Commodities regain fashion status

Until their stellar performance of the last few years, commodities investments were on just about no one’s investment wish list. Trying to discuss your commodities investments at a barbeque was probably more boring than describing your last trip to the dentist. The likelihood was that your friends would think you were mad and wonder why you hadn’t put your money in the latest hedge fund. (Chris Condon, MLC’s chief investment officer, calls this ‘barbeque risk’.)

But commodities are no longer a laughing matter. Since a trough in 2000, commodity prices have risen 84 per cent. This rise has been particularly strong over the past 3 years, and has sparked investor interest.

All too often, investors are attracted by the lure of past returns — and as seductive as they are, past returns can prove to be a very misleading indicator of the future.

Historically, rapid rises in commodity prices have substantially reversed rather than been maintained. Key past examples include the Korean War boom of the early 1950s and the 1970’s broad based commodities boom.

During the Korean War, wool prices increased five-fold as a result of US stockpiling and demand for woollen uniforms. At that time, wool accounted for two-thirds of Australia’s exports and 29 per cent of its gross domestic product (GDP).

However, at the end of the boom there was an inevitable collapse in wool prices.

Similarly, in the oil price shock era, the commodity price booms of both the early and late 1970s ended with significant price reversals.

Historically, commodities have been of particular importance for Australia. While wool is well and truly past its peak, and total commodity exports are down to 7 per cent of GDP, commodities still comprise 60 per cent of Australia’s total goods and services exports. This means that rises in commodity prices significantly affect Australia’s terms of trade (the price of exports relative to the price of imports).

Higher commodity prices increase the terms of trade (chart 2). In other words, fewer exports are required to pay for a given basket of imports. Conversely, as commodity prices slump, our terms of trade and the fortunes of the economy also reverse.

Will the current boom end in a slump?

Past commodity price reversals have led to a view that commodity prices are subject to long cycles. Price booms are caused by either an unanticipated increase in demand, which current supply is unable to meet, or a restriction in supply. These boom causing events have been relatively infrequent historically and are typically unanticipated by investors and consumers.

History has demonstrated that as prices rise, lack of investor interest and even pessimism gives way to growing optimism. As this happens, commodity prices may disengage from the underlying demand and supply fundamentals as speculative demand continues to push prices up.

In a worst-case outcome, supply starts to rise (this can take several years) while demand is falling in response to spiraling prices. As a result, supply ends up well in excess of demand and the result is a price collapse.

An important question is whether it is reasonable to extrapolate this behaviour into the future?

The answer is that this will not necessarily be the case. Some of the fundamentals of the economic environment that existed during previous commodity price booms no longer exist today, and this may mean that the current commodity price cycle is very different. For example, commodity price booms are often associated with rising inflation. However, this may be less of an issue in the current boom.

During the Korean War boom for example, exchange rates were fixed and higher international commodity prices resulted in rising incomes in Australia. An economic growth and an import boom resulted, and commodity price inflation flowed through into general inflation. The result was a rapid rise in inflation and a balance of payments crisis.

Rather than responding with higher interest rates and allowing the currency to depreciate, the authorities put in place import controls that halved the level of imports, which were not abolished until 1960. The fixed exchange rate policy remained in place for Australia until 1983.

However, for many developed countries floating exchange rates were introduced not long before the first oil price shock of the 1970s. This meant that policymakers had available to them the key inflation fighting weapon — interest rates.

However, at that time other policy priorities, probably mistakenly, took precedence and inflation increased. It was not until Paul Volker became chairman of the US Federal Reserve in 1979 that central bankers collectively declared war on inflation. It is now a common principle of central banking that rising inflation will be fought.

This is one of the reasons why commodity price booms may not in the future feed into a sustained rising inflation and boom-bust cycle in the Australian economy.

Related to this, flexible exchange rates also mute the effect of price booms on Australian inflation. When commodity prices are rising, there is a tendency for the Australian dollar to strengthen. For example, it was noted above that commodity prices in US dollars have risen by 84 per cent since a low point in 2000, however in Australian dollar terms the rise has been 65 per cent.

The difference is due to an appreciation in the Australian dollar. This exchange rate effect means commodity prices, which are typically defined in US dollars, rise less from an Australian perspective.

More generally, an important inflation offset is coming from the burgeoning supply of Chinese manufacturing goods. This supply, which is a key driver of commodity price rises, appears to be reducing the flow through of higher input prices into consumer inflation. Again, this reduces the risk of a boom-bust cycle, and makes a substantial commodity price reversal less likely.

The current pace of commodity price rises is unlikely to persist, and additional commodity supply will eventually be forthcoming. However, given huge prospective economic development in China and other Asian countries, the longer-term drivers of commodity prices may well be robust. A recent Reserve Bank of Australia article came to a similar conclusion: “Even if the prices of some commodities did fall back over coming years, it is likely that a substantial part of the recent strength in commodity prices will be maintained over the medium-term.”

Investing in commodities

While it is a positive that commodity price booms no longer automatically generate inflation, this change in behaviour may bring into question one of the most desirable attributes of commodity exposures for investors. That is, the positive correlation between commodity and general consumer prices. In the past, having commodity exposure has provided some important inflation protection for investors. Does changed behaviour mean commodities no longer provide a good inflation hedge?

The first point to make is that although there is considerable confidence policymakers will control inflation, this does not mean policy mistakes will not be made or that there could be other policy priorities that permit rising inflation.

What might be the case is commodity price booms being less likely to feed through into rising inflation, and therefore boom-bust cycles being less likely. This may imply that economic and investment environments are now more stable — this is a positive for investors.

However, commodity exposure should still provide an effective hedge against commodity price driven rises in inflation, whether the rise is a sustained rise or not. Consequently, the inflation hedge characteristics remain valuable. Commodities have exhibited not only inflation protection properties, but also a generally low correlation with many other investment assets. These are attractive characteristics from an investment perspective.

However, while it is clear they have diversifying properties, the perceived long-term nature of commodity price cycles has tended to deter investors. Recognition of the benefits of commodity investments led MLC to include an exposure to commodities in its diversified funds, through one of its diversified debt managers. This has allowed our investors to benefit, to some degree, from the strong recent returns.

However, there has not historically been a specific allocation to commodities in MLC’s diversified funds. An important reason for this is that commodities have tended to have very long price trends, which does not sit well with investors’ tendency to evaluate performance over the shorter term. This is despite recognition of the diversification benefits and inflation protection potential such exposure can provide.

In contrast, MLC’s new long-term absolute return portfolio (LTAR) has an objective to maximise real returns over 20 years. This time horizon and objective is consistent with the inclusion of a strategic allocation to commodities. The result for investors in LTAR is more effective diversification and a lower risk and greater certainty of meeting real return objectives.

Susan Gosling is general manager, implemented consulting, with MLC.