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From Special Report:

Investing in growing assets

Rising global demand for food, feed and fuel presents varying opportunities for long-term investors

By Simona Stankovska | Published Apr 30, 2012 | comments

The doubling of the world’s population in the past 40 years has increased global demand for commodities, resulting in many soft commodities being in short supply.

However, demand has zigzagged over the past five years in response to macroeconomic conditions, with a crash in late 2008 and early 2009 followed by a surge towards the high food prices that helped trigger the Arab Spring, which began in late 2010.

Bill Mott, manager of the PSigma Income fund, whose investments are managed from a macroeconomic perspective, says: “As soon as growth picks up, commodities fly. [This is] in turn sowing the seed for the next slowdown because demand is severely dampened, until prices fall back and we go round again. This will leave us facing a wave of mini cycles or a corrugated economic profile. In this way, we see commodity markets acting as a global central bank, smoothing out the peaks and troughs before they get too large in either direction.”

Commodity investment vehicles experienced £1.5bn in outflows in the first three months of 2012, according to Morningstar, but soft commodities in particular have seen a bounce in recent weeks. This, according to market analysts, is a sign of a global recovery starting to seep through, led by a stabilisation of the crisis-hit developed world. As further evidence, market watchers have pointed to successful bond auctions in troubled eurozone nation Spain and a string of solid US corporate earnings.

The price of barley, rice, wheat, soya beans and cocoa beans was up for the month of April, according to data portal IndexMundi. Soya beans gained the most, undergoing a 7.53 per cent increase in value for the month. Over the year to date they are also up 12.35 per cent. However, soft commodities in general are down by more than 5 per cent for the year, according to S&P Indices. Cotton appears to have seen the greatest decline in value over the past 12 months, with its value down by 56.66 per cent. This is because the cotton market faces two huge uncertainties in the short term: first, how to deal with the hangover left after the high cotton prices of 2010-11 contracted global demand and, second, uncertainty over how China will treat cotton in its programme to stockpile strategic commodity reserves.

Wheat has also suffered, with prices down more than 8 per cent in the past 12 months. The Standard & Poor’s commodity report states: “Higher protein content hard red winter wheat is deliverable into Kansas wheat futures and has suffered more in 2012, notably due to favourable spring weather.” According to the report, the past few years of wheat price history demonstrate how the supply and demand cycles of some agriculture commodities can be rebalanced in a single annual cycle. “The US is the world’s largest grain exporter and the favourable early spring weather has also allowed farmers to plant more corn earlier in the season. Farmers are delighted at the prospect of an ample and early potential harvest of the winter wheat crop, which can be double-cropped with soya beans,” the report claims.

Demographics

Nevertheless, the significant projected rise in the global population and the resulting rise in the demand for food, feed and fuel will present significant opportunities for long-term investors. In particular, over the next few decades, the number of people considered to be in the global middle class is projected to more than double – from 430m in 2000 to 1.2bn in 2030 (or from 7.6 per cent of the world’s population to more than 16.1 per cent).

James Govan, co-manager of the Baring Global Agriculture fund, says: “In the next 50 years, agriculture will be called [upon] to produce more food than in the previous 10,000 years. A significant amount of investment will be required to meet this output objective and should result in strong and rising demand in sectors such as fertiliser, seed, crop protection and machinery over the long term.

“Grain prices are likely to remain at elevated levels over 2012, as from a historical perspective inventories remain low compared to consumption levels. The outlook for agricultural equities should remain strong over 2012, supported by attractive valuations.”

Although he acknowledges that agriculture equities suffered due to macroeconomic concerns and a more cautious investment environment in 2011, the sector still exhibits solid long-term fundamentals.

“The strong long-term demand for food should lead to robust soft commodity prices over time and hence provide strong demand for agricultural products and services, resulting in a structurally positive outlook for agricultural equities,” he adds.

Investors who agree with Mr Govan have a number of options available to them. They can buy agricultural equities, invest in agricultural land, buy a basket of commodity futures – potentially in the form of an exchange traded fund (ETF) – or buy into an open-ended or closed-end portfolio of agricultural investments.

Mutual funds that hold a spread of investments are typically more diversified and carry fewer risks than futures, but few agricultural mutual funds are currently available to retail investors. They also often invest in commodity equities, not the commodities themselves, and stock prices do not always rise if the price of the commodity is rising.

In the futures market, soft commodities play a more central role. They are used both by farmers wishing to lock in the future prices of their crops, and by speculative investors seeking a profit. However, not many investors have a detailed understanding of futures, outside of specialists in the field, which makes it much easier for them to lose money, even if the underlying price of the commodity or basket of commodities rises.

If an investor wants to benefit directly from rising commodity prices, they can invest via an ETF, which normally has a lower expense ratio than its mutual fund counterpart. An ETF can be used to invest in commodities or, more typically, commodity futures directly and can trade like an ordinary stock on exchanges.

Nicholas Brooks, head of research and investment strategy at ETF Securities, says: “It has been a difficult year for commodity exchange traded products (ETPs), as slowing global growth and rising risk aversion caused investors to reduce allocations to cyclical assets and move into cash and G3 bonds. The downtrend was offset by the strong performance of gold, which benefited from the general risk aversion.

“As we enter 2012, a myriad of risks remain, although recent signs of improvement in the US economy and an uptick in the global manufacturing cycle have started the year on a positive note, with ETP inflows broadening out and most commodity prices rising. Europe’s ability to deal with its sovereign debt crisis, the durability of the recent rebound of the US economy and China’s ability to engineer a soft landing will likely remain the main factors driving the performance of commodity ETPs this year.”

Investors can also access soft commodities as part of a general commodities portfolio that plays the associated increase in demand for commodities worldwide. Overall, the best performing general commodity fund in the three months to March 31 2012 was the Goldman Sachs Commodity Alpha portfolio, which returned 3.71 per cent, compared with the worst performing, the DB Platinum Commodity Euro R1C vehicle, which recorded a loss of 38.72 per cent. This range of performance only underlines how important it is for investors to conduct due diligence with such vehicles and understand their various risks and returns.

Simona Stankovska is features writer at Investment Adviser

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