row, something it has never done before.
Bulls believe this exceptional strength is because the current cycle is destined to be 'longer and stronger' than those that have gone before. The explanation for this lies in the emergence of China, India and other developing countries as significant economic powers. As these nations invest in industry and create infrastructure, they naturally require large amounts of raw materials, such as fuel, metal and cement. At the same time, their increasingly prosperous citizens are able to afford to eat more and better than before.
In the face of this sustained increase in demand for commodities, supply is still rather limited. After the last major commodity boom petered out in the early 1980s, prices languished for many years. As a result, there was often little incentive for producers to invest in new mines and oil rigs, or to expand crop output. With demand rampant and supply feeble, the inevitable result has been a sharp escalation of prices for these and other products.
There have supposedly been commodity super-cycles before, the first in the late 19th century and the second in the post-war era. Theory says these episodes were a result of the emergence of the US and Japan respectively as economic superpowers. However, while commodity prices do seem to have enjoyed extended periods of out-performance around these times, the progress was far from uninterrupted. So, even if commodities continue to rise over the next decade, their ascent is likely to be punctuated by big sell-offs.
Is the commodities boom a bubble?
The stratospheric ascent of many commodities has got some investors worried. They believe we're seeing a re-run of the late 1990s technology bubble, with barrels of oil and lumps of coal taking the place of microchips and bandwidth. On the face of it, the commodities boom does have at least some of the ingredients of a classic investment mania, with the potential for a very sticky ending.
The behaviour of many commodity prices is certainly characteristic of a bubble. Take crude oil, for example. The run-up in recent months has taken it to unprecedented levels in real terms. And the sheer speed of the rise resembles the latter stages of the gold blow-off that occurred in 1980 or the final days of the Nasdaq madness in 2000.
During all bubbles, we typically hear arguments to the effect that "the rules have changed" and that "this time it’s different". Talk of there being a 'super-cycle' in commodities, driven by the emergence of China and India, certainly fits the bill. There are strong similarities with all the 'new era' chatter that accompanied the dot-com boom, when bulls even dared to say that the economic cycle had been abolished as a result of technological innovation.
Another hallmark of a bubble is abundant liquidity. A ready supply of cheap money is the fuel that enables prices to continue shooting upwards. Monetary creation has of course been running at a rapid clip in recent years, a product of the historically low interest rates in the US, Europe and Japan, as well as easy lending conditions. Despite the credit crunch, there is still plenty of liquidity out there, especially in the form of the vast reserves of foreign currency holdings held by central banks in emerging markets such as China and Russia.
Monetarist economists would argue that the vast credit creation we've seen in recent years has stoked up inflation again. With so much money sloshing around, investors are trying to find homes for it where it will maintain its value. Commodities have a reputation for going up during such periods, so the money has come pouring in. As a result, commodity prices may now be feeding on themselves: the more prices go up, the more money comes flooding in, generating further price rises.
Identifying a bubble isn't as straightforward in commodities as it is in conventional financial instruments such as equities or bonds. That's because of the issue of valuation: while there are many widely accepted means of valuing a share, the same isn't true of a piece of gold or a bushel of wheat.
