Betting on commodities

BS OPINION

Commodity prices have appreciated sharply in recent months. The prices of steel, iron ore, aluminium, copper, lead, zinc and nickel have all moved up. Even agricultural commodities such as cotton, rubber and wool have seen higher prices. Crude oil prices have resolutely refused to climb down, despite the end of the Iraq war and record Russian production.

The Commodity Research Bureau's (CRB) Composite index, a widely tracked measure of global commodity prices, has risen by 13 per cent year-on-year. Gold prices are touching new highs. Faber's prediction may be for the next decade, but the trend is already plainly visible.

Strangely enough, these rising commodity prices have occurred at a time when growth in the world economy has been tepid, and global trade has been sluggish. Yet another anomaly has been the continuous rise in gold prices at a time when stock prices too have risen. Traditionally, gold has been a defensive hedge against market downturns.

Moreover, commodity prices have been rising against a backdrop of widespread deflationary fears. The explanation for these anomalies lies in the deep structural imbalances prevalent in the global economy. The United States, the world economy's growth engine, suffers from massive current account and fiscal deficits.

The only way for the US to address the problem is by a steady erosion of the value of the dollar. That view has gained further support after the recent G7 meeting at Dubai, which was widely interpreted as signalling a weaker dollar. Since the meeting, the dollar has rapidly depreciated against both the euro and the yen.

Given this environment of dollar weakness, it makes sense to invest in an alternative currency, and the international currency of choice for many investors is gold. Faber also points out that central banks all over the world have adopted a policy of reflating their economies out of trouble, unleashing a flood of liquidity.

This will, according to Faber, sooner or later spill over into rising inflation, hastening the rush to gold and other hard assets. The never ending 'War on Terror', like all wars, is also good for hard assets.

The other factor buoying up commodity prices, as Indian exporters know very well, is Chinese demand. China's unique contribution to the world economy lies in its insatiable demand for raw materials, on the one hand, and its ability to efficiently convert them into low-priced finished goods, on the other.

The first trend leads to higher commodity prices, while the latter leads to deflation for finished goods. Furthermore, with some signs of recovery in the global economy, including Japan, demand for commodities can only improve.

And lastly, it needs to be remembered that commodity prices are rising from very low levels, in contrast to other asset classes such as US stocks, which have remained richly valued. The chances are good, therefore, that the rising tide of liquidity may overflow into the commodities markets in preference to other asset classes.

To be sure, there may be periods of reversal, and the Chinese government has already taken steps to cool its overheated economy. But the long-term outlook for commodity prices remains positive. That should be good news for many Indian companies.