An interesting if slightly worrying article in the Financial Times by Gavyn Davies (co-founder of Fulcrum Asset Management and Prisma Capital Partners) illustrates some of the current thinking and, hence, trends in metal markets as viewed by the financial community. The article leads with this: inflows into the sector reached a new high of $7.9 billion in the month of October, taking total investor commodity holdings to a record $340 billion, according to Barclays Capital. This is of course spread across all commodities, soft (agricultural), hard (metals) and oil but is evidence of the money flowing into the sector inevitably boosting prices. More worrying is his comment regarding portfolio optimization: “Current investor holdings of commodities represent less than 0.5 percent of global financial wealth, whereas portfolio optimization techniques suggest that the ‘correct’ share of wealth that should be allocated to commodities is in the order of 15-25 percent. That is a worrying point of view; if financial investors moved the proportion from less than 0.5 percent to even 2 or 3 percent, the inflows would be too much for the markets to absorb without an unsustainable uplift in prices.
Mr. Davies then goes on to look at the likely direction of commodity prices next year by comparing this point in the global recovery with previous recessions. The best measure he suggests is the change of rate of growth in the global economy. Observing that the growth rate of industrial production dropped from an annualized rate of 11 percent in Q1 of 2010 to about 3 percent in Q4, he put this down to inventory re-stocking in the early part of the year, which is now largely complete. However, with emerging market growth still robust and US industrial production picking up, the article predicts industrial production could be at 6 percent by mid-2011. Supply for many metals is reaching capacity limits and global growth at that level would result in supply constraints. For some metals, that is beginning to happen as evidenced by futures prices in some metals moving from contango to backwardation — that is, spot prices for short term delivery at a premium over longer dated deliveries three or six months out.
The other issue the article raises is the long held and oft-mooted justification for commodity investments having a negative correlation to equities. That is, risk is spread if a portfolio carries investments in both areas — when equities do well, commodities tend not to, and vice versa. Over the last 18 months, though, this has not been the case as both asset classes have risen strongly. One or the other is likely to break this alignment next year and revert to the long-term relationship. Mr. Davies believes it will be equities that will fall as commodity-led inflation caused by the strains of both a growing US economy and growing emerging market economies put unsustainable pressure on commodity prices to the detriment of manufacturing profitability.
He may well be right in his conclusions. What worries us is the extent to which portfolio managers look at their balance of commodity vs. other investments and agree with him that they are too light in metals, oil and agricultural commodities. Too much money chasing investment opportunities drives prices in only one direction.