For the better part of 15 years, investors have considered the benefits of investing in commodities as a way to diversify their portfolios. Today there are around 134 commodity exchange traded funds (ETFs), according to ETFdb.com, giving investors “exposure to various commodities including metals, oil, grains, livestock, coffee and sugar.” This was always a controversial step because commodities, unlike other investments like stocks or bonds, don’t generate an investment income stream as part of their total return. This leaves investors solely at the mercy of market supply-and-demand dynamics that dictate capital appreciation (i.e., a higher price) to achieve a return on investments. Added to this risk is the inherently volatile nature of commodity prices over the course of an economic cycle.
Commodity Prices May Have Peaked
Despite the inherent volatility, investors were happy to take these risks in the years following 2000 as the great commodity super-cycle got underway on the back of growing demand, especially from China. The chart below from the World Bank shows that commodities in a broad range of areas such as agriculture, energy and metals made a handsome return for investors in the run up to the financial crisis of 2008, rising by 62 percent, 154 percent and 107 percent respectively in eight years. However, the World Bank isn’t expecting any such repeat performance in their forecasts to 2020. (See also What Is The World Bank?)
In fact, commodity prices rebounded quite nicely even after the U.S. housing crisis that caused prices to dip in 2008 and 2009. Yet for key industrial commodities – like energy and metals – prices failed to reach their previous record peaks, and around 2011 something began to change. That something was the realization that Chinese economic growth wasn’t going to return to pre-crisis levels either.
Chinese Economic Growth
The chart below from Tradingeconomics.com shows the clear trend in Chinese GDP. Some of this economic slowdown is intentional as part of the government’s policy to shift China away from dependence on exports to domestic consumption. According to the World Bank, China’s growth target of 7 percent, down from an average of 10 percent per year since 1978, signals the government’s intention to focus on quality of life rather than pace of growth.
Commodity prices have responded negatively to this government-engineered slowdown on the back of concerns that Chinese manufacturing will no longer require as many raw materials as it did from 2000 to 2008. The chart below from The Economist shows China’s declining domestic demand for steel as manufacturing slows.
According to the magazine, “China’s steel consumption is roughly half the global total. It peaked in 2013 and ebbed as the country’s frenzied building slowed. Daniel Kang of J.P. Morgan, a bank, forecasts that China’s annual demand for steel will continue falling until 2017 and will settle at about 10 percent below its high-water mark.” The Daily Reckoning, an Australian newspaper, reports that “Goldman Sachs predicts iron ore prices could fall a further 30 percent by 2017. It predicts an expanding market supply in addition to declining Chinese steel production. In other words, prices are heading in one direction only – down.” (See also Is China's Economic Collapse Good For the U.S.?)
The Bottom Line
The global commodity super cycle may indeed be at an end – at least for now. Commodity markets have had cycles before, but concern now centers on the role China plays in the end of this particular cycle. China accounts for 44 percent of the world’s total metal consumption and nearly one fifth of global industrial production, according to the World Bank. So if the government is intentionally slowing the pace of economic growth, there's reason to believe that the commodity-demand picture may be permanently altered. This means investors reliant on rising prices to earn a return may want to consider deploying capital to more traditional income-generating investments.