Great Investment Articles

Investors to pour a further $15 to $25bn into commodities, metals & related indices, during 2007.

Barry Sergeant
22 May 2007

For years bulls and bears have fought over the notion of a "super cycle" in commodity and metal prices. Bears are now poised to again end this year with bloody noses. According to an analysis by Daniel Raab, MD of AIG Financial Products Corp, investors have this year already placed $8bn into commodities, metals and related indexes.

He estimates that the figure for the full year could come in at about $15bn, aided by the launch of more exchange-traded funds (ETFs), and other passive investment strategies for commodities and metals.

The unprecedented flow of funds into commodities, metals and related indices is consistent with the theme developed over the past few years by the likes of Alan Heap at Citigroup in Sydney, Melbourne-based Peter Richardson, London- based Michael Lewis of Deutsche Bank, and Goldman Sachs's Jeff Currie in London. Citigroup has defined a super cycle as a prolonged (decades) trend rise in real commodity prices, driven by the urbanization and industrialisation of a major economy.

The commodity and metals story continues to gain new dimensions, in line with increasing fund flows. With more than five years of an apparent super cycle in the bag, investment bank Lehman Brothers this year anticipates growth of about $25bn in the broader field of commodity investment. Analysts have put the cumulative figure-to-date at between $150bn and $200bn.

The current cycle has seen a significant growth in commodity indexes such as Dow Jones-AIG, Reuters-Jefferies, and S&P Goldman Sachs Commodity Index (GSCI). The rationale behind the latter index (as an example) was creation of an easily traded instrument providing investors with a reliable and publicly available benchmark for investment performance in the commodity markets, comparable to the S&P 500 or FT equity indices.

The S&P GSCI represents an unleveraged, long-only investment in commodity futures, broadly diversified across the spectrum of commodities. Specialised investors can go further, into related instruments, such as the S&P GSCI futures contract (traded on the Chicago Mercantile Exchange), or over-the-counter derivatives, or the direct purchase of the underlying futures contracts.

ETFs are also playing an increasingly important role, having attracted around $2bn in the first three months of this year alone. ETFs are open-ended securities that can be bought and sold by investors on a regulated exchange, in the same way as stocks and bonds. ETFs give investors exposure to commodities without the need to set up futures trading accounts or taking physical delivery of a commodity or metal.

The growing respectability of investing in commodities and metals - raw materials in the broad sense - has been fuelled by investors seeking a hedge out of stocks, bonds, and even cash. There is also the diversifier factor: if the price of crude oil declines, it could potentially be supportive to the equities side of a portfolio, if it reduces inflationary pressure, supporting, in turn and in time, lower interest rates. It has been noted that the US's Calpers, a giant pension fund with assets of more than $230bn, invested $450m into the S&P GSCI in March, just ahead of another rally in crude oil prices.

On the fundamental side, there is no question that serious investor interest in commodities and metals is now increasingly attracted by the merits of the "super cycle" story. According to Heap, there have been two super cycles in the past 150 years: late 1800s-early 1900s, driven by economic growth in the USA, and 1945-1975, prompted by post-war reconstruction in Europe and by Japan's later, massive economic expansion.

Deep research by Citigroup shows that in 1800, the Chinese and Indian economies were by far the largest in the world, dominating global gross domestic product (GDP), with Germany and Japan playing distant second fiddles. During the next few decades, the US economy really started moving, and took over as number one economy soon after 1900.

According to the Bank Credit Analyst, the odds are good that the commodities and metals bull market that began in 2001 has not yet run its full course. Chinese industrialisation and "rapid trend growth in the entire developing world will act as key forces to sustain structural demand for commodities". Heap's team has long stated that the key driver of the super cycle is without doubt materials-intensive economic growth in China.

Few prices go up in a straight line, and speculators inevitably contribute to the story. In January last year, the Citigroup global metal and mining team put it riotously: "A flood of investment funds is driving base metal prices much higher than can be supported by fundamental analysis of supply and demand. It's a bubble which could grow a lot bigger before bursting". There have been some bouts of savage profit taking in commodities and metals, but the fundamental story remains intact for the meantime.