In his recent letter to shareholders, Warren Buffett quotes a 2003 Silicon Valley bumper sticker that said, “Please, God, just one more bubble.”
That wish was granted and investors enjoyed the benefits of a huge bubble in US real estate and in emerging market stocks. Now that those bubbles too are bursting, it’s time to ask, “Where next?” Could the next bubble be in commodities?
On Monday, when the Bombay Stock Exchange (BSE) Sensex plummeted 900 points, the MCX Comdex index on the Multi Commodity Exchange of India Ltd (MCX) hit a record high. Year-to-date, the commodity index has risen 18%, compared with a decline of 20% for the Sensex.
What’s going on? Why should commodity prices rise when equities decline? Of course, it’s not just a local phenomenon. Even as the US economy is slipping into a recession, commodity prices have continued to soar, unsettling central banks looking to cut interest rates to ward off slower growth. The Commodity Research Bureau (CRB) index surged last week to a new record as did the Goldman Sachs Commodities Index (GSCI).
Some observers have said this is one sign of “decoupling,” a signal that although the US may be slowing, growth in other parts of the world is strong enough to keep commodity prices high.
Rating agency Standard and Poor’s (S&P) is the latest to climb on that bandwagon, asserting that while US growth will slow 1 percentage point to 1.2% this year, China and India, although slowing, will grow at 9.3% and 8.5%, respectively. Nevertheless, S&P does see world growth slipping to 3.1% in 2008 from 3.8% in the previous year.
Some observers blame supply shortages, especially for crude oil, while others say that fund buying is behind the price spike.
Perhaps the commodity boom is a mix of all these reasons. While it’s true that global growth is slowing, growth in China is more commodity-intensive than growth in a service economy such as the US. Nevertheless, the State Information Agency, a Chinese government research centre, recently said that first quarter economic growth may cool to 10.5%, from 11.2% in the previous three months because of the storms and weakening export demand. If Chinese and Indian demand is behind the commodity boom, surely prices should soften as these economies slow? Perhaps what is happening is that any slowdown in demand has been more than compensated by a rise in investor interest. That is entirely natural because, with the US Federal Reserve pushing down interest rates, investors expect inflation to accelerate and commodities are viewed as a hedge against inflation.
Moreover, a weak dollar makes raw materials priced in the US currency cheaper for buyers holding other currencies. When the Fed started reducing interest rates, many predicted that emerging markets would be the next bubble, as funds deserted the credit-crisis-hit markets of the West for emerging markets. But after an initial flood of money, emerging markets have not been doing so well. Rather, the money is now flowing to commodities.
To take one example, recent reports indicate that the California Public Employees’ Retirement System, the largest US pension fund, may increase its commodities investments 16-fold to $7.2 billion (Rs29,016 crore) through 2010. Other investors are likely to follow suit. With yields on bonds so low and unprotected from inflation, money is flowing into commodities. What about emerging markets? Markets linked to commodities should do well, even in the middle of all this global market turmoil, Brazil’s Bovespa Index reached new highs recently and its currency is near a nine-year high against the dollar.
Indian stocks linked to commodities don’t seem as fortunate. While the MCX Metal index has risen 22%, the BSE Metal index has fallen 21% this year. (Note that the BSE index is largely made up of steel companies, while the MCX index includes precious metals and non-ferrous metals.) Aluminium stocks such as Hindalco Industries Ltd have outperformed the market this year, tracking the rise in the underlying metal, but the correction in the stock market has still resulted in a drop in their valuation multiples.
Companies such as Sesa Goa Ltd, which deal in iron ore, have naturally outperformed the market because of the buoyancy in the prices of the underlying commodity. But share prices of steel companies have fallen in line with the overall markets, as although steel prices are on the rise, so are those of inputs such as iron ore and coal.
If the rise in commodity prices continues, stocks linked to them should outperform. And since markets always tend to overshoot, the commodity boom may have a long way to go.
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