OVER the past three to four years, various types of resources have grabbed headlines, and continue to do so. Last year, spot prices of some commodities like oil, gold and wheat spiked to record highs.
Oil now exceeds US$96 a barrel; gold has streaked past its historical high of US$850; grains and meat prices are rising.
Rather than fret on the sidelines about the impact of these higher resource prices on the products that you need to eat, wear and use, it would have made some sense to invest some money in commodities. An allocation will give you an inflation hedge, apart from a host of other benefits that include robust returns.
First off, commodities are broadly divided into three segments: metals, energy and agriculture. Prices across virtually the entire spectrum are benefiting from a classic demand/ supply imbalance. That is, supply is struggling to keep pace with demand emanating particularly from emerging markets like China and India. For some commodities like oil, geopolitical tension stokes up a premium as well. And as for gold, it is now being seen as a store of value against a depreciating US dollar.
A look at broad commodity indices will give an idea of the robust returns so far. Since 2003, the Rogers International Commodity Index has delivered cumulative total returns of 144 per cent up to end-January. In the same period, the Nasdaq delivered 80 per cent in total returns and S&P500 61 per cent.
Research spanning 1954 to 2004 shows that while stocks and bonds were negative at the peak of a business cycle when the Fed begins to raise rates and in the early phases of a recession, commodities produced positive returns in both phases.
Yet it is not just demand and supply and a robust global economy that have fuelled the surge in prices. Financial investors, hungry for alternative assets beyond traditional stocks and bonds, have piled in, adding in no small measure to the volatility.
According to research by Barclays Capital, the combined value of assets under management tracking commodity indices, investments in exchange traded products and issuance of new commodity structured products grew by more than US$40 billion last year to US$175 billion in total. In 2006, the increase in assets was even brisker at US$48 billion.
It said: 'The growth of new products and the recent robust performance of commodity assets despite the difficulties currently facing financial markets, suggests further strong growth in 2008.'
What next?
Based on Barclays' research as at January, the year-on-year increase in the prices of some commodities has ranged from minus 10 per cent for nickel to a stunning 98 per cent for wheat.
Naturally, the next question is what lies ahead. Investment guru Jim Rogers, who has designed and constructed his own Rogers International Commodity Index, has famously said that he believed that commodities are in the midst of a multi-year bull market to last until between 2014 and 2022, driven by imbalances in supply and demand.
This view is echoed by a number of fund managers and analysts. Marc Faber, for instance, has said he expected the current cycle, which he dates from 2001, to last until sometime between 2025 and 2040.
Christopher Wyke, Schroders product manager for emerging markets debt and commodities, points out that the average commodity bull market is 20 years. 'The current one will be longer. There are fewer sources of metal and energy, and they're more difficult to find and exploit. Environmental controls prevent new production from coming on stream quickly.
'We think we're in for at least 20 years. Energy is probably at the start of year 6, but you made lots of money in year 5. Metals is probably at the start of year 4 and agriculture at year 2. We're not at the bottom, but we're early cycle, and certainly not in a bubble.'
The caveat, of course, is the expectations for a weaker global economy which could dampen demand somewhat. Even then, analysts at Merrill Lynch are expecting another year of 'solid' returns in 2008, driven by consumption among the emerging markets.
There are a few ways individual investors can participate. Each avenue offers a differing risk/return profile. They could buy the equities of resource producers, including miners. But this would result in a relatively higher correlation to other equities they may hold in their portfolios, obviating any diversification benefit. Diversification, after all, is a key to investing in resources.
A second avenue is to buy physical commodities or trade the futures markets. Both may be impractical for individuals. They could also buy exchange-traded funds (ETFs) or actively managed commodities futures funds.
Commodities' role to help diversify a portfolio is a major benefit that should be examined. Research spanning 1954 to 2004 by academics Gary Gorton and Geert Rouwenhorst shows that commodities are positively correlated with inflation. They found that commodity futures were negatively correlated with returns on the S&P 500 and long-term bonds. The negative correlation with financial assets had something to do with how commodities behaved through a typical business cycle.
The academics found that while stocks and bonds were negative at the peak of a business cycle when the Fed begins to raise rates and in the early phases of a recession, commodities produced positive returns in both phases.
An investment in resources, however, will be subject to volatility. It will be prudent to make an allocation in the context of a balanced portfolio, which can help dampen overall volatility.
Next week, the second part of this two-part feature will explain some of the commodity indices and a new avenue by which individuals can participate.
