The price of raw materials -- everything from oil to gold to corn -- has been soaring, and to find out why, you have to dig all the way to China. You don't have to go quite as far to take advantage of rising commodity prices.
If it comes from the ground, its price has probably been increasing the past 12 months:
*Cotton, up 104%
*Silver, up 57%
*Oil, up 13.7%
Typically, commodity prices rise at the end of a recovery, not at the beginning. At the bottom of an idealized economic cycle, companies have lots of excess materials on hand, because demand has plunged. As the economy picks up steam, companies work off their inventories, and mining companies have enough slack capacity to meet increased demand. At the end of the cycle, demand overwhelms mining companies' ability to produce raw materials, and prices rise. (At that stage, too, the inflation rate rises, and the Federal Reserve starts raising interest rates to get the economy to simmer down.
At least theoretically, however, the U.S. is in the early stages of a recovery. The nation's factories were running at 75.2% of capacity, well below their average 80.6% from 1972 through 2009. But mining companies are at above average shares of capacity.
The reason: China and other emerging markets. "China is the country moving the needle the most," says Alec Young, equity strategist at Standard & Poor's. Currently, China's GDP is growing at 9.6%, vs. 2.6% for the U.S. As more people in China (and India and Vietnam and elsewhere in the world) become more prosperous, they consume more energy, eat better food and build nicer houses. "Everyone who has tried electricity has really, really liked it," says John Dowd, portfolio manager of Fidelity Natural Resources fund.
People like driving cars, too. The average person in the U.S. uses about 22 barrels of oil each year, according to Ned Davis Research. In China, it's 2.3 barrels, and in India, it's 1. "They are in the early stages of achieving maturity of consumption," says Alberto Jimenez Crespo, co-manager of the Nuveen Tradewinds Global Resources fund.
They also like nice food, which is why food prices are rising.
China and India aren't the only reason commodity prices are rising. When demand rises, supply doesn't miraculously rise to support it. It takes years to open a new mine. Ivanhoe Mines, for example, has started the massive Oyu Tolgoi copper mine in Mongolia. Initial production should start next year, says Frederick Fromm, portfolio manager of Franklin Natural Resources fund. "They won't be at full production until 2020," he says.
In many existing mines, increasing production is getting harder. "Ore grades are declining," says Leo Larkin, equity analyst for Standard & Poor's.
In the best-case scenario for commodities, U.S. demand picks up again, driving prices higher for a few more years until production starts to catch up.
What could possibly go wrong? Plenty. In the case of food prices, one above-average harvest could smack down prices quickly, which is one reason many money managers avoid the sector. "You have to predict the weather," Fromm says.
In the case of basic materials, well, there's China. Economies don't grow at 9.6% forever, and the longer they grow at that rate, the greater the risk that inflation will get out of control.
In many emerging markets, where food takes up a third or more of people's budget, soaring food prices results in a slowing economy -- and civil unrest. "When gold goes up in price, no one gets hurt," says Crespo. "If food goes up 60% in a few weeks, it hurts a lot of people."
A swift decline in China's economy could mean a sudden stall in commodity prices. Soaring oil prices could also put a swift hurt on the U.S. economy.
If you're going to invest in a natural resources fund, avoid the insanely narrow funds, such as the Global X Lithium ETF. Use a more broadly diversified fund, such as the five in the table. ETF fans might consider SPDR S&P International Materials fund (ticker: IRV) or WisdomTree International Basic Materials (DBN). If you get too specialized, you could watch your fund's share price fall all the way to China.
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