Low-tech is the new high-tech. Forget microchips, fibre-optics and servers – metals, fuels and crops are where the hottest action is nowadays. The road to riches in the early years of the 21st century is the same one trodden by our forefathers in the 19th century. Investment today is all about real things once again, stuff you can actually touch. It's time to get back to basics – basic materials.
Unless you've been living down a mineshaft these past four years – and a disused one at that – this should all sound pretty familiar to you. After the millennium, the 'old' economy picked up where the 'new' economy left off. As a result, the CRB commodities index is up 110.6 per cent since 2002. That's way ahead of the 28.6 per cent world equities have delivered, despite their strong recovery from the bear market.
And with copper now up 270 per cent, oil up 180 per cent, and coffee up 148 per cent, investors have jumped enthusiastically on the bandwagon. But don't worry if you've missed out so far, we're told. The gains achieved to date are only the beginning of a bull market in natural resources that will last for many years, perhaps even for several decades. Commodities are still screamingly cheap compared to overbought shares and bonds. Buy platinum not Prudential, soybeans not Sainsbury.
However, the spiralling prices and fancy arguments to justify them have created unease as well as exuberance. For some investors, it all looks very much like a re-run of the technology mania that gripped financial markets in the late 1990s. Back then, the internet was supposed to have created a 'new paradigm', revolutionising the economy and making traditional investment rules obsolete. Today, it's the industrialisation of China and other Asian nations that the masses are getting carried away with.
What drives a super-cycle?
The idea of a commodities super-cycle does have some footing in reality, though. History suggests there were two previous episodes in the modern era when commodity prices trended upwards over a few decades. The first of these occurred in the late 19th and early 20th centuries with the industrialisation of America. The second took place following the Second World War, with the rebuilding of Europe and the growth of Japan.
China's transformation into an urban, industrial society is certainly comparable with those two previous episodes. The world's most populous nation has become a voracious consumer of natural resources, particularly oil and copper. So, barring a global economic collapse or some other major shock, China's growth is likely to continue at impressive rates for some years to come. Then, of course, there's India and other smaller nations that are also developing rapidly.
But demand is only half the story here. The limited supply of many commodities has contributed massively to soaring prices. That's because the last boom gave way to two decades of savage price weakness. The CRB commodity index declined in 13 of the 19 years after 1982. In response to this, producers cut back on investment in new facilities. After all, there was no point in increasing supply when prices were already under pressure. Consequently, when demand began to recover after 2000, supply was unable to respond quickly.
Since then, the CRB commodity price index has risen for five years on the trot, beating its previous record run of four straight years in the mid-1970s. Cynics say that this prolonged boom is merely the result of the prolonged bust that preceded it. While producers held back from pumping money into new facilities for an extended period, they are now eagerly making up for lost time. From this point of view, then, talk of a multi-decade super-cycle is dangerously wishful thinking.
And there is evidence that the shortage of supply of many commodities has indeed started to ease just lately. While China has accounted for much of the increased demand for metals in particular, the country is also becoming a major supplier in its own right. Between 2004 and 2006, China went from being the world's biggest importer of steel to being a significant exporter. Something similar has happened with aluminium, too.
"As China aims to move into surplus across a raft of commodities, import demand in these categories will slump and as more and more capacity comes on-stream, the very source of demand becomes a source of supply," says Philip Isherwood, a stock market strategist at investment bank Dresdner Kleinwort. Mr Isherwood's colleagues have also identified a five-year supply-response cycle running through metals' pricing history in recent decades. "This means two-and-a-half years from rise to fall," says Mr Isherwood. "Time is running out."
Commodity bulls, on the other hand, believe that the shortages will take much longer to work themselves through. This is partly due to the extent of the underinvestment during the years of famine for commodity prices in the 1980s and 1990s. But they also believe that the demand from China will continue to grow massively as its population becomes increasingly affluent. So although China is best known for producing goods for export, domestic consumption is set to become ever-more important.
It's certainly hard to dispute the potential demand of 1.3bn people living in a fast-developing economy. However, cynics reckon that this sleeping giant could take a lot longer to awake.
For all the Chinese economy's spectacular growth in the past decade or so, around 850m of its people still survive on less than $2 a day. While the comparatively tiny elite in the cities are buying luxury Western goods, the vast majority cannot aspire to buying even basic household items.
In fact, despite their belief in a long-term uptrend in commodity prices, not even the super-cycle's cheerleaders believe that the ascent will be entirely smooth. A look back at the two previous super-cycles shows significant volatility around the trend. During the boom between 1885 and 1920, the real price of copper endured four dramatic peaks and troughs. An investor who bought in at any of the high points would have had to wait several years just to break even again, assuming they didn’t succumb to what must have been a huge temptation to cut their losses.
Why commodities might crash
The obvious time for a violent dip within the overall commodities uptrend would be an international economic slowdown. If foreign demand for Chinese goods were to soften for even a short while, then production in that country would have to respond accordingly. In turn, such a dip risks hitting demand for metals and other inputs, perhaps just as the bottlenecks in their supply are easing. This could have an exaggerated effect on their prices, if only in the short run.
Still, commodity bulls aren't fretting about the threat of an economic slowdown. That isn't because they believe that a slowdown or recession won't happen at some point. It's because they don't think it would necessarily have the impact on commodity prices that we might expect it to. History offers them some support here. Commodities did well in the 1930s, era of the Great Depression. They also prospered in the 1970s, when another devastating international recession occurred.
The reason often suggested for this apparent resilience during such hard times comes back to supply and demand. The years leading up to the 1930s and 1970s commodity booms are both said to have been periods of underinvestment in new supplies. And when supplies are tight, it takes years to correct the imbalance. This can cause prices to rise even when demand for metals and their end-products are unimpressive.
What is especially interesting about commodities' performance in those two previous eras of economic hardship is their contrasting general price environments. The 1930s were years of deflation, falls in the general level of prices. The 1970s, however, were years of inflation, the opposite phenomenon. Nevertheless, in both instances, investors obviously saw real, tangible things as a sound investment.
Academic research also supports the view that commodities are a good hedge against inflation. In a study of the period from 1959-2004, Gary Gorton and K Geert Rouwenhorst concluded in a 2005 paper that "commodity futures are positively correlated with inflation, unexpectedly inflation and changes in inflation". Those commodities generally thought to move most strongly with inflation are energy, industrial metals and precious metals.
One explanation for this positive relationship between commodity prices and inflation is that the former causes the latter. Rising commodity prices – caused by supply and demand imbalances – end up feeding into general price rises. Dearer fuel, metal and food ingredients leads to higher prices for consumers. The chart, below, suggests there might be something in this view. Spikes in the CRB index in the 1970s and the 1980s were both followed by rises in UK RPI inflation.
But perhaps money is the root of the evil in this case. Monetarists preach that when governments or central banks create lots of new money, it ends up causing inflation. And it is possible that a lot of the newly created cash ends up sloshing into commodities and other tangible things – such as art and real estate – that investors believe will hold their value in the face of general price inflation.
KEY POINTS
• There have been two commodity super-cycles in the past: during the industrialisation of America in the late 19th and early 20th century; and after the Second World War with the rebuilding of Europe and Japan
• The CRB commodity index has now risen for five years in a row
• During the boom between 1885 and 1920, the real price of copper endured four dramatic peaks and troughs
• Commodities did well in the 1930s, the year of the Great Depression. They also prospered in the 1970s, when another devastating international recession occurred
• Commodity futures are positively correlated with inflation
• The commodities generally thought to move most strongly with inflation are energy, industrial metals and precious metals
