Long term, the decision to invest in commodities seems logical. Edward Trafford, Northern Trust’s senior basic materials and commodities analyst, summarizes the fundamental premise: The demand for commodities – raw materials ranging from copper to crude oil – will grow while supply is largely fixed. This dynamic creates a compelling investment thesis, particularly considering the accelerated demand growth we are seeing from the emerging economies of China, India and Brazil.
Of course, that’s not the entire story. Investing in commodities is also risky. Commodity markets are subject to a number of volatile and unpredictable short-term forces, ranging from unpredictable weather patterns to government interventions that may limit pricing or impose quotas. Emerging economies, particularly China’s, have an outsized impact on commodity prices. That’s because commodity demand is fairly stable and established in countries like the United States. China, on the other hand, has rapidly evolving and increasing patterns of usage and consumption, which exert steady upward price pressure.
But just how will emerging economies affect the outlook for the commodity markets, and what does this mean for investors?
Changing Needs of Developing Economies
In developing economies, both the consumption and production of commodities are in flux. For one thing, consumer spending patterns change as per-capita income increases and people allocate that disposable income differently.
“In emerging economies, when consumers have an additional dollar of income, they are likely to spend a relatively large share of that dollar on food products. In richer countries, where we tend to be well-fed or even excessively fed, a much smaller share of an additional dollar of income will go toward food,” says David Schweikhardt, a professor in the Department of Agricultural, Food and Resource Economics at Michigan State University.
There’s also a shift in the type of food products purchased. As a country’s economy develops, its people are more likely to buy meat instead of beans, for example. This affects demand not only for meat but also for the grains used to feed cattle, hogs and poultry. A multiplier effect is inherent as a middle class emerges in developing countries. “In order to produce 1 kilogram [kg] of poultry, it takes 2 kg of grain. One kg of pork equates to 4 kg of grain. And for beef, the ratio lifts to 1:7,” Trafford says.
Demand for energy and construction materials such as lumber, aluminum, copper and petroleum-derived goods, such as PVC piping, also increases as a country builds out its infrastructure. In China, the government’s proactive spending intensifies this trend. “China is building roads, airports, rail and general infrastructure not for use today but instead based on the idea that this capacity will be ‘consumed’ over the coming five to 10 years,” Trafford says. “This has had a profound impact on commodity markets by pulling forward demand today that you would have seen ramp up at a much slower rate.”
China Sets the Tone
Indeed, China’s status as the most prominent developing economy and bold policy moves mean the country has a singular impact on commodity markets. The relevant importance of other emerging economies, such as those in Brazil and India, are still years – perhaps decades – behind China.
Trafford is bullish on the long-term prospects for commodities because of the growth of emerging economies. But he’s concerned about the possibility of a short-term price correction as China moderates its rapid build-out philosophy, credit tightens and traders liquidate inventory. He doesn’t see the emerging economies of India or Brazil and/or the developed economies of the West being able to compensate for this short-term demand pause. Considering that China is struggling to curb domestic consumer inflation, he argues that a slowdown in the industrial infrastructure build is likely.
“China is the primary force in commodity markets, consuming anywhere from 20% to 65% of global production,” Trafford says. “If it decides to step out of the market, it would have a profound impact on commodity prices.”
In addition to affecting demand, China also may influence the commodity markets by altering the supply of certain key commodities. The Chinese government has signaled its intent to shift production away from low value-add products, where it lacks an inherent competitive advantage, and toward those that are more complex and higher margin. Given wage inflation in the 10% to 12% range, this becomes increasingly important to ensure that its workforce remains productive, employed and stable.
Trafford sees China reducing its aluminum production given that the country is short both power (50% of the cost of producing aluminum) and bauxite (the raw materials used to manufacture the metal). Such a move would drive aluminum prices upward, as the available global supply would decline. That possibility is one reason why Trafford believes aluminum is a compelling investment right now.
Additionally, as power costs remain elevated, and the costs associated with bauxite mining and refining increase, so too will the price of aluminum. Trafford sees higher global power costs as one consequence resulting from the unfortunate Japan nuclear fallout. Those companies vertically integrated into low-cost inputs will likely be the net beneficiaries.
In addition to his positive outlook for certain processed metals, such as steel and aluminum, Trafford likes the prospects for diversified miners that control the entire production chain and benefit from their ownership of low-cost production assets, which provide significant operating leverage when commodity prices rise. These companies also are insulated from increasing raw materials prices – a trend that continues as it becomes increasingly expensive to extract each incremental ton of ore.
Commodities and Currency
Commodity prices have historically had an inverse relationship to the U.S. dollar and interest rates. As a result, many investors include commodities in their portfolios as a hedge against inflation. Most Northern Trust investors typically invest in commodities via mutual funds and Exchange Traded Funds (ETFs).
A short-term risk for these types of investments is commodity prices have been driven up by an infusion of cash from investors in the market mostly because of inflation fears. Trafford calculates that over the last five years, gold ETFs have increased their physical holdings of gold to 65.6 million ounces in 2010 from just 16.7 million ounces in 2006. To put this into perspective, global production from mines in 2010 was 83.1 million ounces (therefore total ETF holdings represented 78.9% of annual mine production).
The larger trends that work in favor of commodity sectors like agriculture must be separated from the macro-economics involved in the inflationary environment in which we find ourselves, says Kevin Kimle, professor and chairman of the Agricultural Entrepreneurship Program at Iowa State University. “People don’t want to hold cash, so money flows into harder assets [such as commodities]. You get investment as reaction,” he says. “That’s all fine, but if anything ever changes – the market imposes higher interest rates or political leadership in the U.S. or elsewhere gets set on a more stable monetary policy – some of the air in commodity prices could pretty rapidly come out.”
Force of Nature
Commodity prices also are subject to the whims of weather. For example, the floods in Australia in late 2010 ruined crops and closed mines, substantially affecting global commodity markets. Such events make commodities a dangerously volatile investment, though analysts try to contextualize these types of exogenous factors when making long-term projections.
Trafford, for example, has carefully analyzed agricultural prices in the 2010/2011 period and determined the majority of price increases have been driven by a confluence of atypical global weather patterns – the likes of which have not been seen since 1917 and represent a 1.8 standard deviation from the norm.
Bank on Commodities
As the world’s population grows, and large emerging economies in China, India and elsewhere continue to develop, the long-term outlook for commodity investments is bright. But that doesn’t make them easy or a sure thing.
“Commodities are not the kind of investment where you just put your money in and check back in six months, because there’s a lot of short-term volatility,” says Michigan State’s Schweikhardt. “You have these large mega-trends that are very positive. But commodity markets are always subject to considerable instability because many [commodities] have a natural production process.”
Still, Trafford recommends investors that maintain a commodity allocation within their portfolios remain cognizant that the sector can be prone to acute, short-term fluctuations. “We see an attractive dynamic [for commodities] over the medium-term as supply fails to meet demand, thereby keeping upward pressure on pricing,” he says. “For this thesis to play out, emerging economies need to continue developing. We are not projecting an exogenous shock stunting development in China, India or Brazil over the coming decade.”
This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation, and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, investment horizon, tax status or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy can not be guaranteed.