Not long ago, there were three asset classes: stocks, bonds and cash. Some were not even sure if cash counted as an asset class.
The last few decades, however, have seen the “financialisation” of swathes of the world economy where prices were not previously set by markets, or at least not by markets led by the same investors who also set the prices of stocks and bonds.
Until the end of the Bretton Woods era in 1971, currencies were pegged to the dollar, which was pegged to gold. Since then, trading has boomed in foreign exchange; credit; emerging market stocks and bonds; and commodities. All these markets can be swiftly entered and exited by international investors, who are attracted by the chance to improve diversification.
But financialisation has led to controversy since last year’s crisis.
Was it the entry of international capital that allowed the simultaneous creation of bubbles in many emerging stock markets, several overvalued currencies throughout the emerging world and, most contentiously, the extreme boom and bust in many commodity prices?
Many influential voices are asking this question.
The United Nations Commission on Trade and Development devoted a chapter in its trade and development report to “the financialisation of commodity markets”.
It wrote: “Commodity prices, stock prices and the exchange rates of currencies affected by carry trade speculation moved in parallel during much of the period of the commodity price hike in 2005-08, during the subsequent sharp correction in the second half of 2008 and again during the rebound phase in the second quarter of 2009.”
The “herd behaviour” of many participants reinforced impulses to sell positions in commodity futures when prices began to fall. Financial investors treated commodities “increasingly as an alternative asset class to optimise the risk-return profile of their portfolios” and paid “little attention to fundamental supply and demand relationships in the markets for specific commodities”.
A concern was the “growing influence” of index traders, who “tend to take only long positions that exert upward pressure on prices”.
Unctad alleged that the positions they held had become so large that “they can significantly influence prices and create speculative bubbles, with extremely detrimental effects on normal trading activities and market efficiency”.
A broadening of regulators’ mandates, and a strengthening of oversight, was “indispensable”.
Given the riots over food shortages in many emerging countries when agricultural commodity prices peaked, these were emotive charges.
The circumstantial evidence for a connection between increasing financial market involvement and last year’s boom and bust is strong. There was no precedent for a fall in the oil price as sharp as that seen last year without a big geopolitical event to drive it.
The charges chimed with the concerns of politicians. The issue has generated so much heat that Joe Lieberman, an independent regarded as one of the most moderate politicians in the US Senate, last year proposed that index funds and institutions be barred from holding commodity futures.
The US Commodity Futures Trading Commission is looking into imposing limits on the positions investors can hold in specific energy futures, while many investors are working out contingency plans if the futures markets should be limited.
The controversy is important because retail investment money is pouring into exchange-traded commodities – structured notes similar to exchange-traded funds that are traded on exchanges and backed by commodity futures.
These funds began to appear early in this decade. They are a major part of the arsenal of asset allocators.
Critics argue that by taking a position in futures and holding it, these funds add upward force on prices without any countervailing pull downward.
According to Deborah Fuhr of Barclays Global Investors, one of the largest ETF providers, the assets under management by commodity ETFs in Europe doubled in the first eight months of this year and stand at $9.6bn.
In the US there were inflows of $23.8bn to commodity ETFs in the first eight months. More than half of this went into precious metals.
But the evidence remains circumstantial. It is difficult to trace a causal link between the influx of money to new markets and shifts in prices.
Philip Verleger, the oil industry economist, went so far as to say before Congress that the effect of index investing on oil prices during the spike of 2008 was “zero”.
He said that “commodity index funds act to stabilise oil price movements. Rebalancing due to changes in oil prices relative to other prices could cause these firms to add or subtract oil futures in a manner that tends to steady prices”.
It could be that the problem corrects itself. Investors were attracted to these markets in large part because they had a low correlation with stocks and bonds. After 2008 showed that this could reverse into a strong correlation, there could in the long run be less interest from institutions.
However, the renewed flows into commodity funds this year argue against this.
While some extra controls on financialisation seem politically inevitable, there is debate on whether the trend can be reversed. The nature of financial innovation suggests that once markets have established themselves, they are difficult to banish.
According to Andrew Lo, of the Massachusetts Institute of Technology, “it’s unlikely we can put that genie back in the bottle”.
His caveat is not encouraging.
“The way to do that might be if we have a pandemic and 30 per cent of the population is wiped out. At that point we will see financial transactions become much simpler and markets becoming much less complex.
“I hope it doesn’t happen that way, but as an academic I have to answer the question.”
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