The commodities boom may be a source of unwelcome inflation, but it has also been a powerful engine for emerging market economies and will very likely be a key component of the global growth equation in 2008.
Government and corporate leaders from both developed and developing countries gathering in Davos Switzerland for the World Economic Forum’s annual meeting will be weighing in regularly on that economic dynamic.
With the exception of crude oil and gold -- some would also say platinum – most economists and money managers are not expecting the extraordinary gains of recent years to continue in 2008, as demand and capacity become more in sync.
“My guess is that we're going to see some moderation in many commodities over the next year or so,” says Michael Mussa, a senior fellow at the Peterson Institute for International Economics, who served as research director of the International Monetary Fund for a decade. “The story in individual countries may be somewhat surprising, but the basic story is this will probably look like other commodity booms.”
Modern history is littered with commodity boom-bust cycles. Mussa points to such periods in the early 1950s, 1970s and 1980s, when on a short-term basis “supply is pretty stagnant and there’s a surge in demand.”
Changing Cast of Players
Unlike booms of the past, however, that surge is demand is not solely from developed nations. China and India are absorbing huge amounts of raw materials and many of the producer nations are fellow emerging markets.
By one measure, half of emerging market exports now go to another such country.
What’s more the sudden and vast wealth produced by the booms is also reshaping geopolitics, prompting countries like Russia and, to a lesser extent, Brazil to assert themselves on the world stage.
The sea change is significant enough that the International Monetary Fund, which updates its world economic outlook Jan. 25, will try to quantify the globalization of commodities in a report to be released in April, says deputy director of research Charles Collyns.
“The change in commodities prices is part of the bigger picture of strong growth in emerging markets,” says Collyns. “The rise of emerging markets and the rise in demand for other countries products had consequences we didn’t anticipate."
Adds Andrew G. Sharkey, president and CEO of the American Iron and Steel Institute: "Emerging market economies are going be the diver for the [steel] industry in the future because that’s where the bulk of the demand will come from.”
Sharkey expects iron ore prices to increase at "least 30 percent" this year because of strong demand, with producers like Brazil -- among others -- benefitting.
The list of countries and commodities involved in the boom is staggering and reads like an old World Book encyclopedia. Argentina (grains), Brazil (soybeans, iron ore, orange juice), Burundi (coffee) Chile (copper), Mozambique (copper, crude oil) South Africa (gold, platinum, uranium), Zambia (copper).
The commodities boom in emerging markets is also providing a bit of a twist on the globalization, which often sees developing countries as consumers of Western goods.
“God’s little joke is that some of the greatest resource deposits are in some of the most difficult political environment,” says Leonardo Martinez-Diaz, a political economy fellow at The Brookings Institution. “Globalization has made these markets more liquid and connected supply and demand in more ways. Twenty years of futures commodities trading has given consumers a lot of flexibility.”
Digging Down For Investors
The last year brought enormous rallies in unexpected commodities. The price of nickel and copper essentially quintupled. Aluminum (and crude oil) doubled.
Leo Larkin, a metals analyst at Standard & Poor’s, says iron ore “will probably see the biggest increase, ” partly because China remains a net importer of the raw material and “platinum may see an increase” in 2008.
Gold, which has basically been rising without interruption since 1001 however, is unlikely to repeat those extraordinary gains. “I think we’re overbought,” says Larkin, who believes the precious metal is in a multi-year bull market. “It’s possible we’ll test $1000 [an ounce] but maybe close around $960-$970.”
Larkin says he is negative or neutral on most companies he covers based on valuations. He likes BH Billton, a diversified producer of aluminum, copper, iron ore and uranium, which acquired Alcan last year. His two “favorite” base metals companies are positive Alcoa and Tech Cominco, “strictly on valuations” (Both are trading near 52-week lows at around $29 a share.)
Larkin notes that half of the world’s copper is now going to China, where it is used in construction, homebuilding and electronics and most importantly power stations, which the country is building by the dozens. Most of the demand for tin and nickel now comes from China.
(Neither Larkin nor members of his family own shares in the companies he covers but “affiliates” of S&P may provide services to those companies.)
Frank Holmes, CEO and CIO of US Global Investors, is about as selective but much more optimistic.
“We’re very bullish on certain commodities, “ says Holmes, citing copper, gold, platinum and steel.
Holmes says short supply will keep copper and gold strong, saying the “big mining companies can’t easily replace big production.” Meanwhile, China and India will keep demand strong, thanks to big government budgets and infrastructure spending. He’s negative, however on aluminum, given China’s current contribution to production.
Companies he likes and owned by his firm include Eastern Platinum , Yamana Gold , and Freeport McMoran Copper & Gold (see adjacent video for interview with CEORichard Adkerson). Holmes' firm also runs Global Resources Fund, $1.5 billion mutual fund investing in oil, coal and metals companies, who top holdings include Schlumberger, Occidental Petroleum,PetroChinaand Rio Tinto.
Holmes is among those who is also fairly bullish on agricultural commodities, again because of China, where he notes the desert is growing, “ a real serious issue” when it comes to food production, and a drought in Australia. For that reason, Holmes likes fertilizer producers like Mosaic because they can increase cop yields. His firm has also “bought corn and wheat.”
Martinez-Diaz echoes that point, saying agricultural commodities have more “shocks and uncertainties", which support prices.
Merrill Lynch’s global emerging markets equity strategist Michael Hartnett says the firm remains positive on agricultural commodities, along with precious metals and oil, but is negative on industrial metals because they’re “more vulnerable to the economic downturn.”
Global Outlook For 2008
That is the wild card for both commodities and emerging markets in 2008.
Conventional wisdom says a US recession and a slowdown in Europe would have a sizable effect, “making it very, very tough for emerging markets and commodities to go up,” says Hartnett.
“The domestic demand story in emerging markets is more independent and more sustainable than in the past,” he says, adding that one theory holds that a US recession would helps cool inflationary pressures in places where growth has been too strong, thus at “some stage you’re going to get another buying opportunity.”
Hartnett notes that many emerging market indices are already pretty far off their October 2007 highs.
Holmes agrees, saying any US-European effect will be temporary, such that “emerging markets have a big rebound after a correction.”
Any global slowdown won’t affect all emerging markets equally, especially given China’s unique role in the global trade equation, serving as both an enormous producer and consumer.
Hartnett sees the most insulated markets such as Middle East oil producers, Israel Russia, India and Malaysia as the most resilient with big trade countries like China and Brazil the most vulnerable.
“I think the case is still strong over the medium term that they will be very good places to invest,” says Robert Hormats, vice chairman of Goldman SachsInternational and a frequent Davos attendee. "They’re more and more integrated into the global country. They get the benefits and they also get the negatives. At the same time, they’re in a much more robust condition to withstand that than a decade ago.”