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 certainly proved the case during the first couple of months of the year.
When global equities rallied in the week ending 21 March, commodities gave back some gains, thus demonstrating their “negative beta” credentials. Yet, for all the sophisticated spin about alternative assets, commodity investors are really taking a big bet on China. The hardsell for commodities goes something like this. An investment in a commodity index will increase overall returns while reducing portfolio volatility. Global investment banking, securities and investment management firm Goldman Sachs Group Inc. finds that commodities have a negative correlation with financial assets.
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 TIPS, or treasury inflation-protected securities, when consumer prices start to rise.
It’s believed that commodities provide a good hedge against a fall in the dollar’s foreign exchange value.
There’s a theoretical argument for buying commodities when real interest rates are low. High real rates are said to be bad for commodity prices as they provide an incentive for producers to increase output as they get to sell the stuff sooner and place the money on deposit. High rates increase the opportunity cost of hoarding assets which produce no income. Low real rates have the opposite effect. After the technology boom ended, Peter Palmedo of brokerage Sun Valley Gold Llc. wrote a paper arguing that gold returns were inversely related to the rate of return on other assets, such as stocks. To cap it all, there are genuine shortages in many commodities.
According to investment banking firm Barclays Capital, or Barcap, stocks for many commodities have dwindled to near record lows relative to consumption. As the title of a recent financial services firm UBS AG report suggests, there has been a “growth of scarcity.”
Barcap estimates that inflows to commodity funds last January were twice their level a year earlier. Cumulative investments in commodities are approaching $160 billion, says UBS. This is around 160 times more than a decade ago.
After the credit crunch appeared last summer, commodities more than justified investors’ faith. Gold climbed nearly 50% 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 unfavourable. Many commodities have been trading at peak levels relative to their long-term trend. Take the case of gold. Over the last two centuries, gold has maintained its value in real dollars. In 1833, an ounce of gold sold for $20.65. Adjusted for inflation, that’s around $500 in current dollars. The current marginal cost of mining gold is $470, according to UBS.
Research suggests that gold tends gradually to revert its historic value in real dollars. Yet the precious metal has been selling this year for more than twice fair value.
Current high valuations overwhelm other arguments for buying gold. Those who claim that gold protected investors in the bear markets of the 1930s, mid-1970s and 2002 fail to observe that gold was cheap in dollar terms before each of these economic crises. When gold has been expensive, as was the case during the recessions of the early 1980s and 1990, it has not provided a safe haven.
Meanwhile, non-US investors face a 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 jewellery, who are the world’s largest gold consumers.
Those who invest in commodities today may have been persuaded they are purchasing an alternative asset which will improve their risk-adjusted returns. But 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 gross domestic product, China has become final arbiter of global commodities prices.
High levels of consumption in the developed world and a high rate of investment in the developing world lie behind the commodity boom. As the credit crunch takes its toll, Chinese exports to the US have been falling. But domestic consumption has picked up. Anyone considering buying commodities now should ignore the alternative investment story. Instead they should ponder the following questions: Will the bottlenecks, which have pushed up commodity prices, disappear as the US economy enters recession? Or has the increasing prosperity of China and other emerging markets raised the price of commodities to a new, permanently high level?
Edward Chancellor is a member of mining firm General Molly Inc.’s asset allocation team.