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Will This Commodity Slump Propel The FTSE 100 To New Highs?

A retired fund manager with a prudent approach to risk, my dad used to manage about $1bn of funds in the old days. He used to warn me about the risk of prolonged weakness in commodity prices, but now he has been mostly silent for a while.

Up Or Down? 

The prices of commodities, just like those of any other assets, rise and fall in cycles, but are unlikely to hover around certain levels for a long time. 

In fact, a rapid rise is usually followed by a rapid decline that could last months or years, and vice versa. 

As a private investor now, dad is lurking for an opportunity. 

Then, the FTSE 100 is an obvious choice, I told him this week. 

Is The FTSE 100 At Risk? 

Miners and oil companies are some of the main constituents of the FTSE 100, so any movement in their stock prices could have a big impact on the performance of the main index.  

While everybody is worried about China now, and that’s reflected in depressed commodity prices around the world, is there any solid reason to be bullish? 

The 2008 crisis surprised me not so much for the collapse of the global banking system, but for the strength that commodity markets showed soon after the first cracks of the financial meltdown had emerged. Fundamentals and supply/demand dynamics played a minor role in that rally, in my view. 

China was seen as the engine of the world’s growth, while other emerging market economies that today are faced with one of their worst recessions in a generation — such as Brazil — are no longer there to boost demand.

But seven years ago, systemic risk was at its highest level since the Great Depression of the 30s. 

Trends

Between the end of 2007 and early 2009, the FTSE slumped to its multi-year low of about 3,500 points.

Back then, the CRB Commodity Index — a commodity futures price index — dropped to a level that is in line with its current reading of 199 points, yet now the FTSE 100 trades around 6,600 points.

So, can you imagine where the index could go if the CRB Commodity Index repeated its +85% post-2008 performance? 

China’s devaluation is aimed at keeping the country’s annual GDP growth rate at about 7% — even 6% would be a respectable growth rate, I’d argue. According to data from the World Bank, its growth rate has declined from 7.8% in 2012 to 7.4% in 2014. 

It could diminish further, of course, but that will be a lengthy process, while a currency war with the US, of which we have been warned in recent days, could be a less likely outcome than many economists predict. 

And even if some bearish economists were right, I do not see why the UK should be materially affected. 

Dividend Risk

At its current level, the CRB Commodity Index also trades in line with the highs that it recorded before it slumped in 1996 and in 2000, but I have one recurring thought, and that is: the main index could overtake its record of 7,122 points within less than a year! 

On the face of it, the UK’s banking system is much stronger than it was following the credit crunch — with miners and oil producers, their combined weighting is almost 40%. 

Meanwhile, several big players in the resources space — such as BP and Rio Tinto — might be able to deliver rich dividend yields even if their margins are stained.

Keep an eye on their dividend policies to assess broader market risk. 

That was the only advice I got from dad. 

Where Is Value Then?

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.