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Inflated hopes

Recent macroeconomic developments have created a supportive environment for commodity prices. Turmoil in global financial markets led to slower growth in the US economy, which in turn led to lower US interest rates and a weaker dollar.

Looking forward, rising inflation is also supportive. Gold is seen as the ultimate hedge against inflation but other resources also perform well in an environment of rising prices. There are a number of other factors that encourage our belief that resources stocks are likely to continue their strong performance in the medium term. The major reason is the industrialisation of China and the associated demand for building materials of every kind. Ten years ago, China accounted for 10 to 15 per cent of global demand for hard commodities such as copper, aluminium and steel but this has now risen to around 25 to 30 per cent.

We believe that we are seeing a situation analogous to the rise of industrial Japan during the 1950s and 1960s when demand for materials drove the share prices of commodity producers to successive highs. Demand from emerging economies and China, in particular, has already led to sharply higher commodity prices and this process is likely to continue for some time to come.

Until commodity prices started their recent rally, resource companies had been relatively restrained in their search for new deposits. The last decade was characterised by low real commodity prices that gave companies little economic incentive to spend capital on exploration.

Exploration expenditure has now risen sharply but any discoveries will take years to come on stream and we expect demand to outstrip supply for years to come. Furthermore, the existing supply of commodities is under significant pressure to meet current demand. With many producers running at maximum capacity, any unforeseen disruption to supply is having a magnified impact on the underlying commodity price.

The oil market is a case in point. Oil producers have little capacity to increase production and yet demand is increasing. Demand from emerging economies is only just starting to pick up while demand from developed countries shows no sign of easing. The oil sector remains subject to unpredictable supply disruptions, such as geopolitical risks, acts of terrorism and unfavourable weather events, all of which contribute to higher prices. We expect limited supply and healthy demand to keep the oil market tight this year.

The investment community must also come to terms with increasing demand for soft commodities. Not only is the continued growth of the world population boosting the demand for food but the increasing wealth of people in emerging countries is also altering the kind of food demanded. As consumers have greater disposable income, they increasingly tend to spend it on higher-protein foodstuffs like meat. This boosts the need for animal foodstuffs.

Rising demand for food, both for humans and animals, pushes up the price of soft commodities but also increases the price of other agricultural commodities, including fertilisers that are used to boost crop yields and agricultural land.

Demand for biofuels is another factor that has led to competition for crops and growing space. As the price of gasoline rises, governments are considering ways to secure their energy needs and one is to use ethanol derived from vegetable matter.

We remain positive on the outlook for global commodities. Ongoing demand from China and other emerging economies, continued supply disruptions and relatively low levels of inventories have propelled most commodity prices higher and we see little reason for prices to reverse direction. Advisers should consider increasing their exposure to this exciting area, particularly as inflation puts pressure on more traditional investment sectors.

Ian Pascal is marketing director at Baring Asset Management

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