Popular Bet in Global Financial Markets—That Prices Would Keep Rising—Is Unraveling
Investors are suffering mounting losses as a decadelong rise in commodity prices unravels amid slowing emerging-markets economies, rising supplies of oil and metals and the eventual end of central-bank stimulus policies that propped up prices for raw materials.
The sharp reversal in the prices of commodities, ranging from gold to copper and aluminum, is undermining one of the most popular bets in global financial markets: that prices would keep rising, fueled by strong growth in China and other developing economies and the relative scarcity of many raw materials.
Institutions and individuals have poured more than $440 billion since 2004 into index funds and exchange-traded funds tracking broad commodity indexes, according to Barclays PLC. BARC.LN 0.00% That dwarfs the net flow of $25 billion into U.S. stock funds over the same period, according to Morningstar.
Commodity prices as a group nearly doubled between 1998 and 2008 as measured by the Dow Jones-UBS UBSN.VX +3.46% Commodity Index, with some index components such as oil and gold rising as much as sevenfold during that time and leading to talk of a commodities “supercycle” among analysts and strategists.
But prices never regained their peak after the 2008 financial crisis, and have been drifting down since mid-2011. The trend has worsened this year, leading investors and analysts to call the end of the supercycle. The index slid 10.5% in the first half of the year, with raw materials dearest to China’s growth—industrial metals such as copper, aluminum and nickel—posting declines of as much as 20%.
Major investors such as John Paulson have acknowledged large losses on gold bets, while mining giants including Rio Tinto Group and Anglo American AAL.LN 0.00% PLC have posted massive write-downs on projects this year as falling demand and prices have slashed projected returns. That has hurt investors who sought exposure to commodity markets through investment in corporate equities.
Investors are heading for the exit. Assets under management in commodity investments are down 21% from their peak last year, now sitting at $349 billion, Barclays said in a note Friday. This year, the slowdown in China and a gradual recovery in the U.S. economy have further damped enthusiasm. The sector is facing its third straight annual decline, according to the Dow Jones-UBS index, and commodity funds are headed for their first net outflow since the crisis.
“I think the supercycle is dead,” said Nic Johnson, a portfolio manager at Pacific Investment Management Co., or Pimco, who oversees about $27 billion in commodity investments across the firm’s funds. Pimco is a unit of Allianz SE ALV.XE +0.68% of Germany.
In addition to China’s slowing growth, other factors are weighing on commodities, including the crash in gold prices as U.S. central bankers signal an eventual end to ultralow interest rates as the domestic economy improves, the rising cost of credit that underpins leverage in commodity markets and more attractive returns in equities markets.
China, the world’s second-largest economy after the U.S., said this month that gross domestic product expanded in the second quarter at a 7.5% annualized clip. That is down from 7.7% in the first quarter and well below the 10% average over the last three decades.
For years, gains in China fed the supercycle, in part because the nation used an investment-driven growth model that consumed vast amounts of raw materials in the construction of roads, housing and electricity grids.
But now, amid concerns about over investment in housing and signs of stress in China’s financial sector, political leaders are hoping to reorient the economy toward more consumer-driven spending, similar to other large economies.
Softening growth in China stands to reduce demand for goods and put a lid on the economies of its trading partners. The result is a shift in the world’s supply-demand equation and the end of an era in the market.Citigroup C -0.65% said in an April note that it “expects 2013 to be the year in which the death bells ring for the commodity supercycle after its duly noted sunset.”
Across China, factories that once bustled with activity are going idle, and warehouses that brimmed with supplies are emptying out as managers cut back on restocking in response to falling demand.
Zhang Heng, general manager of Shaanxi Longyu Trade Co., said his company has reduced imports of copper and lead concentrates, as some clients have closed their plants.
“Existing clients adopt a hand-to-mouth buying pattern, as they want to make sure that each ton of the metal they make will produce some kind of profit,” Mr. Zhang said.
Investors such as former hedge-fund manager Stanley Druckenmiller, a onetime protégé of George Soros who ran Duquesne Capital Management LLC until he closed it in 2010, have warned that commodity-exporting nations such as Australia and Canada are vulnerable to a Chinese pullback. The Australian dollar fell this month to a three-year low against the U.S. dollar.
Other factors are at work as well. The boom in U.S. oil production from shale discoveries is boosting supplies of oil and refined products, a shift that many analysts believe could lead to lower prices in the coming years, although price have risen recently. In many commodity markets, outsize increases in capacity and resulting overproduction in response to high prices are helping to drive prices lower.
And trading by banks, which were once major players in commodities markets, is being curtailed in response to declining market conditions and increased regulation. The Federal Reserve said Friday it is reviewing its dec
ade-old policy of allowing banks to participate in physical commodity markets, through ownership of assets ranging fr
om power plants to metals warehouses.
The collapse in gold futures, which have fallen nearly 30% since their peak last October, hit both index performance and investor sentiment. Meanwhile, rising equity markets have provided investors with more attractive returns.
Underpinning the massive wager was a bet that strong growth in emerging-market economies would boost living standards for billions of people, stoking demand for materials ranging from crude oil, platinum and gold to wheat, cotton and burlap. Many investors also favored commodities as a way to mitigate declines in the value of the U.S. dollar, amid wars in Iraq and Afghanistan and expansive Federal Reserve policy following the 2008 financial crisis.
To be sure, some managers haven’t reduced their allocation to commodities despite the
near-term falloff. They say China—and the world—will continue to grow and consume more in the long run.
“We’re becoming wealthier and wealthier as a globe,” said John Brynjolfsson, managing director of global macro hedge fund Armored Wolf, who said he isn’t changing allocations or strategies in reaction to the China slowdown. “Ultimately that is great news for commodities.”
Adding to the pain for many investors: the volatility of commodity prices. Despite years in which returns sailed well into the double digits, annual returns averaged just 0.3% in the last decade, making the sector a poor choice for those employing a broad buy-and-forget strategy more common in equity markets. The Standard & Poor’s 500-stock index returned 0.8% on that basis during the same period.
