commodities

One of the host areas of investment in recent years has been commodities. Strong gains were seen in the commodity prices over the last year. This marked something of a recovery from previous lack-lustre performance seen since the ‘cycle top’ peak in 2012.

The decline in commodity prices from the top is the result of both decreasing demand and investor sentiment. Demand from China, a key consumer of commodities hit prices hard. With a lack of demand for hard commodities prices were hit hard, making it difficult to back commodity assets to go higher.

In recent years China has been a key driver of prices within the sector. This comes down to the Chinese governments need to supply its huge infrastructure spending with the resources necessary for completion. Iron, steel, coal and many other precious metals were eagerly imported to help complete these infrastructure tasks. However as soon as the tap of demand was turned off, prices slumped.

The recent recovery owes much to the restructuring of balance sheets within China and the return of economic growth. The Chinese market has faltered a few times but remains a strong growth market over the longer term. However, the return to growth is not the only reason why investors are seeking to return to this sector.

Following the last boom there was a worry that debt levels in many commodity companies were at extreme levels. Servicing debt can prove to be a problem. It is even more of one if the demand for your asset dries up. Certainly, the demand in China has been a key driver of prices in recent years.

Following on from fast expansion to meet ever growing needs, many companies within the sector had taken on large amounts of debt to rapidly expand their operations. The need to compete and meet needs saw a large level of debt accumulate and stretch many balance sheets.

The key take from this period was that investors were not keen to back such high levels of debt for fear of a decline in demand. In retrospect, this was something that company directors should have addressed sooner. Nevertheless, their ability to rebuild their balance sheets and reign in levels of debt have left the sector looking in much better shape than it has for some time.

One last point to take. Commodities will often perform better during time of rising inflation. Markets move in cycles and from a low inflation environment markets can quickly move to high inflation. With the first signs of inflation creeping into the main global economies, this could now prove to be a good time to start backing this asset class.

forex