Escalating index fund investment in the U.S. commodity markets may rival the dot.com bubble in terms of capital, risk and uncertainty, noted Peter Egli, an analyst with Plexus Cotton Ltd., speaking at the Ag Market Network's Dec. 13 teleconference.
Egli says cotton analysts can no longer draw conclusions by only studying the cotton market balance sheet. “We need to be keenly aware of influences such as competing crops, inflation and the U.S. dollar. On top of that, we also need to be aware that commodities in general have become a very popular alternative investment vehicle for pension funds, insurance funds and many individual investors seeking diversification to stocks and bonds.”
Egli noted that on Dec. 12, November 2008 soybeans closed at a life-of-contract high of $10.64. December 2008 wheat futures were also at the contract high of $8.37 and corn futures were $4.50, also a contract high. “These are all unprecedented levels that promise much fatter returns to farmers than cotton at 65 cents.”
And things could just be getting started. “I've seen some predictions by Goldman Sachs of soybean prices rising to $14 and corn to $5.50.”
As a result of higher prices in competing crops, Egli expects world cotton production to trend lower next season, “and the same could be said about consumption. I don't believe USDA's 128 million-bale consumption number is correct. If it was, I believe we would have a different market right now.”
Egli said that the slowdown in U.S. housing and the economy in general has led to a softening in demand, “although that is somewhat counterbalanced by the growth we still have in Asia.”
He pegs global consumption for 2007-08 at between 122 million to 123 million bales, although stocks will continue to be tight.
The 800-pound gorilla in the cotton price equation has little to do with fundamentals, noted Egli. “Over the last three to four years, the U.S. commodity markets have seen a huge influx of investment in speculative money — pension funds, insurance funds, hedge funds have started to pool large sums of money into commodities, and cotton has been a beneficiary of some of that money simply because it forms part of the index.”
Egli noted that there is currently $65 trillion invested in the global bond and equity markets. “Recent studies estimate that about $750 billion is invested in commodities, mostly through derivatives. Part of that investment, about $140 billion, is held in long-only, index funds and about $55 billion is in hedge funds. In all, about one out of every $90 invested is currently invested in commodities.”
There is good reason for this influx of cash, according to Egli. The Goldman Sachs Commodity Index is up 25 percent year-to-date, while the average hedge fund has earned about 12 percent and returns for stocks and bonds is in single digits.
As a result of these earnings, index funds have doubled their investment over the last two years. More and more pension funds are allocating somewhere between 3 percent and 5 percent of their holdings into commodities. For example, Calpers, which is the largest U.S. public retirement plan, invested $450 million this year into the Goldman Sachs fund.
“This plays into the cotton market because cotton gets a certain percentage of every dollar invested in one of these index funds, which operate only from a long position. For example, for every $100 going to the Goldman Sachs commodity fund, 81 cents goes to cotton in the form of a long position.
For the Dow Jones AIG Commodity Index, cotton receives about $3 out of every $100. And in the Rogers Commodity Index Fund, cotton gets $4.05 out of every $100.
As these investors pool money into the commodity index funds, “it leads to an increasing long position,” Egli says. “Cotton currently amounts to about 92,000 contracts in the long position, or 9.2 million bales. In addition to that, we have to add a significant amount of longs that hedge funds hold which are not reported separately.”
As a result of this crowding in by index and hedge funds, open interest has gone up considerably over the last two years, from about 80,000 contracts to as much as 250,000 contracts. “I believe this investment allocation in commodities has just started and that we will see these index fund investments grow substantially as investors seek diversification from equities and to hedge against the threat of inflation.”
This is very important to the price of cotton, noted Egli. “What if over the next two to three years, these index-fund-related longs continue to grow to 30 million or 40 million bales. Does the trade have enough cotton to hedge, or enough money to go short against these long positions? I believe there are plenty of recent examples that this crowding into long positions has blown up commodity prices higher than what commodity analysts thought was justifiable from a purely supply/demand point of view.
“I do see certain similarities to the dynamics that led to the dot.com bubble in the late 1990s, as new investments are chasing stocks regardless of the fundamentals justification. The scary thought regarding commodities is that the investment trend has just started and is still miniscule in terms of the global investment game. Just imagine what would happen if just 1 percent, or about $650 billion, would migrate from equity bonds into commodity funds, which are currently at $140 million.
“It's a very interesting story that is developing. I cannot stress enough that we cannot turn our head to what is happening here. We have to be careful not to be caught up too much in the sentiment of the day.”