Commodities – an asset class coming into its own

There are strong reasons to suggest that commodities investment is the story of the moment, and that it is poised to become even more prominent on the investor’s horizon. Commodities now have a significant influence on the global economy and effectively represent the largest non-financial market in the world.

Certainly, the sector has produced some spectacular returns over recent years, all too notable in the sevenfold increase in the price of oil since the turn of the century, and a similarly astronomic advance in the cost of copper in the past five years. In a recent review of the commodities market, the Financial Services Authority (FSA) notes that, “it is a reasonable conclusion that investment in commodities markets will continue to grow, and is moving away from a cyclical opportunistic market to a genuine asset class.” In an area of the market that may be unfamiliar to to the average investor, this article seeks to set out some of its principal features.

One of the headline aspects of commodities markets is their cyclical nature. These cycles are driven mainly by imbalances in supply and demand: as demand increases, suppliers may struggle to increase capacity, and the lag will drive up prices. As suppliers catch up, there is a tendency to overshoot the market, and overcapacity brings downward pressure on prices. However, bull and bear cycles tend to run for relatively long periods, for anything up to 25-30 years. The current bull run is being fuelled at least in part by limited supply capacity after years of underinvestment, and follows a bear market that had its origins in the 1970s.

Another element that can have an effect on returns is the geo-political climate. While the long-term outlook remains upbeat, volatility increased and prices fell early in 2007, following concerns about economic growth and monetary policy in the USA. These factors have a tendency to work themselves out, however, and in the meantime present buying opportunities at depressed values. Then, upward pressures on some commodities co-exist with the downward movements elsewhere. Since energy is a major component of the broader market, the influence of OPEC is significant, as the organisation seeks to maintain a floor price for oil through cutting its members’ rate of production. Price hikes can also be expected in the event of a deterioration in the political situation in the Gulf, which seems likely given Iran’s provocative activities.

In all this, the rise in commodities, and investment in them, has only become stronger; the upward trend is forecast to continue and more players are entering the game, producing acute demands for experienced commodities managers. The powerhouses behind this trend are the Chinese economy, with India running an impressive second. These countries show no sign of slackening their double-digit growth rates and China’s boom in particular is a massive consumer of metals and energy. Only a global economic melt-down will halt the sheer scale of China’s demand for commodities, and markets can only maintain their upward trend.

So what does this mean for the investor?

One of the best advantages of commodities investment is the diversification it brings to a portfolio. Quite apart from maintaing yields when bear conditions kick in elsewhere, commodities are negatively correlated to both stocks and bonds. This was illustrated in the wake of the dot-com collapse in 2000. Investors turning to commodities to boost their yields more importantly discovered the benefits of the diversification that came with the switch. In adverse markets, equities and bonds tend to follow the same direction. Unless they have a global reach, they can also be affected by factors that are specific to conditions in their country’s economy. Traded around the world, commodities transcend country-specific influences and rarely, if at all, move in line with local events.

The markets have grown, and new participants have piled in. These range from institutions such as pension funds, through high net worth individuals, to retail investors. As a result of this interest a range of new products has been developed, including futures contracts that provide some hedge against volatility, indices and pooled investments such as exchange traded funds that diversify risk. Along with the investment groups that already offer funds that trade in commodity securities, the opportunities for investors to gain exposure to this sector are increasing.

On a final note, it is widely expected that Chinese demand and supply limitations mean the bull run in commodities has some years to go; the sector can now be considered a full-blown asset class which is moving away from an extreme cyclical character. However, while this could well prove to be the case, historically the markets do not run smoothly. Even the most bullish commentators expect spikes and corrections, and institutional investors know enough to regard their holdings as long-term investments. The message here for other investors is that a ‘buy-and-hold’ strategy is necessary to ride out volatility in what is in essence a very dynamic market.

1 Apr