Are commodities set to mirror the dotcom bubble?

Oct 11, 2011

In this issue:
» Rising rupee to hurt state oil companies
» Pharma deals to be scrutinized closely
» New telecom policy is announced
» Iron ore weathers correction in commodities
» ...and more!
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No one is likely to forget the dotcom bubble of the late 1990s, where any IT company with the dotcom tag but without a discernible business plan was trading at astronomical valuations. The bubble burst at the turn of the century and caused losses to millions of investors.

Now the attention has shifted to commodities and the talk is that commodities are set to extend their bull run in the long term. And the recent correction in prices has only sparked interest in investors to jump the bandwagon. But the notion that prices will keep rising is a dangerous one and one wonders whether the enthusiasm for commodities does not match the euphoria for IT stocks before the IT bubble burst. Some similarities exist. For instance, at the height of the dotcom era, technology stocks saw 30% of all the money invested in global equity markets. When the bubble burst, commodity stocks, notably energy and materials, rose to replace tech stocks as the preferred investment. By early 2011, commodities accounted for 30% of the global stock markets.

However, a sustained bull run in commodities is not necessarily a good thing. Sure, investors and financiers stand to gain. But the negatives are also numerous. Rising oil and metal prices, for example, would only weigh heavy on the profitability of India Inc. and choke industrial production thereby slowing the economy down. Surge in food and oil prices, as has been witnessed in recent times, dampens consumption and thereby demand. Indeed, to brand commodities as the next exciting thing in global financial markets hardly seems prudent.

Further, while supply side constraints do exist in certain commodities such as oil, whether demand will outstrip supply for all commodities going forward remains debatable. Prolonged recession in developed economies has certainly impacted demand there and while the world turns towards China to correct this imbalance, the overdependence on the Chinese dragon does not bode well either. What matters therefore, is to understand the dynamics of each commodity before taking the decision to invest in them.

At the end of the day, just as it is important not to follow the herd while investing in stock markets, investors need to apply the same principles while investing in commodities as well. Taking a general view that that prices of all commodities are set to rise and finding justifications for such high prices will only erode wealth in the longer term.

Do you think that prices of all commodities are set to rise going forward? Share with us or post your comments on our Facebook page.

 Chart of the day
Interest rates on 10 year government bonds give some idea of what the state of an economy is. For instance, today's chart of the day shows that interest rates for Greece have zoomed considerably as compared to its peers in the developed and developing world. This is hardly surprising. With Greece on the verge of default, as the government finds it difficult to honour its debt, interest rates on bonds have surged. These rates are, however, quite low in the US, where prolonged recession has led the Fed to keep them there. This is despite the fact that the US is as heavily indebted as Greece is. India's rates, meanwhile, are on the higher side too as the country's central bank battles to bring inflation down by tightening its monetary policy.

Data Source: The Economist

One sector's gain is indeed a loss for another. While the IT sector has been given a new lease of life following the sharp depreciation of the rupee in the last month or so, the same is proving to be the proverbial Achilles' heel for state run oil marketing companies. This is because the weakening of the rupee by Rs 1 against the dollar negatively impacts their costs by as much as Rs 80 bn per annum. Add to this the escalation that the crude oil prices have seen since 2010 and it becomes clear why the marketing companies are being forced to borrow money even for their working capital needs. This is certainly not a good situation to be in. To meet the nation's ever expanding energy needs, it is imperative that the oil marketing companies be in good financial health. And such a scenario doesn't look probable as far as the eyes can see. A prolonged slowdown in the developed world as well as China is perhaps our only real hope left.

The Indian pharma sector is eliciting a lot of interest from players across the globe. And why not? Given its dominance in the generics space, not just the large but also smaller players in Indian pharma offer lucrative growth prospects. At a time when the MNC drug companies are facing the threat of losing out on blockbuster patents, the tie up with generics partners can be a life saver. Several Indian drug majors have already inked lucrative deals with the MNCs, which sparked fears that the latter would raise drug prices in the country. Thus, the government has proposed to bring in the Competition Commission of India (CCI) and the Foreign Investment Promotion Board (FIPB). These entities will keep a watch on acquisitions in the pharma sector to stave off the possibility of cartelization. While 100% FDI will be allowed in greenfield expansions, it is the brownfield expansions (where MNCs acquire stakes in Indian companies) that will be subject to closer scrutiny. It essentially wants to ensure that the dominance by MNCs do not adversely affect drug prices. The developed markets are currently struggling to bring down their healthcare costs. At such times, the Indian government also wants to ensure that India does not do away with its cost advantage.

The much awaited reforms for the telecom sector kick started yesterday with the announcement of the draft New Telecom Policy. The sector that has been reeling with intense competition has had its eyes towards the government for quite some time now. Rules related to spectrum pricing, its allocation as well as the much needed consolidation in the sector were the key issues that were aimed to be solved by this policy. But for all those who thought that the government would finally act are in for a shock. The policy initiatives do not give a clear stance on any of these issues. In fact by the looks of it, all it does is to try and present the government in a better picture. No one can accuse the government for its inaction. They have come up with some initiatives. But these initiatives do not address the problems that have been strangulating the growth of the sector. The policy initiatives appear to be nothing more than a weak attempt by a corruption tainted government to try and get back into the country's good books. Unfortunately, it is this very same weak attempts and policy inactions that have led it to lose face in the first place.

Owing to the economic and debt crisis in the developed economies, commodity prices have fallen sharply in the past few months. In fact, the LME (London Metal Exchange) index, a basket of base metals, has declined by 20.5% since the beginning of 2011. However, iron ore, the mineral used in steelmaking has dropped by just 0.7% during the same period. It must be noted that the physical market for iron ore is less influenced by short- term speculative trading than markets in copper and other base metals. As a result, the price of iron ore is believed to be a better indicator of the underlying demand and supply balance.

Iron ore prices have weakened in recent times on account of idling of furnaces by European steelmakers due to poor demand conditions. China accounted for about 59% of the total world steel imports in 2010. However, there are indications that the Chinese economy is gearing towards a slowdown. In that case, it is difficult to say how long iron ore prices will continue to hold on.

Property prices across major cities in India have skyrocketed in the recent past. The price appreciation has been so meteoric that markets believed it to be unsustainable over the longer term. Subsequently, in anticipation of a correction, people delayed their purchases. However, if the report from a leading real estate agency is to be believed, correction in property prices appears to be a remote possibility. The report says that India's top seven cities are likely to witness a shortfall of 1.3 m units over the next five years. With demand expected to remain buoyant, property prices may further increase in the metros. While majority of the demand would be from the mid-housing segment, the potential from the low income housing group also appears to be latent. In fact, the demand in the mid-low income housing is expected to outstrip supply by almost three times over the next five years. So, while there may be apprehensions that prices in metros are unsustainable and ripe for correction, the demand-supply dynamics tell a completely different story.

In the meanwhile, the Indian stock markets were trading in the green for most part of the day today although profit booking at higher levels led the indices to pare some of their early gains. At the time of writing, the benchmark BSE Sensex was up by 76 points (0.5%). While IT stocks were in the red, most other sectoral indices were trading in the positive. Asian stock markets too were trading form with Hong Kong and Indonesia leading the pack of gainers.

 Today's investing mantra
"A lot of success in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc" - Charlie Munger

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2 Responses to "Are commodities set to mirror the dotcom bubble?"

shome suvra

Oct 11, 2011

Commodity prices should be equal to its marginal cost for a company. In dollar carry trade maximum assets are positively correlated.


anupam garg

Oct 11, 2011

It is relieving to know that CCI and FIPB are scrutinising the manner in which MNCs are entering...despite the fact that Indian pharma is 1 of the cheapest (which is news 2 me), the prices of drugs is still quite high, even for generics...just hope the good for nothing ministry of health doesn't interfere to fatten its wallets now

& it is dishearting to know the industry scenario of real estate...buying a house is any person's dream & seems like its going to remain that way

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