The commodity case

When you want to integrate an asset class into a diversified portfolio, you base your decisions on mainly 3 factors (in decreasing order of importance): the return, the risk and the correlation to the rest of your portfolio

Looking first at return, commodity markets are the only major asset class to have corrected during the last couple of years due to some fundamental imbalances (mainly oversupply). What is currently interesting is that the negative news have already been incorporated in the price, giving the investor more margin and contrary to equity markets commodities aren’t dependant on ongoing quantitative easing by the major Central Banks. If you decide to invest in a market you want to buy when the market is cheap or at least fairly priced. Today it’s the case for commodities especially in comparison with equity markets knowing that both are based on the real economy.

Risk is the second factor and we know that commodities tend to be more volatile than bonds and in line with equities. In today’s world what is for important is liquidity; there is a strong emphasis for example on corporate bond or high yield markets which could lack liquidity in case everyone is looking for the exit at the same time. Needless to say that these trades are crowded, this isn’t the case for commodities where investors deserted the asset class already months if not years ago.

Today’s correlation is clearly in line with the past, namely commodities are barely correlated with equity and bond markets but I know that in time of positive returns for bond and/or equities the client isn’t really interested by diversification and low correlation but rather by being concentrated on the highest returning asset class. Nevertheless in light of the possible increase of interest rates by the U.S. Federal Reserve, diversification will again be of utmost importance.
In terms of fundamentals the commodity markets are generally oversupplied due to the increase in supply witnessed the last couple of years; the best example is naturally shale oil production. This situation is the result of high commodities between 5 to 10 years ago inducing producer to increase production and due to the lag between the decision and the production reaching the markets, the pressure is felt now and not 5 years ago. Nevertheless I think that this situation is temporary and that the surplus will disappear faster than expected, because companies are cutting their expansion due to low prices and demand is responding positively to these same low prices.

China due to its size as a supplier and/or consumer is of course the most important player for commodity markets. The fact that the government wish to rebalance the economy toward more domestic consumption and less exports will affect some commodities. But I see it more as a zero sum game with winners and losers, thus industrial metals demand growth could weaken in the future but some agriculture products like coffee or cocoa would benefit.

Whatever investment you, some setbacks are always possible. Here I see clearly 2 factors which could affect negatively commodity prices but not only them: a worldwide economic recession and an ever stronger U.S. dollar.

Outlook:

The first quarter did not bring the expected upturn in the commodity market. Quite the opposite, commodities are still in the doldrums up to mid-March. The sell-off is widespread. However, precious metals showed only a slightly negative return, which is surprising since the US dollar was up by 10% based on the US dollar index. Commodities are the asset class with the largest negative correlation to the US dollar, which is not currently helping the sector. Nevertheless, there are sporadic signs of improving sentiment: for example, the increasing number of kilometres travelled in the US and the forecast by the International Energy Agency of a shortage in crude oil production at the production sites Eagle Ford, Niobrara and Bakken are likely to lead to a stabilisation in the crude oil market in the second quarter. However, the supply would have to be reduced consequently to ensure a sustainable recovery, which in my view is unlikely to happen this year. In addition, high inventory levels are having a negative impact on the futures curve. This is reflected by an especially pronounced contango structure in the US.

The picture is similar with respect to grains and oilseeds, where inventories are sufficiently stocked up worldwide. In addition, South America is also starting to export its harvests (mainly corn and soybean crops), putting US exports under pressure. However, this situation has already been factored into prices. The beginning of the planting season in the northern hemisphere will be subject to considerable uncertainty this year, in addition to the usual weather-related uncertainties; there is the added question of the wheat harvest in the Black Sea region.

The metals sector, however, is affected by the slowdown in the Chinese economy, particularly in the construction sector, which accounts for about 10% of global copper demand. We are currently seeing a fundamental divergence within the sector, which is why we are focusing more on relative trades than on direct investment. However, the indicators are often generally confusing when a market is at a bottom.

Fabien Weber – commodity & currency – GAM