The recent commodity story has been all about China

A new period has emerged over the last few years. Growing economies, particularly China, have experienced strong growth and inflation simultaneously. They have tolerated inflation, and let growth rage on. Commodities have had a renaissance. There has been debate about whether China will try to cool inflation, but in the meantime, commodity prices have soared as the hungry dragon searches the world for raw materials.

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For instance, you could have bought Australian dollars in 2003 as a kind of commodity play.

• The widespread view then was that Chinese demand for commodities would drive prices higher, and that Australia was well placed to benefit as a supplier.
• There were other things in favour of the Aussie dollar, such as strong growth and relatively high interest rates, which gave added confidence.

You would have done well during this perid, given the usual lacklustre environment for trading in commodities.


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Long periods of high growth and high inflation are rare

To invest into commodities, you can choose to buy:

• individual commodity
• existing commodity index (basketo of several commodities)
• companies, such as steel or oil companies, which will benefit from higher prices of their products, or,
• the currencies of countries which have a lot of natural resources

The best time to do so is when inflation and economic growth are both strong.

In practice, though, there have not been many periods where growth and inflation are able to rise at the same time.

• Authorities normally respond to higher inflation by raising interest rates. They only have difficulty keeping a lid on inflation if raising rates weakens the economy too much.
• When there is strong growth, the authorities have a lot of room to move without causing a recession, and so they are able to stamp down on the inflation if necessary.
• Therefore, it has been rare to find long periods of high growth and high inflation.
• (This helps to explain why commodities have seen a 50 year or so price decline in real terms.)

CRB Index since 1950:

In the 1970s:

• there was high inflation, largely caused by OPEC, without strong economic growth.
• Commodities has their best run for a long time but prices still barely rose in real terms, because inflation caused a tripling of average price levels.

In the 1980s and 1990s:

• saw the opposite experience, with falling inflation and many periods of good growth.
• This was miserable for commodity prices in real terms. The economic growth was not enough.
• The increased demand by the growing world economy was generally offset by falls in the costs of production and extraction due to dramatic improvements in technology.
• Technology also helped economies reduce their dependence on the more expensive commodities, such as oil.
• Social changes also reduced the growth in demand for commodities, as economies became more service oriented, and less reliant on manufacturing.

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CRB Index

While you can choose your own selection of commodities, it is probably easier to use an existing index. The most watched indicator index is known as the CRB index.

Future and options on the CRB index are traded on the New York Board of Trade. It is made up of different categories of commodities:

• Energy: crude oil, heating oil, natural gas
• Grains: corn, soybean, wheat
• Industrials: cotton, copper
• Livestock: cattle, hogs
• Precious metals: gold, platinum, silver
• Softs: cocoa, coffee, orange juice, sugar

Because it covers such a diverse range of materials, its movements will mask moves in the individual components, and smooth out the supply problems. Obviously, there are many other commodities which are not included int he CRB index.


Alternative methods

As an alternative to trading an index on an exchange, there are a number of different ways to trade commodities - apart from keeping silos full of corn in your backyard.

• You can also invest in companies, such as steel companies or oil companies, which you feel will benefit from higher prices of their products.
• Or you can even go a step bigger, and buy into the currencies of countries which have a lot of natural resources.

Related posts:
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The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Trade in a basket of commodities

The strategy to adopt will probably be to trade a basket of several commodities, rather than any specific item. This is because to get the net effect of growth and inflation, you will need to remove a lot of the randomness in the price caused by supply factors.

These supply driven commodity markets can present extra difficulties. These markets are often turbulent.

• They can be influenced by events in remote countries, many of which can be unstable and corrupt.
• They can also be influenced by the random effects of the weather. You don't want your view that higher inflation will cause higher commodity prices to be upset by good weather causing a bumper crop in bananas.

Most of the information driving commodities can be quite obscure. It is a difficult task for investors to somehow get hold of that information. So by trading a basket of commodities, you will win some and lose some on the individual items, and allow the economic fundamentals to dominate. You would rather do that than bet on whether there will be a bad season in an unpronounceable country.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading