Commodities may deliver the goods

The market dynamics that have been driving the commodity markets for the last 18 months remain in place

LAST year, the commodity markets were dominated by the seemingly irrepressible rise of gold – with $5,000 an ounce figures being bandied around as potential targets for the yellow metal. That was before margin calls and a shift in risk sentiment checked its price. But it was not just gold that had a good year. Commodities across the board had a robust showing in a turbulent financial climate. Despite markets being buffeted by the Arab Spring, the Eurozone sovereign debt crisis, Japanese and New Zealand earthquakes and the US debt ceiling standoff, prices for physicals weathered the storms. As well as gold prices rocketing and silver prices reaching heights not seen since the Hunt Brothers tried to corner world markets, copper also recorded record highs.

So what does the commodities sector look like as a whole going forward? Broadly speaking, the market dynamics that have been driving the commodity markets for the last 18 months remain in place. The European sovereign debt crisis is not going to disappear at any time soon. Although this has driven haven assets ever higher, the fallout of the crisis has been fears of a slowdown in European demand for infrastructure commodities, dragging on prices. At the same time, the threat of a Chinese hard landing remains on the cards. Look to the effects of any adverse Chinese industrial production figures on proxy commodities and currencies for an indication of the jitteriness of the markets and the fear that a hard landing from the superpower will kick the legs out from under global commodity demand.

But while physical commodities have held up reasonably robustly in the tumultuous financial climate, commodity-related equities have taken more of a buffeting – exposed to the same levels of volatility that have shaken the equities markets as a whole. In 2011, mining was the worst-performing cyclical sector. Take a look at the chart (top right) for the disconnect between spot gold prices and equities since 2007. The chart represents a telling snapshot of the physical commodities versus mining equities dynamic. As volatility shook the markets, investors agnostically sold off equities – irrelevant of creed – and flooded into Treasuries and commodities – particularly gold. Gold miners and other gold-related equities are in a market limbo – the gold bull market is providing them with huge margins, but the risk-off environment that has driven the spikes in gold prices is unfavourable to equities. In a world of financial uncertainty, the muddy waters of corporate cash flows and earnings predications seemingly offer less reassurance than spot prices of a physical, tangible commodity.

So why should investors look to commodity-linked equities at all? “Although in the short term, shares in commodity producers look less than appealing, the long-run fundamentals look favourable,” says Evy Hambro, manager of the Blackrock gold fund, arguing that supply and demand dynamics should drive the sector as the urbanisation of China accelerates – while demand has ramped up, the structural changes required for the commodities sector to match this demand can take 30 years or more, with miners struggling to keep up with the demand, driving up prices for the physical commodities. Hambro points out that as a result of these increased prices, miners’ balance sheets have been flush with cash, and such companies are choosing to return this cash to investors in the form of dividends and share buybacks.

As such, for those willing and able to weather market volatility, commodity equities present a good buy opportunity should the sector find steam again.