Recent Market Dynamics
The overriding market dynamic that has governed the price behavior of global hard assets has been supply and demand, often characterized by impressive price trends, and followed by equally impressive reversals. Historically, as demand has risen, prices have risen in tandem. Increased demand combined with higher prices has generally led to increased production. This in turn has traditionally led to declining prices.
Supply and demand relationships continue to govern the prices and values of global hard assets. But the factors driving demand have been altered significantly over the past decade. Globalization has spurred development around the world, resulting in higher overall consumption in high-income countries and sharply higher consumption in middle-income countries. In particular, demand for hard assets in China, India, the MENA countries and in Latin America have placed unprecedented strains on the hard asset industry’s ability to keep up with demand. The result of this process has been sharply higher prices. Raw commodities prices, as represented by the Dow Jones/AIG Commodity Index, have risen 124% over the past five years while the market value of those companies that facilitate worldwide supply, the global hard assets industry as measured by the RVE Index, has risen 321% over the a same period.
The global outlook for sustainable economic growth remains strong and somewhat inflexible. China, which has experienced real GDP growth of 9.2% per annum over the past two decades, is forecasted by the OECD to grow at an annual rate of more than 8% per annum into the foreseeable future. To put this into more tangible terms, construction projects in the city of Shanghai alone consume more than 5% of the world’s current output of metallurgical coal and a comparable percentage of current steel output. Per capita consumption of animal protein in China has risen from 44 lbs. per annum in 1980 to 110 lbs. in 2007 and continues to grow at these high rates. In this context, it should be noted that 7 measures of volume of vegetable protein is needed to produce one measure of volume of animal protein, creating a near-exponential shift in regional demand patterns for coarse grains.
Nor are these types of inflexible distortions in traditional hard asset demand patterns confined to China. India, whose population recently crossed the one billion threshhold, continues to add approximately 25 million new citizens per year at the same time it is experiencing rises in per capita consumption of nearly every hard asset.
One after another middle income and developing country is experiencing similar, if not comparable, increases in population and living standards, with attendant rising demand for hard assets. According to the World Bank, GDP growth in emerging market countries as a group has averaged well over 6% per annum over the past five years, approximately double the growth rate of developed countries. The World Bank expects this dynamic to remain in place for the next five years. At the same time, poverty levels are declining, indicating greater consumption.
Related Market Factors
Surging global demand for hard assets is often compounded by the nature of the industry, which leads to increased demand in a self-fulfilling way. Rising demand for copper, for example, results in the need for more copper mines, which requires more mining equipment, which requires steel, energy and, of course, more copper. Money spent in China on Colombian copper also creates jobs in Colombia, which results in higher levels of consumption of other hard assets in Colombia.
Similarly, certain price interactions take place between different categories of hard assets. For example, rising energy prices have exhibited an historic tendency to drive up prices of agricultural goods, since energy, as it relates to farming, storage, transportation and chemicals, is the single largest input cost for most agricultural products. By the same token, high-energy prices might precipitate a shift in consumption, resulting in increased demand for coal and a consequent price rise in that commodity.
Market dynamics other than supply and demand also play into defining the development of the global hard assets industry. Most hard assets are globally fungible, meaning that they have a relatively consistent value across jurisdictions.
Accordingly, many hard assets act like a surrogate global currency of sorts, even though most of them trade in US dollars. A weak dollar, for example, implies higher prices for hard assets, often irrespective of supply/demand considerations. A strong dollar will generally have an opposite effect.
As the dollar has declined 27.09% in value against a trade-weighted basket of foreign currencies over the past five years, commodity prices have been exposed to consistent price pressure in US dollars.
Hard Assets Through Equities
There are three primary ways to gain investment exposure to the global hard assets sector. These are:
Commodity Futures. Futures contracts on various commodities, usually based on the actual delivery of the commodity in a fixed quantity and at a fixed location, are offered on recognized futures exchanges around the world. Though delivery of the commodity seldom takes place, this mechanism assures investors and traders accurate pricing. Typically, commodity futures closely track the spot price of the underlying commodity, incorporating generally minor distortions related to storage, interest rates and similar factors. Futures contracts have a limited life and expire on a predetermined date. As a result, futures contracts must be “rolled” from the expiring contract month to another month. This often results in another pricing distortion. Depending upon market conditions, rolling a futures contract may involve “backwardation,” which adds to the overall return on a long futures position or “cantango,” which reduces the overall return on a long futures position.
Physical Commodity Hoarding. This is simply buying the physical commodity and burying it in the back yard. This form of investment is impractical for many commodities, which require large storage space or are subject to spoilage or decay. Certain commodities, such as gold, lend themselves to this practice, although a bank vault is generally used instead of the back yard.
Commodity Equities. Equities can be an effective way to gain exposure to commodities. The value of a portfolio of hard assets equities is often influenced, although not determined, by the value of the commodity the companies in the portfolio produce. Like other equities, these companies will be influenced by a number of factors unrelated to commodity prices, such as earnings, operating efficiency, regulation, management expertise and interest rates. Furthermore, some hard assets producers “hedge” their production, so that short-term commodity price fluctuations may have little influence on the overall performance. In spite of these imperfections, equity price trends generally follow patterns comparable to the prices of the underlying commodities, especially when commodity prices are strongly trending. During protracted periods of stable or flat commodity prices, correlations all but disappear, as factors other than commodity prices exert a more dominant influence on the prices of equities. Another factor to consider is that corporate profit margins, once established, tend to contract more slowly than declines in commodity prices.
The following table shows the performance of the equity-based RVEI over the past five years and that of the commodity futures-based Dow Jones/AIG Index over the same period.
