The Commodity Cycle will stay up: Business Standard: 31st January 20111

Global economic recovery and surging demand as a result of it presage higher prices all round

The commodity cycle in 2010 has been interesting, defying as it does movements in fundamentals at times. Prices have tended to increase over the year across all categories at a time when the world economy is just about recovering — the International Monetary Fund (IMF) projects developed countries to grow by 2.7 per cent in 2010 and emerging markets by 7.1 per cent to bring a cumulative growth of 4.8 per cent for the global economy.

Two issues flow from this. One, if the present increase is being brought about by emerging markets, then when the developed economies grow, there will be a further strain on prices. Two, even farm products have shown an increase in prices when there was no apparent crop failure.

The accompanying table gives information on global price movements for various commodities over the 12 months to November 2010. There are different stories emerging from various commodity groups. Both gold and silver moved up but the increase in gold price was moderate compared with silver. More interestingly, the traditional link between dollar movements and the price of gold was severed. The dollar movement was quite idiosyncratic — strengthening vis-à-vis the euro when the Greek crisis unfolded and declining subsequently. But bullion held on quite well and became the preferred asset class with investors finding it a safe haven. Silver gained further as investors in the futures markets took greater exposures. Further, the physical demand for silver increased thus putting pressure on the price. The coefficient of correlation between gold and silver prices remained high at 0.93. However, the same between gold and the dollar was -0.1065 against a long-term relation of -0.95. The fact that currencies are volatile and that inflation is a concern given the liberal monetary policies being pursued has made bullion a safe bet.

Non-precious metals follow the rules of demand and supply. Demand is normally associated with the upswing in the economic cycle. Has the cycle turned? One is not sure as central banks are still pursuing liberal monetary policies to provide liquidity and keep rates low so that the recovery can follow. Metal prices declined in the middle of the year at the time of the Greek crisis and then moved up.

Crude oil has shown an increase on a point to point basis, though there were phases when the price remained at lower levels. The price rise was also sharp in euro terms thus challenging the argument that prices were up only due to the weak dollar. Quite clearly, higher demand as well as the seasonal winter effect has fuelled this price increase.

Agriculture has been a curious case because despite sanguine projections for most crops, with minor distortions coming in wheat (Russia), prices have increased. USDA data shows higher production levels for rice, oilseeds, oils, cotton and sugar. Yet, prices have shown an upward tendency. This is a concern because it shows that overall farm growth has not kept pace with demand, so prices are being dragged upwards. This is a kind of a wake-up call across the world to bring about the necessary farm improvements as demand would tend to grow at a steady rate and has to be met with enhanced supplies. In fact, in several developing countries like India, which are witnessing high growth, lower levels of deprivation have increased demand for food products and higher growth in future will bring more people into the consumption stream which will put further pressure on prices.

2010 has quite clearly been a boom time for commodities where rising prices have delivered good returns to investors, even though consumers, both at the retail and industry level, paid more for their products. Looking ahead in 2011, growth should pick up in developed countries, which means that demand for non-precious metals will remain bullish unless there is a downward curve for the emerging markets, which looks unlikely because consolidation is in place. Bullion will be a favourite as currencies remain unstable and central banks pursue easy money policies. One is still talking of QE3, which means that interest rates will remain low and funds will flow to the emerging markets, and bullion will draw the benefits of being a safe anchor. Crude price will depend on OPEC in general, as demand will remain steady. With the dollar-euro struggle to persist, crude will remain stable in the range of $80 to $100 a barrel. Farm products will continue to be driven by the major producers and weather conditions in India, the US, Brazil, Russia and China in particular will swing the direction. Given the maintenance of income growth, a downward movement is unlikely and a gradual increase is possible. In short, looked at from any way, we will remain up on the commodity cycle in 2011. That is good news for investors.