It’s not often that investors have cause to celebrate when their money goes up in smoke. But owners of commodity funds may feel differently. After all, many have acquired positions in the belief that commodities will act as a hedge against a fall in the stock market. That proved the case early this year. When global equities rallied in the week ended March 21, commodities gave back some of their gains, thus demonstrating their “negative beta” credentials. Yet for all the sophisticated spin about alternative assets, commodity investors are really making a big bet on China.
The hard sell for commodities goes something like this: An investment in a commodity index will increase overall returns while reducing portfolio volatility. Goldman, Sachs & Co. finds that commodities have a negative correlation with financial assets, which helps protect a portfolio during what the investment bank calls “hostile markets.” Similar claims are made for gold, the ultimate safe haven in times of financial Armageddon. Goldman says that its own commodity index, the GSCI, acts as a good hedge against inflation, performing even better than Treasury Inflation-Protected Securities when consumer prices start to rise. It’s also widely believed that commodities provide a good hedge against a further fall in the value of the dollar.
There’s a theoretical argument for buying commodities when real interest rates are low. High real rates are said to be bad, as they provide an incentive for producers to increase output (they get to sell the stuff sooner and place the money on deposit). High rates also increase the opportunity cost of hoarding assets that produce no income. Low real rates have the opposite effect. After the technology boom ended, Peter Palmedo, portfolio manager of investment firm Sun Valley Gold, wrote a much-cited paper that argued that gold returns were inversely related to the rate of return on other assets, such as stocks. Given that U.S. inflation-protected bonds have recently traded with negative real yields, the outlook for gold and other commodities should be excellent.
To cap it all, there are genuine shortages. After a long period of underinvestment and several years of growing demand, bottlenecks have appeared for just about every commodity from aluminum to zinc. According to Barclays Capital, supplies of many commodities have dwindled to near-record lows relative to consumption. As the title of a recent report by Swiss bank UBS suggests, there has been a “Growth of Scarcity.” Current shortages are deemed structural rather than cyclical. The supply situation has been made even worse by temporary factors, such as electricity blackouts in South Africa, labor disruptions in Chile and flooding in Queensland, Australia. Shortages of agricultural commodities have been exacerbated by U.S. government policy, which has diverted domestic corn output to the highly inefficient manufacture of ethanol.
It’s not clear whether commodity investors are persuaded by these arguments or simply entranced by soaring prices. Either way, they have been ebullient of late. Barclays Capital estimates that inflows to commodity funds in January were twice the level of a year earlier. Cumulative investments in commodity index funds are approaching $160 billion, says UBS. This is about 160 times more than they were a decade ago. By the end of last year, exchange-traded funds held some $30 billion in physical goods, up 90 percent over 12 months, according to economist A. Gary Shilling.
After the credit crunch appeared last summer, commodities more than justified investors’ faith. Gold climbed nearly 50 percent between August and mid-March. The GSCI index rose by two thirds over the same period. Whipsawed by the credit crunch and the declining stock market, many investors are probably considering jumping on the commodity bandwagon. They should think again.
For a start, valuations are unfavorable. Many commodities have been trading at peak levels relative to their long-term trend. Take gold. Over the past two centuries, gold has maintained its value in real dollars. This makes sense because mining costs rise roughly in line with inflation. Research suggests that gold tends gradually to revert back to its historical value in real dollars. Yet it has been selling this year for more than twice fair value. Likewise, copper enjoyed no real price appreciation over the past century. But it has also been trading far above its inflation-adjusted trend.
Current high valuations overwhelm other arguments for buying gold. Those who claim that gold protected investors in the bear markets of the 1930s, the mid-1970s and 2002 fail to observe that the metal was cheap in dollar terms before each of these economic crises. When gold has been expensive, as during the recessions of the early 1980s and 1990, it has not provided a safe haven. Expensive commodities provide inadequate protection against a further devaluation of the dollar. Between last summer and early February, commodities rose by about 60 percent while the dollar declined by some 8 percent on a trade-weighted basis. As a result of this overshoot, the dollar could have much further to fall before it catches up with commodities.
Investors outside the U.S. face a different dilemma. It only makes sense for them to buy gold or other commodities as a hedge against a dollar devaluation if they believe their own currency is vulnerable. If that’s not the case, they would probably do better keeping their money at home. Such thoughts don’t yet seem to have bothered Indian buyers of jewelry, the world’s largest gold consumers. Nevertheless, high prices have already begun to discourage gold consumption.
Those who invest in commodities today may have been persuaded they are purchasing an alternative asset that will improve their risk-adjusted returns. In truth, they are gambling on China’s future. With its double-digit rate of economic growth and an investment level equivalent to half of GDP, China has become the final arbiter of global commodities prices. That’s true for base metals (copper, tin, zinc, iron ore and lead), energy (oil and coal), and the “ags” (soybeans and wheat). Surging demand from China has produced the current shortages in the world of commodities.
High levels of consumption in the developed world and a high rate of investment in the developing world lie behind the great commodity boom. As the credit crunch takes its toll, Chinese exports to the U.S. have been falling. The key question is whether domestic consumption in China and other emerging markets can take up the slack.
Anyone considering buying commodities should ignore the alternative-investment story and ponder the following questions: Will the bottlenecks, which have pushed up commodity prices, disappear as the U.S. economy enters recession? Or has the increasing prosperity of China and other emerging markets raised the prices of commodities to a new, permanently high level?
Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.
