Wednesday, October 27, 2010

Commodity Fundamentals Look Positive

iShares S&P 500 (IVV) Vs SPDR Gold Trust ETF (GLD), Power Shares DB Agriculture Fund (DBA) 

Not only have stocks enjoyed a rally since the summer but so have commodities. Gold surged to an all-time high of $1,387.35 an ounce. Tin is at a record high and so is cotton. Soy beans have rallied 16 percent this year and corn has surged 37 percent.

There are a number of cyclical, and event driven factors that are at play. Stronger corn prices are a result of lower corn production forecasts, due to poor weather in the U.S corn belt. A drought in Russia, leaves wheat supplies at 25 year lows. A strong economic rebound in the developing countries, has caused a dramatic improvement for commodities. The causes of the current strong prices are many, and some may be temporary. However, the underlying fundamentals of a constrained supply, a weak U.S. dollar, and surging demand from  emerging markets particularly China are likely to result in stronger prices in the future. 

PowerShares DB US Dollar ETF (UUP) Vs 
PowerShares DB Commodity ETF(DBC) 
Commodities prices are mostly denominated in U.S. dollars and a falling dollar translates into rising commodity prices. The U.S. government has spent large amounts to keep the U.S. economy afloat during the financial crisis and is soon expected to see a $1.8 trillion gap between revenue and expenditure. These massive federal deficits undercut the dollar's value. A simulative  monetary policy does as well. Quantitative easing (i.e. printing money) in the U.S. is expected to further flood the financial system with cheap dollars raising a concern for higher inflation in the future. The possibility of currency wars as many countries try to get  competitive by devaluing their currency, will likely play an increasing role in rising commodity prices as well.

The demand for commodities in the emerging markets is the biggest reason for higher commodity prices. In 2006, the emerging markets' share of world output outpaced developing markets in nominal GDP terms. As those economies try to catch up to the developed, the the use of commodities intensifies as  the  standard of living improves and the countries become more urbanized.

As these nations become increasingly more industrialized, the sheer number of workers who will be buying their first house, their first car, and their first television are raising per capita consumption and demand of commodities. The world's urban population is growing by 70 million people per year and soon over half of the world's population is expected to live in urban areas. As populations migrate from rural areas into urban settings, additional schools, roads and other infrastructure will be required to accommodate them. This building boom of essential infrastructure is expected to propel demand for commodities like steel, concrete, oil and copper for years to come.

Bottom Line
Commodities have a place in a portfolio as as a means of improving diversification and reducing risk. The possibility of strong prices in the next few years, makes the use of commodities even more compelling.

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