Every year the markets like to have a new craze, says Kate Burgess in the FT, and in 2004 it looks like it is going to be metals. Traditionally, commodities such as these are bought for their value as a hedge against inflation and their sensitivity to the global economic cycle. Now, however, they are being bought as a result of "the China effect". According to Merrill Lynch, China now accounts for between a fifth and a third of global consumption of alumina, iron ore, zinc, copper and stainless steel. Hence, a 40% increase in Chinese copper imports in the first half of last year was almost single-handedly responsible for pushing copper prices up to a six-year high. This is unusual stuff, says JP Morgan Fleming's Tom Elliott. Not for a long time has the largest user of commodities in the world also been the fastest growing user. In fact, the last time we saw this "quite remarkable" combination was during Japan's rise to industrial pre-eminence during the 1960s and early 1970s. Then, too, commodity prices soared. As they will probably continue to do this time around, says Michael Arndt in BusinessWeek. But given how much equity prices have jumped in anticipation - nickel miner Inco was up 66% in 2003, while miners Phelps Dodge and Freeport-McMoran were up 100% and 166% respectively - the question now is whether the good news about China is already reflected in share prices.
One reason for investors not to get too excited, says Lex in the FT, is the dollar. Raw materials tend to be priced in dollars and the dollar has been depreciating against most other currencies pretty precipitously. Thus, the net impact on the earnings of mining firms, for example, "will be determined by the extent to which changes in underlying commodity prices are offset by currency shifts". And while optimism is "running high" for metal prices in the first half of 2004, "there is also a clear consensus for further dollar depreciation". No wonder then that, having outperformed since the beginning of July, the FTSE Mining sector was beginning to underperform by December. Note that for UK miners such as Xstrata Lonmin and Anglo American, a 10% appreciation in the rand against the dollar hits earnings by 10-15%. The fact is that currency swings may prove to be more of a drag on earnings than expected: metals groups will struggle to go on doing well. Indeed they will, say analysts at Morgan Stanley. Talk of a new, China-driven era in commodity price inflation is "beguiling", but valuations in the mining sector are now too near peak levels to look good.
Perhaps, but there are still areas within the asset class well worth investing in, US fund manager Arnie Schneider tells Barron's. Consider steel and coal. In the US, both industries have suffered from decades of underinvestment and a recent period of "duress" characterised by bankruptcies and subsequent consolidation (meaning that there is little or no spare capacity remaining in either industry). In addition, inventories "have been drawn down below normal" and, in the case of coal, many mining operations are "reaching the end of their useful lives", mining "lower and lower ore grades at deeper and deeper levels that are more and more expensive to reach". All this will keep prices up and, in an environment where "it is hard to see inflation picking up meaningfully in the intermediate term" (so interest rates are likely to stay low), the profit margins of domestic US companies with dollar-denominated cost bases will stay high too.
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More generally, investors need to consider the Russia factor, Darius McDermott of Chelsea Financial Service tells The Daily Telegraph. The former Soviet states have for years been in an extremely weak economic position and as a result they have been forced to sell commodities "at knock-down prices".But that is not the case any more. And that, says Charles Wyatt of Minesite.com in the Daily Mail, can only mean one thing: prices "may appear to have risen" over the last few years, but there is a long way to go yet. Indeed, in real terms commodity prices are "nowhere near their highs of the late 1960s and 1970s". Valuations in the sector may look high now, but if commodity prices keep rising, the sector's shares will follow.
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