Interactive Investor

Made in China: The boom and bust of the commodities super-cycle

8th December 2016 09:10

Cherry Reynard from interactive investor

Interactive Investor is 21 years old. To celebrate, our top journalists and the great and the good of the City have written a series of articles discussing what the future might hold for investors. Here's Cherry Reynard on the commodities super-cycle.

Everyone remembers the drama of the technology bubble: the mega-deals, the colourful chief executives and the spectacular bust.

Far less sexy, but equally profound for many investors, was the commodities super-cycle: the huge boom that saw natural resources companies achieve sky-high valuations on the back of China's industrialisation.

The popularity of natural resources companies started almost as soon as the technology bubble burst, as the market searched for a new story.

After all that blue-sky thinking and new paradigms, it was reassuring to back companies that dealt in something tangible. What could be more tangible than oil, steel, copper and iron ore?

Made in China

Growth in China was the catalyst. Between 1998 and 2007 China's GDP grew at an average rate of 9.9%.

Importantly, this was resources-hungry growth. The country was industrialising at a dizzying pace, and building new cities and infrastructure. In doing so, it stoked unprecedented demand for commodities, particularly base metals. Prices soared.

Olivia Markham, manager of the BlackRock Commodities Income Investment Trust, says: "The super-cycle started in 2001/02, following the unprecedented growth in demand that came from rapid urbanisation in China.

The price of iron ore rose 15-fold between 2005 and 2011"The mining sector had come out of the 1990s with very little new supply entering the market. This meant there wasn't enough supply to meet the new demand and prices rose."

Iron ore was a good example. Its price rose 15-fold between 2005 and 2011, peaking at $187 (£143) a tonne in February 2011.

This was good for groups such as Rio Tinto: the firm's share price rose by more than 100% in the two years to 2008. Anglo American shares rose in price from £1,300 to £3,500 over the same period.

Anna Stupnytska, global economist at Fidelity International, points out that commodity prices were also supported by accommodative monetary policy from developed market central bankers.

Interest rates were probably lower than they needed to be, given the level of economic growth. This drove liquidity and fuelled the boom. Like all good booms, there was much financial indiscipline. Companies spent huge amounts trying to bring supply on-stream quickly.

There was a wave of consolidation activity and vanity mergers.

Commodities became a significant part of the blue-chip index - almost 20% at one pointThere were big company deals such as those between Barrick Gold Corporation and Equinox Minerals, but merger mania also saw a number of smaller, single-commodity producers snapped up by larger rivals.

Markham says: "Companies focused on growth and capital spending. They wanted to grow production at almost any cost, and capital allocation was very poor." Nevertheless, in the short term, those fund managers with an allocation to the sector could do no wrong.

James de Bunsen, a fund manager in the multi-asset team at Henderson Global Investors, says: "Particularly in the UK, if a fund manager believed in the commodities trade while it was working, it almost didn't matter what they did elsewhere. It was a major influence on returns."

Commodities became a significant part of the blue-chip index - almost 20% at one point. De Bunsen says the boom also spurred product asset management innovation.

A wave of ETFs designed to capture investment demand emerged. A number of sector funds came to the market. Commodities were increasingly seen as an important source of diversification and returns in investment portfolios.

Prices plummet

Inevitably, things started to go wrong. Expectations were too high.

Stupnytska says: "Higher prices had spurred innovation, such as the shale oil industry in the US. With that and higher production elsewhere, there was an oversupply of commodities.

"The macroeconomic environment was more sluggish, with huge debt and very low growth.

The JP Morgan Natural Resources fund saw double-digit falls every year from 2012 to 2015"However, the main trigger [of trouble] was slowing growth in China. This saw a major repricing of commodities."

It didn't happen all at once. Markham says the mining sector was hit hard in the global financial crisis, but it underwent a relatively buoyant recovery. It is only in the past four years that the sector has been in real trouble.

She adds: "People's expectations about growth in Chinese demand started to change, but supply in the mining sector takes a long time to respond."

There were plenty of casualties among fund management groups. The natural resources specialist funds had a torrid time. The JP Morgan Natural Resources fund, for example, saw double-digit falls in each year between 2012 and 2015.

Investment trusts also suffered as poor investor sentiment saw discounts widen at the same time as asset values fell. Notable casualties were Baker Steel Resources, which fell in value by 69.9% over five years, and New City Energy, which lost 62.1% of its value over the period.

Other UK funds with large weightings in natural resources companies were also hit. Perhaps the highest-profile example was the M&G Global Basics fund.

Resource companies' declining dividends were a major blow to income investorsThe fund had been built on ongoing emerging market demand for "basics" such as commodities.

When China faltered, performance plummeted and manager Graham French left (in 2013). The fund has since been repositioned.

Trackers also had a difficult time. The UK's major indices had built up a relatively high weighting to mining companies during the boom.

These businesses had also proved a valuable source of dividends, which declined - another knock for income-seekers, who had only just recovered from the blow inflicted by the banking sector on dividend payouts.

A turnaround in sentiment?

A number of attempts have been made to call a turn in sentiment towards natural resources companies and therefore a recovery in prices.

It appears that it may finally have arrived, as the sector has staged a significant recovery since the start of the year. Supply has come out of the market.

Markham says: "Capital expenditure has fallen by 60% from 2012." Equally, Chinese growth has proved more resilient than feared. Other factors support the commodities sector. 

"If we are going to see governments start spending on infrastructure projects, this could be positive for the mining sector," says Markham.

This looks like a real possibility, as governments seek to stimulate growth.

Commodities have proved themselves to be a volatile and unpredictable asset classHowever, Stupnytska believes it is premature to call the end to the disruption in commodity prices. "It will probably take another two to three years for the supply side to shrink," she says.

"It would be complacent to assume we've reached the bottom; so many events could happen."

Will another country take up the oversupply that has resulted from the slowdown in China? Probably not. Countries moving up the economic ladder - India, for example - may support commodity prices in the longer term.

However, commodities have proved themselves to be a volatile and unpredictable asset class, and many investors won't be tempted back in a hurry.

 

This article was first published in our special publication 21: Twenty-one years of Interactive Investor. Download your digital copy for free here.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser