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Commodity value

Nothing exemplifies “boom and bust” better than commodities markets. War, weather, cartels – all can exert a powerful effect on commodity prices. Political uncertainty in the Middle East can send the oil price sky-rocketing. The industrialisation of economies such as China can bid up demand for industrial inputs like nickel and tin.

And yet, commodities provide real benefits for a well constructed investment portfolio. A key attraction is their low correlation with other asset classes. Gold, for example, provides a well-known safe haven investment when share prices are falling and times are uncertain.

Over the first decade of the 21st century, commodities outperformed other major asset classes. Between 2000 and 2009, spot prices on the S&P Goldman Sachs commodity index rose by 170 per cent while prices on the Dow Jones AIG commodity index increased by 232 per cent.

That remarkable run of success came to a juddering halt with the financial crisis. In July 2008, the S&P Goldman Sachs Commodity index reached a high of 890. By February 2009, it had plunged to 306.

Happily, the downturn has been only temporary. Subsequent months have produced a strong recovery. Spot prices rose by more than 50 per cent over 2009 – the strongest annual rise since indices were established in 1970. Commodities ended last year on a high, with the barrel price of US crude oil climbing above $80 and with copper, lead and zinc all enjoy-ing annual gains of over 100 per cent.

So far in 2010, prices have been volatile but the overall trend is rising. Prices of bulk commodities have risen sharply, stoked by continued demand from Asia. The nickel price was up by 35 per cent in the three months to March while the oil price remains firm. At the same time, gold and silver have jumped to record highs.

That recovery has been fuelled by a number of factors. Among the most important is the transformation of China from an agrarian economy to an econ-omic powerhouse. Its near-$600bn economic stimulus programme has boosted demand for raw materials. China now accounts for up to half of all demand for certain industrial metals. As China grows ever more economically powerful, it will dominate demand for other basic resources. Commodities are physically scarce – as demand climbs, so too will prices.

The rise in popularity of the asset class has driven a number of innovations – notably, the advent of commodity exchange traded funds. Some years ago, prices were largely determined by farmers, mineral and energy producers and mercantile traders. That is no longer the case. The combined volume of such transactions is dwarfed by those of speculators – especially through the futures market. Monthly financial activity is much bigger than physical production. As a result, returns from commodities have become more closely correlated to the capital markets cycle, slightly weakening the diversification argument.

Nevertheless, many of the long-term structural factors that have driven dem-and for commodities in recent years remain in place. These include population growth, increasing urbanisation and rising incomes – factors unlikely to reverse in the near future.

Simon Wood is investment director, multi-manager at Swip

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