The appetite for commodities in emerging markets is supporting prices, says Philip Poole, global head of macro & investment strategy at HSBC Global Asset Management, despite fears of further economic problems in the West
Many investors remain worried about a potential double-dip recession in the developed, world, particularly in the US and the UK.
It does not seem to make much sense that many commodity prices have bounced strongly and are once again testing recent highs. But the world has changed and the key drivers of demand for commodities, both hard and soft, are now the economies of the emerging and not the developed world.
In these rapidly growing, populous markets, per capita consumption is coming off an extremely low base and demand is likely to remain robust. Many of these economies are still growing strongly, with China the most important example.
It is worth noting, however, that neither India nor China suffered from a contraction of output during the recent crisis but more a moderation in their respective paces of growth. Ultimately, the reality for the most part was that the recession was a crisis endured by the industrialised world and not by many emerging regions.
The appetite of the world’s emerging markets for hard commodities is likely to stay strong in the foreseeable future, which in turn should continue to support prices.
Key emerging economies are entrenched in a self-sustaining, commodity-intensive phase of development, which promises to keep commodity consumption growth high, even if growth in the industrialised economies is weak.
And there is plenty of potential for commodity and resources demand to increase more as incomes and consumption levels in emerging economies remain low by Western standards.
The urbanisation of the world’s emerging countries should also potentially spur on further demand.
The power of this is that for virtually all commodities, both hard and soft, per capita consumption in rapidly growing populous countries – China, India and Indonesia, for example – is coming from a very low base.
As these nations focus on domestically-driven economic growth, the impact on demand should continue to provide support for commodity prices.
Coupled with this is an important supply-side constraint that should compound this impact in the case of many key commodities. Due to the impact of the financial crisis, a plethora of investments in the commodity sector were put on hold and in many key areas it seems likely that there will be little new supply coming to the market over the next few years.
Analysts at Standard Chartered estimate that almost $200bn of investment projects were suspended because of the financial crisis in iron ore, copper, and coal (thermal and coking) alone. In their view, this is likely to severely limit new supply through to the end of 2013.
In the soft commodity area – especially grains – disruptions to climatic patterns have again put a strain on supply. The drop in wheat and barley production due to drought in Eastern Europe is just the latest example.
This combination of medium-term demand-side pressure against the background of a limited short-term supply response in many commodities looks set to keep prices supported.
A short-term improvement in macro data in the developed world, alongside evidence that China is slowing and not melting down, is likely to help to reduce the negative overhang that has dampened investment activity and prices in a range of commodities.
Commodities have become a much more tradable asset class in recent years, attracting investment from retail, institutional and leveraged investors.
As well as gaining exposure to underlying prices it is possible to benefit from commodity price upside via investment in commodity-related currencies, external and local sovereign debt of countries where payment potential is geared to commodity-related tax revenue streams and relevant listed equities.
On the foreign exchange side there is choice of developed and emerging markets currencies. The former sector includes Australian dollar, Canadian dollar and Norwegian krone, while the latter includes Brazilian real and Russian rouble.
On the debt side Russia also features, while debt markets such as Nigeria and Venezuela are almost pure plays on the oil price.
Commodity stocks are a powerful play on commodity prices, given that their cost base tends to be relatively fixed and revenue and profitability often fluctuate dramatically with price changes.