Pension funds want commodity exposure because they are fiduciaries.
The world is starting to demand a currency risk premium for holding U.S. dollars. And prudent investors are acting accordingly in their stewardship of assets held for future generations.
Suppose you lived in a country where spending and tax cuts are spiraling out of control, David M. Walker, then comptroller general of the United States, wondered in a November 2005 report about the U.S. Is it prudent to be exposed to one paper currency?
So institutional investors are moving at least a small part of their dollar-denominated claims, that is, investments, into Treasury inflation-protected securities and real assets like real estate, infrastructure and commodities.
We only trust paper claims on future goods if the value of currency in terms of real commodities is stable. That is why you would demand a major risk premium on a paper contract denominated in, say, Zimbabwean dollars.
The market for future paper claims in U.S. dollars is enormous. Whether they are stocks, bonds, credit derivatives, post-retirement health care or future unfunded entitlement payments by the U.S. government, these are all claims on future real goods. You do not retire and eat stock certificates. The problem is that we can end up with more paper claims on future wealth than can be met. At this stage we have a process of creative destruction where many paper claims will get wiped out. So mortgage claims or ratings' evaluations or major financial entities suddenly turn out not to have the value we expected.
A strong paper money has been the heart of every great empire since the Chinese invented the concept of a paper currency.
In the United Kingdom, we faced this challenge a century ago. If the world accepts and uses your currency as the money for the world, then you do not have to match domestic spending to your domestic savings. Economists cutely call this association the poisoned chalice. If you choose to have a deficit, then foreigners will pick up the tab. Eventually, however, the world came to realize that there were too many debts due in pounds. At the end of World War II, £1 was worth $4.50. Drink from the poisoned chalice, and the long party ends with a long-lasting hangover.
Since the turn of the 21st century, the value of the U.S. dollar has fallen sharply in terms of real commodities.
Since the fixed exchange-rate system broke down in 1971, the U.S. excessively has expanded the supply of dollars. Any central bank that kept a fixed exchange rate has been obligated to convert dollars into their own currency: global inflation.
The first currencies in the world were commodities. Commodities are valued because people use and consume them. The first financial markets in the world were for commodities. These markets were created by the private sector so that future supplies could be assured.
Paper currencies hold risks. As Franz Pick, the late renowned currency analyst, indicated, we measure a paper currency by how much we trust its future value in real terms.
The only reason we believe it is good to hold claims denominated in U.S. dollars is because we believe inflation will be controlled. To be a world currency, money must have three attributes: it must be a medium of exchange, a unit of account and a store of value. Inflation erodes the store of value.
Institutional investors around the world are only just beginning to gain exposure to commodities. Institutional long-only commodity futures investment is estimated at $240 billion. This investment is primarily in the two leading indexes: S&P GSCI and Dow Jones-AIG Commodity index. Annual trading in the commodities in these indexes is more than $35 trillion. Institutional investor exposure to commodity futures has been blamed in some quarters in Washington for the rise in commodity prices. Yet it is a tiny percentage of trading. The price of commodities in which there are no futures contracts is rising just as rapidly as those in which institutions invest.
A key point has been lost in recent rhetoric: Institutions rarely buy physical commodities. They keep their cash invested in collateral, then they separately hedge their future inflation risk by going long commodity derivatives, usually by buying futures contracts. Institution purchases primarily affect the premium or discount for future commodity purchases, not spot prices.
Consumers pay spot prices for commodities. Spot prices are determined by clearing today's market supply and demand. If there is an excess of oil in the spot market, speculators' views on the future are irrelevant. In contrast, today's price of paper claims on bonds and stocks is always determined by investors' long-term assessments. One certain fact about commodities is reversion in prices. When a commodity price rises sharply, new supply emerges and the real price falls. So the oil price could easily fall 30% over the next 12 months. Sadly there is an excess of dollars, so a fall in the oil price does not mean that all commodity prices will fall.
Commodity prices are rising for a simple reason: the other 90% of the world's population is now rapidly entering the global economy. When a peasant moves from rural agricultural subsistence into an urban environment, his commodity demand starts an inexorable rise toward the high U.S. level of resource usage. This footprint is enormous. The second reason is that commodity prices in U.S. dollar terms are in a supercycle, meaning the U.S. is spending way beyond its means, and the Fed has monetized an excessive proliferation of future dollar-denominated claims, meaning the Fed has created a huge amount of liquidity to prevent institutions failing to meet their paper obligations. Politicians have written future checks and the Fed is trying to validate these paper claims. The supply of commodities is fixed in the short run, so when the Fed creates more dollars, the value of commodities relative to dollars falls. Inflation is back and fiduciary investors seek protection from it through commodity investment.
Ronald G. Layard-Liesching is chairman of Mountain Pacific Group, Bellevue, Wash. He was a founding member of the DJ-AIG Commodity Index committee. He is author of the CFA Institute publication Investing in Commodities.