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Commodities: Reviving the old
Investor interest in commodities has increased significantly in recent years driven mainly by increased globalisation and the awareness that Asia remains an economic force that will increase with time. But not only this, investors have reflected on the lower investment returns that have been generated by traditional assets classes since the bursting of the Dot.com bubble and, consequently noted the powerful cyclical and structural forces that benefit commodities. Unlike traditional asset classes like equities or bonds, investors not too familiar with the positive characteristics and properties of commodities tend to focus on the high volatility element of this long-standing asset class.
The UBS Commodity study published today hopes to alleviate some fears that investors have about this asset class and focuses on the characteristics of commodities, as well as looking in some detail at the groups that make up commodities as a whole.
The study is split into two parts. In the first part more general aspects of commodities are treated: Apart from the commodity markets description the study takes a look at the most common commodities indices but also discusses characteristics of commodities in a portfolio. Furthermore, some fundamental questions that are on the minds of investors are treated, such as what drives the commodities market but also why commodities have regained popularity.
In the second part the study goes further by focusing on the most important commodities and their specific characteristics. In energy, structural issues that have been plaguing the oil price are treated, but also issues that will play a major role in the development of the oil prices in the future. In addition to this, the study gives an insight to natural gas heating oil and gasoline markets. Apart from energy, the study also looks into the dynamics of base metals (copper, aluminium, zinc, nickel, tin and lead) and precious metals (gold, silver, platinum and palladium). Lastly, the study takes a look at the so-called 'soft' commodities, i.e. agricultural products, where the focus is on the three most traded, namely coffee, sugar and cocoa.
Zurich/Basel, 20 June 2005
UBS Wealth Management Research
+41-44- 234 70 51
The study 'UBS Research Focus - Commodities' can be found at: www.ubs.com/economicresearch
Over the last two years the structural forces that have played a key role in the development of commodities can also be seen throughout our history. Empires and economies, both in ancient and modern history, have been built on the process of transformation through the development of new technology that has taken society another step forward. From the start of the industrial revolution in the 18th century, commentators on economic, social and political change have been fascinated by the power that can be evoked through the process of industrialisation and urbanisation, as both go hand-in-hand. The process has taken traditionally agrarian and peasant societies into a new socio-economic phase of development. Development of infrastructures, like railways, roads and sea ports that in turn leads to the expansion of international trade. The link between these developments is not only the use of improved technology but also the use of raw materials, or the building blocks of industrialisation such as copper, aluminium, nickel, oil and its derivatives.
Despite the fact that commodities are one of the oldest traded asset classes the perception that they from investors is very different. Commodities are perceived to be high risk, high volatility investments that do not have a role to play in a modern diversified portfolio. However, the UBS commodity study puts this perception into a clearer light and highlights that commodities can play a crucial role in a well-diversified portfolio due to their correlation to inflationary forces and lower correlation to stocks and bonds. This gives commodities a very different characteristic from the normal asset classes, which could be a reason that investors have remained not too familiar with them. Furthermore, historical returns from commodities have been very attractive over the long term and thus this makes commodities an interesting investment opportunity.
But what about the current pricing and have prices not already reached historical highs?
On an absolute basis prices are at high levels and thus we would agree with this statement. But the study argues that looking at the absolute price of a commodity over time doesn't tell us much, unless we acknowledge the fact that - at least over the past century - all prices were moving up, i.e. purchasing power has fallen. Commodity prices and inflation are closely related, which makes it easy to blame commodity prices as the main culprit for periods of high inflation like in the mid-1970s and early-1980s. Rising commodity prices might push up production costs and this in turn - depending on the pricing power of the producer - imply higher consumer prices. The conclusion that we give is that while oil actually gained in real terms over the whole period, gold managed to retain its value. Whereas, copper and aluminium prices, representative of base metals, actually rose over their respective periods under review at a slower pace than the overall consumer price index. The explanation for this is that the extraction and production costs came down over the whole period. What is also interesting is to compare how the different commodities behaved since 1970, i.e. before the big inflation push of the 1970s and early 1980s. Only oil and gold managed to retain or even gain value. Copper and aluminium lost more or less 50% of their real value. As a consequence we believe that despite the overall rally in commodity prices since 2002, we are still a long away from the highs expressed in real terms that we saw in the last commodity bull market. Further-more, commodities only protected you against inflation if you had chosen the right ones.
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