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By Bob Lyon  | Monday, June 13, 2011

Since 2008, investors have faced volatile financial markets, buffeted by fears of sovereign debt default, inflation expectations, currency debasement, and slow growth in developed economies. And yet, one bright spot has remained constant through these tumultuous times – resources. Skyrocketing demand from emerging market countries for key resources like oil, coal, and copper and depleting supplies bode well for commodity prices in the years to come.

The fact that resources are in the midst of a secular uptrend can primarily be attributed to a shifting global economic landscape that has disrupted the supply/demand relationship of the resources equation. While this creates volatility, it also presents opportunities for investors. The question is, how can investors benefit from this tightening supply-demand equation and how should they gain exposure to resources as a long-term source of growth for their investment portfolio?

One of the most significant variables driving demand for commodities is accelerating growth in emerging markets. While developed markets are struggling with massive debt loads, high unemployment, and lacklustre GDP growth, emerging market countries like Brazil and China are experiencing strong increases in production, consumer spending, urbanization, and infrastructure. This has led to booming demand in these countries for much-needed commodities such as oil, copper, coal, and iron ore to fuel manufacturing, building and development. The International Monetary Fund (IMF) has predicted that for the next several years, annual GDP growth in emerging market countries will continue to outstrip that of developed markets; these growth expectations continue to support rising demand for resources.

China is leading the way

The biggest growth story right now is China, where policymakers are working to manage the country’s explosive growth in order to normalize wages, cut individual income taxes and spend more on social security and health care. As households in China become wealthier as a result, they will become greater consumers, which should support the ongoing strength in commodity consumption. At the same time, China’s continued push to bolster its infrastructure could also open up a growth opportunity for later stage commodities such as platinum and nickel.

In fact, purchasing power parity is on the rise throughout the BRIC countries (Brazil, Russia, India and China) as household income and spending rises, contributing further to commodities demand growth.

Exhibit 1: China’s share of global commodity consumption

Source: UBS

The supply side

While emerging market demand for resources is incredibly strong, there are clear pressures on the supply side of the equation. The big challenge is scarcity – commodities like oil, copper, and gold are finite resources that are becoming increasingly more difficult to locate, extract, and process. Adding to the scarcity are limits on how much drilling and mining can be done, especially with tighter regulatory requirements and a growing emphasis on sustainability and environmental safety. Such requirements make it much more challenging to begin new mining or drilling operations and increase the time and cost involved, resulting in higher commodity prices.

Many commodities are experiencing considerable supply pressures. Industry analysts believe demand for copper will outstrip supply in the next 10 years, largely driven by China’s appetite as it continues to rapidly build its infrastructure. At the same time, the world’s thirst for oil continues to grow and is not expected to subside any time soon. According to Bloomberg, world oil consumption reached 85 million barrels a day in 2009, triple the 30 million barrels the world consumed in 1966. And as emerging market countries put more cars on the road, there will be a steep increase in global demand for oil to power those cars. According to estimates by the Boston Consulting Group, BRIC countries alone will account for more than a third of automotive sales in the next four years.

Yet the benefits of high commodity prices are not universally shared by all. While commodity producers can charge higher prices because resource supplies are the tightest they’ve ever been – and prices will likely remain higher for much longer periods than we’ve experienced before – such prices can have a negative impact on global economic growth. In fact, the IMF estimates that a 10% increase in the price of oil would reduce global GDP growth by 0.2%-0.3%.

Considering the asset allocation equation

It is critical for investors to navigate the line between the supply and demand sides of the commodities equation. To effectively manage the risks in the sector, we believe investors can benefit from an actively managed, equities-based approach over direct commodity investment. Here’s why:

First, active security selection provides an opportunity to balance macro factors and risks, such as inflation and currency valuations, with company fundamentals, which can potentially reduce overall portfolio volatility while still capturing the strong returns being generated by the asset class.

Second, investing in resource companies offers the ability to participate in future discoveries, production growth, and cash distributions in the form of dividends the company may pay out.

Third, introducing a basket of resource companies to a portfolio offers some important diversification and risk-return benefits. As Exhibit 2 shows, over the long term, various commodities such as oil, gold and copper have displayed a low correlation to the broader market. Introducing assets that are not well correlated to one another enhances diversification and contributes to reducing overall risk in a portfolio.

Exhibit 2: Commodity correlations with the S&P 500 TR Index

  Oil Gold Copper
10 Years 0.38 0.15 0.45
20 Years 0.30 0.08 0.39
30 Years 0.28 0.07 0.38

Source: AGF Portfolio Analytics, Bloomberg as at December 31, 2010

The efficient frontier in Exhibit 3 shows what return an investor could expect from a portfolio of stocks and bonds for a given level of risk. The data clearly show that by adding a moderate allocation to a global resource equity strategy, an investor can effectively improve the risk-adjusted return profile of their portfolio.

Exhibit 3: Commodities can improve a portfolio’s risk-adjusted return profile

Source: AGF Portfolio Analytics and Bloomberg, 20 year data to December 31, 2010 – Model Portfolio comprised of Barclays Global Aggregate Bond Index, S&P 500 TR Index, MSCI TR European Index. Global resource allocation – 60% MSCI (Dev.) World Energy Index, 40% MSCI (Dev.) World Materials Index.

Commodities as an inflation hedge

Commodities such as gold, copper and oil have traditionally been useful hedging tools for investors looking to manage inflation risk, and this is expected to continue in the coming years, particularly as increasing demand and supply constraints continue to push prices higher. Take oil as an example. Over the past 40 years, while inflation has increased steadily, the price of oil has more than kept pace despite its volatility and has consistently offered an inflation hedge to investors despite market shocks. Over the same period, the U.S. dollar lost 84% of its purchasing power. Although oil did react initially to the shock of the 2008-2009 global financial crisis, prices have climbed significantly since then, even in the face of persistent low growth and fiscal and economic challenges in developed countries.

At AGF, we strongly believe investing in resource companies will continue to be attractive to investors in the coming years. The challenge will be to take on opportunities without opening up a portfolio to an unnecessary level of risk. An active equity allocation to resources will provide enhanced return potential and better diversification, in turn enabling investors to achieve the optimal risk-adjusted performance for their investment portfolios.

Bob Lyon, CFA, is Senior Vice President & Portfolio Manager for AGF Investments Inc. He provides leadership for all of AGF’s resource-focused portfolios. Working closely with the AGF research teams, Bob combines a global top-down view with detailed bottom-up analysis.

Important information

The commentaries and other information contained herein are provided as a general source of information based on information publicly available as of March 2011 and should not be considered as a forecast, research, personal investment advice, recommendation or an offer or solicitation to buy, sell or hold any securities or other financial instruments. Every effort has been made to ensure the accuracy of the commentaries and other information at the time of publication. However, market conditions may change. In addition, the accuracy and completeness of the commentaries and other information contained herein cannot be guaranteed. The manager and its affiliates may from time to time invest in hold or sell securities or other financial instruments relating to companies or other entities referred to herein. Reliance on the commentaries and other information herein is at the sole discretion of the reader. The manager accepts no responsibility for individual investment decisions arising from or in any way based on the reader’s reliance on the commentaries and other information contained herein. Past performance may not be indicative of future results.

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