Commodity prices looking vulnerable
By Craig Alexander, Vice President & Deputy Chief Economist, TD Bank Financial Group
After a great run for Canadian commodities, it may be time to rebalance your portfolio and look for investment opportunities abroad. |
There has been a powerful bull market
in commodities over the past four years. Even taking into acount the drop in
prices between mid-May and mid-June, the TD Commodity Price Index still
hovered some 104% above its trough in December 2001. Moreover, the rally has
been broadly based. From early December 2001 to mid-June 2006, crude oil prices
soared by 260%. Despite being constrained by mild weather last winter, natural
gas still managed a dramatic 140% increase.
While base metals have been vulnerable to the greatest selling pressure of late,
they remain up 174%, with gains from all the major metals. Copper led the way,
rising a whopping 360%. Precious metals have also been on a tear, with gold
rallying from US$277 per ounce at the end of 2001 to just shy of US$600 in mid-June
2006.
Fuelled by global demand
Rapid, and increasingly synchronous,
global economic growth has been the principal catalyst driving the dramatic
price gains. Indeed, world economic output in 2004/05 rose at the fastest pace
in more than three decades. Much of the torrid growth came from emerging economies,
like China, that require commodities for their development.
Rising demand alone would have fuelled a powerful increase in commodity prices,
but the pace of growth in demand has also created supply pressures for many
products. Add in rising geopolitical risks and natural disasters that have aggravated
supply concerns, and the result is a perfect confluence of factors that has
pushed prices dramatically higher.
This has been a windfall for many investors and a boon to the Canadian equity
market, producing double-digit gains in the heavily commodity-leveraged S&P/TSX
Composite Index. From its low point in October 2002 to mid-June 2006, the benchmark
Canadian equity index jumped by 85%, and that’s despite the recent correction.
With the strong appreciation in the Canadian dollar, it has paid off for investors
to stay in the Canadian market. Even though some investors may have reduced
exposure to commodities in recent weeks in response to volatility, the portfolios
of many investors may still be overweight in Canadian equities — more
specifically, commodities.
Maintain diversification
Perhaps the most critical tenet of
financial planning is diversification. Investors are encouraged to regularly
check that the asset mix in their portfolios is aligned with their risk tolerance.
Recent developments have underscored the fact that commodity prices are inherently
volatile. Even in a secular bull market, there are bound to be swings in prices.
And the risks on this front appear higher than normal at this time.
While the vast majority of the price gains have been supported by fundamentals,
the particularly strong increases since the start of 2006 in selected commodities
look to be increasingly driven by speculation. If so, periodic major pullbacks
in prices are a distinct possibility.
Moreover, the prospects for demand growth are beginning to look less favourable.
TD Economics believes that the pieces are falling into place for a U.S.
economic slowdown. A cooling
in U.S. housing markets is likely to lead to a significantly weaker pace
of consumer spending in the coming quarters.
Volatility ahead
If the U.S. economy does weaken, the
impact is likely to be a retreat in commodity prices. TD Economics anticipates
a further correction in commodity prices in the order of 10% before the end
of the year. Some prices, notably crude oil and base metals, could fall by 20%.
The bottom line is that we are probably in a long-term bull market for commodities,
but investors should be aware that prices do not just rise smoothly and indefinitely.
Portfolios should be diversified to minimize the fallout from any future volatility
in commodity prices. And given the outperformance by Canadian equities in recent
years, it would seem prudent to start looking abroad for investment opportunities.
