The world is currently facing some of the most challenging financial markets seen in the last few decades. The subprime crisis and its fallout has helped tip the US into a recession that may have a serious impact on global growth for some time. However, the turmoil surrounding the commodity markets has, until recent weeks, been largely unnoticed and yet events in these markets have the potential to have a far greater global impact than a slow-down in the US.

Over the last 24 months most commodities have witnessed enormous price appreciation as world demand for fuel, raw materials and food has exploded. The price pressures behind the rise in oil prices are well documented and attributed to increasing demand from the emerging markets, notably China and India. Base metals have also benefited from the same demand pressures as emerging economies invest in their infrastructure by building new railroads, airports and even cities. Precious metals have in turn been well supported through a combination of low mine supply, a weak US dollar and gold’s historical safe haven status in times of uncertainty. Agricultural commodities have witnessed price increases due to demands from increasingly urbanized populations and alternative uses such as bio-fuel production.

In fact, the rally in agricultural commodities appears to be in its infancy. Commodities cyclical research shows that compared to previous bull-market cycles, which were not backed by such significant demand drivers as China and India, prices in real terms are still a long way from their highs. In other words, sugar, coffee, cocoa and corn may still be relatively inexpensive.

Commodity prices and a weak US dollar

Until recently investors had accepted that much of the drive behind higher commodity prices was the weakening dollar. The argument went that as commodities are universally priced in dollars, with the dollar weakening, commodities must rise in price terms to offset their value in other currencies. This argument has some merit, but price rises in commodities had slowly been outstripping dollar weakness for 2 years, and if we look at rises since the beginning of 2008 their out performance is startling. So far this year the dollar exchange rate index has weakened 6.3%; consider this against a basket of commodities: gold is +13% stronger, oil +16% stronger, corn +30% stronger, natural gas +35% stronger and rice +63% stronger.

The fight to feed people — governments react

Across the globe, Russia to Argentina and Mexico to China, we’ve seen the impact of tightening commodity markets with either social unrest or imposition of export tariffs to protect national markets. The river for such widespread social unrest has been a real fall in the level of inventories, particularly in food staples. Wheat, rice and corn inventories currently stand at multi-year lows, and with poor harvests forecast in the southern hemisphere and export restrictions from major producing countries, price pressures will likely continue for the time being.

Commodities and a weakening global economy

Investors have also been complacent about commodity price increases on expectations that commodities could sell-off in response to a US or even global recession. Recent JP Morgan Commodity Research analysis refutes this view. Examining commodity returns before and after the onset of the last five US recessions, JP Morgan have shown that commodity indices have on average rallied 15% from the beginning of a recession.

Rising commodity prices and inflation

In fact, the correlation between commodities and inflation is well documented. Anyone witnessing the inflation of the 1970s will know this well. However whilst the commodity matrix has rallied over the last few years, inflation has been remarkably benign. Therefore the final theme that is worth exploring is the potential impact that continued commodity price rises may have on inflation.

One can argue it is less likely that we see inflation as a result of the current surge in commodity prices than in the 1970s. In the 1970s, inflation became entrenched in economies not just as a result of commodity price rises but also because central banks had little autonomy and governments were the drivers of monetary policy. The result was that as monetary policy became a political issue and increasingly arbitrary in nature, inflation expectations went unchecked as governments pushed for growth at the cost of inflation. As a result of those lessons learnt, central banks emerged from the high inflationary era with greater autonomy and in many cases a clear brief to control inflation.

However, no economic cycle is identical to another. There is no doubt that in recent years our belief that central banks would be perpetually able to control inflation has made us complacent to the risks of inflation. Inflation has two key drivers, in-put costs driving out-put prices and consumer price expectations driving wage demands.

In terms of input costs, the developed world has experienced an era of tremendous price deflation due to globalization. Goods have remained cheap because consumers can readily log onto the internet and source the most competitively priced goods globally — in other words price discovery and transparency has become remarkably more efficient. However, given that much of the lowering of prices was due to the origination of goods in the same economies that currently have witnessed massive growth over the last decade, the argument that prices will remain perpetually low is somewhat stretched. In other words, China and India will eventually not be able to pass on negative price pressures. Indeed, as India and China have been the drivers of commodity prices surges, their increasing input prices means that output prices will eventually have to rise.

The other key driver of inflation is consumer expectations. Inflation became so entrenched in the 1970s because consumers became used to the expectation that inflation would continue to rise. This set off a vicious spiral of increased wage demands to counter expected rising prices that could only be met through firms raising prices, and so on. Rising food prices, particularly in the emerging economies where the cost of food is a significant proportion of disposable income will have to lead to consumers demanding higher wages and this may well begin to build in higher inflation expectations and thus the beginnings of an inflationary spiral.

Already news stories have emerged detailing that the Chinese authorities are heavily subsidizing food prices in Beijing to quell any inflationary driven social unrest leading up to this summer’s Olympics. Therefore, it would not take a huge leap of faith to see the beginnings of inflation already taking place in the emerging economies.

When we consider that the emerging economies are potentially most vulnerable to inflation and that the western economies are most dependent on emerging market goods to keep their own inflation stable it becomes easy to see a chain of events that drives inflation higher as emerging economies pass on higher costs. All of this will be driven by a continuing surge in commodity prices.

From an investor’s point of view, commodities as an asset class should have an increasing importance in their portfolio. Commodities are an excellent diversifier of returns in that they have low correlation to global economic cycles and a high correlation to inflation. Given the current economic forecasts of falling growth with inflation pressures they hold an even greater importance.

Indeed, commodities have shown enormous volatility this year and investors should consider most closely any investment vehicle that can capture both the upside and downside of commodity market price movements. A fund of hedge funds which trade exclusively in commodities will give investors access to commodity price movements and diversification of returns from a number of uncorrelated investment managers.

Richard Sherwin is a director of Blacksquare Capital. Blacksquare Capital is launching commodity fund of heedge funds on June 1, 2008.