Investors were badly stung by commodities in 2008 but they have been quick to forgive and forget. According to Barclays Capital, inflows into the sector reached a new high of $7.9bn in October, taking total investor commodity holdings to a record $340bn.
Since the rally in risk assets started in August, commodity spot prices have risen by about 20 per cent and there is a case for worrying that this may be a crowded trade in the near term. But current investor holdings of commodities represent less than 0.5 per cent of global financial wealth, whereas portfolio optimisation techniques suggest that the correct share of wealth that should be allocated to commodities is in the order of 15-25 per cent. So there is an enormous distance to go before investing institutions are likely to be satiated with commodities.
Furthermore, this is the phase of the global economic cycle when commodity prices tend to rise most rapidly. The early stages of the rebound in world output had relatively little effect on commodity returns, largely because the responsiveness of supply proved greater than had been expected. Producers had substantially increased their capacity during the price boom of 2005-07, and this capacity was brought on stream as demand began to pick up.
But the cushion of spare capacity has now largely been used up, so price pressures could be much greater if global commodity demand continues to expand rapidly.
In past cycles, the best guide to the behaviour of commodity prices has been the change in the rate of growth in the global economy. (This seems to work better than simply using the growth rate itself.) The growth rate of global industrial production has dropped during 2010 from an annualised rate of about 11 per cent in Q1 to about 3 per cent in Q4, largely because of a fall in the contribution from inventories in both China and the US.
But the inventory adjustment is now virtually completed, and industrial production may bounce back to about 6 per cent growth by mid 2011, bringing with it a further strengthening in commodity demand.
Unlike in the past 18 months, supply may not be able to cope with this, so much higher prices could ensue. This is especially true in cyclical commodities such as oil and industrial metals. And a further boost to returns will come from the fact that the futures curves in many important commodity markets have recently shifted from contango to backwardation , meaning commodities for immediate delivery now command a premium.
In 2010, futures prices have generally been much higher than spot, and the standard investment strategy of buying and rolling futures prices has cost investors about 11 per cent this year. With curves now back to normal, this drag should disappear in 2011.
What about the diversification benefits of commodities? Since about 1970, commodity returns have averaged about 10 per cent a year (5 per cent above cash), roughly the same as equities. Equally importantly, the correlation between commodity and equity returns has been negative for most of that time, establishing a clear benefit for commodity holdings portfolios.
But the exact opposite has been the case in the past few years. In fact, since 2007, commodities have shown a positive correlation with global equities averaging as high as 0.8 or 0.9, which seems to negate their diversification benefits.
These high positive correlations are most unlikely to prove permanent. Recently, large swings in the global appetite for risk have affected both equities and commodities in the same direction. But risk appetite does not usually vary so much over short periods. Other factors such as global demand and supply shocks generally determine the correlation between equities and commodities.
What type of shock seems most likely in 2011/12? Provided that Chinese growth survives the current tightening in monetary policy, as it probably will, both China and the US will soon be growing simultaneously at close to their trend rates.
During 2008, when this last occurred, the combined growth of the world s two biggest economies finally proved too much for the supply capacity of commodity producers, and spot commodity prices trebled in a very short period. This commodity price shock subtracted about 3 per cent from global demand, and was more responsible for the Great Recession, and the precipitous decline in equities, than many people have realised.
We may discover in the next few years that a healthy US recovery is not compatible with rapid emerging market growth without some strong upward price pressure on commodities. This could unhinge the equity rally.
Commodity-driven inflation may not be the most likely outcome next year, but it is a risk worth considering. Commodities still remain the best way of hedging against this risk.
