Analysis: Commodities to continue rally

Thanks to soaring oil prices and a sliding dollar, the major commodity indices have outperformed most global equity indices in 2008. This is particularly why commodities are termed as "alternative investments", that protect an investor's portfolio in times of abrupt market volatility.

Over the last couple of years, commodities have exhibited long-run positive returns that often equal or exceed the long-term returns of stocks with comparable risk. There is a large number of commodity indices in existence globally and the key difference among them is largely the weightage given to the individual commodities included in the index.

There are quite a number of convincing reasons why commodities tend to outperform other asset classes in times of uncertainty in a general economy. First and foremost is the fact that commodities are "real assets" (identifiable assets, such as goods, buildings, equipment) unlike stocks and bonds, which are "financial assets".

Therefore commodities tend to react to changing economic fundamentals in ways that are different from traditional financial assets. This is largely the reason why commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds. Commodities also provide a significant hedge to one's portfolio in times of "economic surprises" (like the sub-prime crisis) and also in times of geopolitical surprises.

However, it is interesting to note that post 2004 (until Q3-2007), commodities and equities have started to show a strong positive correlation largely because of excessive liquidity in the markets.

The abundance of carry-trade funds – the practice of borrowing vast amounts in low-yield currencies such as the yen to re-invest for a profit elsewhere – and the launch of a number of easier investment products like exchange traded funds (ETFs) is largely regarded as the reason for the emergence of this positive correlation.

From Q3-2007, as the major economies of the US and the UK started to crumble under the sub-prime crisis and the housing sector chaos prolonged the possibility of recovery, the global equity market also tanked – with the exception of those in the Middle East. But commodities refused to reflect the slide and instead showed a rally that took gold to $1,030 and crude to $135.

So, have commodities emerged as an exclusive mainstream asset class of its own rather than just being a small addition to an overall portfolio? The short answer is: yes!

Research has proved that the addition of commodities to one's portfolio over the past few years has resulted in higher portfolio returns per unit of risk.

Commodities are basics of economic growth and global growth is independent of the financial morass in some economies. More than 100 countries recently enjoyed annualised growth of more than five per cent. The four BRIC nations – Brazil, Russia, India and China – combined are now bigger than the US economy.

At one end we have US, UK and other key economies that are progressing with a meagre growth rate of less than three per cent and at the other end we have China accelerating by more than 11 per cent, India growing at 8.3 per cent, Russia progressing ahead with eight per cent growth and Brazil with more than five per cent.

That's not all. The Mena region has been leaping ahead and is likely to be one of the fastest growing in the world over the next two years with average real GDP growth of six to eight per cent. The key is to remember that these countries are in the initial phases of an economic boom.

This means that solid demand for commodities from these nations will continue, nullifying any drop in demand due to a slower growth in the United States.

The global growth this time around has been largely broad-based and short-term financial troubles are unlikely to curtail the demand for any major commodities.

This means that commodities will continue to have an extended demand this year, the year ahead and in years ahead.

The author is assistant vice-president of research and trading at Vision Commodities