Where next for commodities?

Deutsche Bank investment director Paul Wharton examines the drivers for the commodities market.

If the Great Depression was a consequence of a long experiment with a gold standard, the current economic policy framework – led by the US Federal Reserve and enthusiastically embraced by the Bank of England – is a mirror-like experiment with fiat currency.

A gold standard limits the supply of cash in the economy to the quantity of gold in reserve. The current policy of quantitative easing (QE) is explicitly aimed at boosting the supply of cash.

The likes of Paul Krugman and Ben Bernanke have argued that adherence to the gold standard inflicted a lasting and devastating deflation on the world economy and led to a more or less permanent loss of output and productive potential. QE, on the other hand, hopes to avoid that problem by encouraging an equal and opposite reaction – in effect, an “inflation”.  

In a world of semi-fixed quantities, boosting the supply of money reduces purchasing power. The incentive to spend is increased and the value of debt eroded. At the same time, of course, the process might involve a transfer of wealth from creditors to debtors as the monetary value of claims on borrowers declines in real terms.

This creates the nagging fear of the return of inflation due to a de facto devaluation of the monetary base. And it is this fear, in turn, that is behind soaring investor interest in commodities.

Central Banks might be able to print money – £175bn at the last count for the Bank of England – but they cannot print gold, oil, wheat, corn or aluminium. This is why investors are looking to preserve their “real” wealth in assets that cannot be effectively devalued. The flow of investor funds into commodity-based investment has never been higher.

In assessing this phenomenon we must address certain key questions. Firstly, how serious is the inflation problem and are the fears surrounding it misplaced? Secondly, is the economic outlook strong enough to support continued strength in commodity prices?

The answer to the question of inflation depends on the so-called “exit” strategies that Central Banks undertake to withdraw the emergency stimulus. Exiting too soon would risk stopping a nascent recovery in its tracks; existing too late would risk inflation taking off.

The answer to the question of economic outlook, meanwhile, is mixed.

Many of the factors that will drive commodity prices higher over the medium term remain firmly entrenched. Any recovery in global demand will be skewed to the developing world, where commodity demand growth has always been strongest. This reflects not only the urbanisation and industrialisation underway in these countries but the fact that China, India, Brazil and Indonesia will be resilient in the face of the credit crisis, given the large pool of local savings in these countries.

There will, however, be new challenges – the most significant of which is likely to be a sharp slowdown in Chinese fixed asset investment growth.

For the purposes of this analysis we can break down the commodities “complex” into four key areas:

• Energy – oil and gas
• Industrial metals
• Agriculture
• Precious metals

Energy

Less than two years ago commentators were positing the idea that oil might breach $200 per barrel. The onset of the recession has taken the heat out of that demand spike, and prices dropped extremely sharply.. However, while high energy prices are a “tax on growth”, low energy prices provide a stimulus all of their own. The oil price has recently stalled below $70, perhaps pointing to a weak environment in the near term.

Industrial metals

Industrial metals posted strong gains during the second quarter of 2009. The return of risk appetite and the pursuit of reflation trades have been helpful, but the key factor has been the Chinese restocking cycle.

Analysis suggests this process has likely peaked and that, coupled with the onset of a seasonal slowdown, recent momentum will reverse in the second half of the year. The severity and longevity of the current slowdown are again key. Longer term, the “emerging market” story should underpin demand and pricing.

Agriculture

The agricultural sector has been the worst performer among the four broad commodity sectors during the second quarter of the year.

Issues that should be considered when investing in this sector include diversification, weather-related supply disruption and demand for better food as the populations of emerging markets gradually become wealthier and move up the value chain. Population growth, limitation of fresh water supply and global warming point to supply pressures as a chronic feature in the global supply chain. Though the sector is therefore volatile, prudent risk-management warrants exposure.

Precious metals: gold

Gold is seen as the safe haven from profligate governments. On the one hand, it hedges against inflation/debasement; on the other, it is viewed as secure from the outright failure of the financial system.

The price is likely to be underpinned by the conflation of several concerns: fear of secondary financial collapse, fear of outright inflation, generalised loss of confidence in the management of paper currencies, desire to safeguard wealth in non-monetary assets and fear of an outright dollar devaluation.

In addition, the Central Bank of China has also announced it intends to raise its share of reserves. This is expected to flow through to broader Sovereign Wealth funds.

Conclusion

Investing in commodities, and precious metals in particular, serves a defensive purpose. Done amid fear of badly managed central and government intervention in credit creation, it acts as a hedge against inflation/debasement.  

It is also enterprising, however, in the sense that there is an underlying assumption that Chinese and emerging market growth will resume and the current level of investment and capacity in the global supply chain is insufficient to prevent an upturn in demand from creating upward price pressure.

The key risk is that growth does not resume quickly and that investment in capacity keeps pace with a moderate rise in final demand.

Like many assets today, commodities represent an explicit play on Chinese growth. All roads lead to Beijing in this regard – but then at present this is an issue not just for commodities but for the global economy as a whole.

Paul Wharton is investment director and portfolio manager, Deutsche Bank Private Wealth Management.