Commodities and Futures: Base and precious metals lead upsurge in popularity

ALL but ignored over the past few years because of falling prices, commodities have suddenly become fashionable again as investors search for an attractive return.

Previously dull markets are staging large-scale moves, sometimes defying the laws of supply and demand.

The upswing in popularity is most obvious in base and precious metals markets. Two weeks ago copper prices reached an 18- month high on the London Metal Exchange.

Last week the surge in LME zinc prices prompted suggestions that the exchange executive might have to head off technical squeezes, not only in zinc but also in several of its markets that are facing supply tightness.

Philip Crowson, an RTZ economist, said the London Metal Exchange was 'beginning to rival Mae West in the number and frequency of squeezes it has experienced'.

Gold, which proved unflappably quiet during the Gulf war after the initial shots were fired, is experiencing volatile trading at the mere mention of tension between Iraq and the United Nations.

Some soft commodities, most recently cocoa, also appear to be coming out of hibernation.

The tide seems to have turned for the commodities sector because it represents a more attractive investment than the alternatives. Low interest rates are the key - in the US, loan rates are at 30-year lows.

Fund managers are frantically seeking a more lucrative home for their cash than equity markets, bonds or property can provide.

The commodities rallies of the 1970s reflected the surge of investment into traditional inflation hedges. But now, scores of other inflation hedges exist so commodities no longer serve that purpose.

Andrew Smith, metals analyst with Union Bank of Switzerland, said: 'This is deflationary interest, independent of the fundamentals of supply and demand.'

Because other investments are not performing as well, US and British commercial banks are homing in on commodities and recommending them to clients.

Mr Smith noted that Japan is getting in on the act. Its Finance Ministry recently permitted insurance companies to include commodity funds in discretionary portfolios.

At the end of last year base and precious metals prices were languishing in a recession-induced trough that appeared never-ending.

But since then, even though recessionary conditions in the US and UK have not abated significantly, aluminium, copper and palladium have risen by roughly 25 per cent. Zinc has climbed nearly 10 per cent since 16 July.

Mr Crowson said: 'These markets are not all reflecting the physical supply and demand balance. They are reflecting fund investment, trading opportunities and the growing use of the market by producers and consumers as a hedging medium.'

The bandwagon effect is also kicking in. As prices rise, computer-driven investment programmes get 'buy' signals and more investment funds purchase the metals.

Another factor is that options and other sophisticated derivative instruments are being used to trade commodities these days. This means that the price is increasing reflecting 'paper' demand rather than genuine demand for metal or grain.

Volumes on the LME are consequently breaking new records practically every month. June was its biggest month ever. Its executives have been involved in an international marketing campaign over the past year aimed at metal producers and consumers, but that alone cannot be responsible.

The LME welcomes increased activity on the exchange but can do without quixotically volatile prices. Producers are pleasantly surprised to see such high prices in a recession, but consumers who must buy the commodities are grumbling at the volatility.

Traders say that another potential danger is that artificial demand will encourage increases in productive capacity that are not really justified, storing up trouble for the future.

'The danger is that the game stales and fundamentals reassert themselves,' Mr Crowson warned. 'Prices could drop quite fast. At some point the music is going to stop.'