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Taking the commodities bull by the horns

Finance : Alternative Investments

Commodities have shown impressive rates of return for wily investors over the past few years. But what is the prospect of this trend continuing? John Adams investigates the role of China and asks whether investors should get in while the going's good.

John Adams is a freelance journalist based in the UK.

Talk of the commodities super-cycle is becoming increasingly voluble. And, despite a recent commodities wobble – the CRB commodities index has slipped 12% since last May – the longer-term trend has been impressive. Indeed, and to name just a few star performers, a barrel of Brent crude has risen over 90% in the past three years, the copper price is up 100% in the same period, while zinc has risen nearly 200%. Uranium is an especially hot metal – its price has more than doubled in just the last year. Since 2002, the CRB commodities index has risen over 110%, easily beating the less than 30% hike in global equities in that period.

Chinese consumption
But before making commodities the cornerstone, or even a constituent, of an investment portfolio, it's worth considering whether that boom can continue. And that involves an assessment of China. Indeed, China is almost universally perceived to be the key reason for the commodities upswing and it's easy to see why. China, with its 1.3 billion people, has already become the world's largest consumer of zinc, nickel and copper. Between 2002 and 2005, according to the International Monetary Fund, China accounted for 48% of the increased global demand for aluminium, 51% of the increased demand for copper and 87% of the increased demand for nickel.

So whether commodity prices will continue to rise looks dependent upon whether China's phenomenal rate of consumption holds up – and that isn't as clear as it seems. After all, the Chinese government wants a more sustainable level of commodity consumption in the longer-term, while development itself could also hit Chinese commodity demand. Between 2004 and 2006, for instance, China went from being a major steel importer to a major exporter and that's happening with other commodities, such as aluminium.

Then there's the potential impact of a global economic slowdown. Should US house price pressures, for example, act to dissuade US consumers from spending on Chinese imported goods, then a knock-on effect that weakens Chinese commodity demand is possible. However, commodity bulls may point to periods of past economic distress that coincided with strong commodity markets. Commodities did indeed do well during the Great Depression in the 1930s, as well as during the economic upheavals of the 1970s. That suggests that when times get tough investors perceive real, tangible materials as a safe bet.

Supply and demand
The huge influx of money into commodities in recent years – the Bank for International Settlements estimates that the value of derivative contracts jumped 400% between June 2004 and June 2006 to a staggering $6.3 billion – may justify concerns, too. That's because the boom has attracted plenty of speculative money that might have pushed up prices beyond what can be justified by supply-and-demand fundamentals – in other words, a classic bubble. Indeed analysts at Merrill Lynch think that commodities listed on futures exchanges, and which are therefore more easily accessible to speculative investors, trade well above those that are traded in physical markets and where it's much harder to take speculative positions. The speculative money could pull out fast at any sign of prolonged weakness, precipitating dramatic price collapses.

But countering this is the fact that, within China, industrial production isn't the only source of robust commodity demand. It is estimated that China's urban population will rise from its current 530 million to 875 million by 2030 – that's equivalent to some 50 cities the size of Greater London being constructed in just two decades. Such a hugely materials and energy intensive stage of development alone could keep the commodities super-cycle moving upwards.

And with urbanisation often comes changing consumer tastes – potentially signalling good news for "soft" agricultural commodities. Taking one example, the OECD estimates that beef consumption in India and China could rise by a third between now and 2015. Moreover, and regardless of developments in China, the world's other population giant, India, shouldn't be forgotten. India is generally reckoned to lag China's stage of development by about a decade and just as Chinese commodity demand moderates, so it's possible that growing Indian demand could keep prices moving up.

It's also worth remembering that the current commodities bull market only began about five years ago, which is short by historic standards. The last great commodities boom lasted for 16 years, between 1966 and 1982, and it seems reasonable to assume that with such globally significant trends as the long-term development of the world's two most populous nations as background, the current commodities boom has rather longer to run. Indeed, UBS Wealth Management thinks the commodities wobble seen since 2006's second half could soon end, with a resumption of the bull market anticipated in the second half of 2007. Inevitably, Asia is a factor in UBS' thinking: "The relatively strong growth we foresee in China and elsewhere in Asia should prevent global demand declining as much as in previous cycles."

Diversification characteristics
Yet merely being convinced that there's still plenty more commodities upside isn't enough to abandon the principle of investment diversification. In the past 40 years the CRB commodities index has risen about 250%, but the UK's stock market has risen over 4,000%. When dividends are reinvested over that period – and commodities don't pay dividends – the return on UK equities in that 40-year period rises to well over 24,000%. So just focusing on commodities at the expense of other investments, especially equities, could be to miss a trick.

Commodities do possess a useful diversification characteristic, however. "Commodity prices have traditionally been negatively correlated to price movements of other financial instruments," notes the UK's financial regulator, the Financial Services Authority (FSA), in a commodities report released in March. Essentially, commodities do well when other asset classes, such as equities, do badly – an excellent way to offset risk and cut portfolio volatility. Of course, there's no hard and fast rule as to how much is best to invest in commodities although, according to the FSA, private wealth managers say their clients typically have 3–7% of their portfolios in commodities.

Neither is it necessary to physically buy a commodity, or become proficient in the complex ways of derivatives and options, to gain exposure to commodities. Through such companies as IG Index, spread-betting is one of the simplest ways to take a punt on commodities – indeed, IG Index came into being in the 1970s so that UK investors could circumvent the currency controls in place at that time in order to invest in gold. Other possibilities include exchange-traded commodities – these are exchange-traded funds that track a commodity or an index. And investing in a diversified managed fund, which holds shares in commodity-focused companies, would also provide exposure.

All in the timing
But regardless of the investment route into commodities, timing matters. "Throughout history the public has always piled into the latest bull market right at the top," points out Jim Rogers, regarded as the high priest of commodities by many in the market and founder of the Rogers Commodity Index. And so far, he believes, "few have caught on to the bull market in commodities".

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