With equity and bond markets at all-time highs, opportunities are harder to identify for asset allocators. It might thus be timely to revisit the investment thesis of commodity investing, especially if we consider that we are now well into the 9th year of a commodity bear market.
Where are we in the commodity cycle?
The commodity market reached its peak in 2011, after years of strong performance known as the “Chinese driven commodity super-cycle”.
The 2000s commodities boom or the “Chinese driven commodity super-cycle” was the rise, and fall, of many physical commodity prices (food, oil, metals, etc.) which occurred during the first two decades of the 2000s (2000–2014), following the Great Commodities Depression of the 1980s and 1990s. The boom was largely due to the rising demand from emerging markets such as the BRIC countries, particularly China during the period from 1992 to 2013, as well as the result of concerns over long-term supply availability. There was a sharp down-turn in prices during 2008 and early 2009 as a result of the credit crunch and sovereign debt crisis, but prices began to rise as demand recovered from late 2009 to mid-2010. Oil began to slip downwards after mid-2010, but peaked at $101.80 on 30 and 31 January 2011, as the Egyptian political crisis and rioting broke out, leading to concerns over both the safe use of the Suez Canal and overall security in Arabia itself. On 3 March, Libya’s National Oil Corp said that output had halved due to the departure of foreign workers. As this happened, Brent Crude surged to a new high of above $116.00 a barrel as supply disruptions and potential for more unrest in the Middle East and North Africa continued to worry investors. As such, the price of oil kept rising into the 2010s.
The commodities super-cycle peaked in 2011, driven by a combination of strong demand from emerging nations and low supply growth.
Commodity cycles tend to follow economic cycles, and global growth has continually disappointed since the financial crisis. Combined with increased production capacity, driven by the China boom, we have been met with both over-supply of a broad bucket of commodities as well as a slowdown in demand growth. The covid-crisis triggered another demand shock.
All, however, may not be doom and gloom. Historical data would suggest that the average duration of a commodity downswing is around 7 years, with price declines averaging minus 40% (research by the IMF & Capital Economics from period 1950 to 2014).
The broad-based Bloomberg Commodity Index is currently showing levels not seen since 2002 and has been massively underperforming equities (see chart below).
Chart: GSCI Commodity Index to Dow Jones Industrial Average Index ratio (source: Incrementum)
While we had experienced a ramp up in production driven by the last boom, we are now witnessing a reversal, with a convergence between rising production costs and falling market prices.
This may all signal that, combined with significant price declines in numbers of commodities over the last few years, we might be approaching the bottom of the current cycle. True, oil prices have collapsed and might stayed stuck within a narrow trading range until we get further clarity on how the post-covid world will look like. Some other segments of the commodity spectrum remain in bear market – e.g soft commodities. But on the other hand, we have seen some interesting moves within Precious Metals and Industrial metals. Indeed, Gold is now trading at an all-time high of $2,000 and could continue to rise if central banks continue to print money, pushing real bond yields to new lows. Still in the precious metals space, Silver is surging and might be on its way to $30. Meanwhile, we have seen some progress by industrial metals throughout the summer. For instance, Copper is trading at its highest level since April 2018.
So what are the characteristics of commodities as an asset class and how can investors get exposure?
Commodities as an asset class
In the investment world, most asset allocators have deemed commodities as an ‘Alternative’ asset class, as commodities don’t tend to represent an asset class that is found in most traditional portfolios. The vast majority of allocators have been considering commodities in their strategic asset allocation to increase portfolio returns, for diversification purposes and as a form of protection from inflation.
When it comes to expected returns, most broad-based commodity portfolios exhibit equity-like risk adjusted returns over the long term. Portfolio managers look either to exploit these cyclical opportunities or take advantage of arbitrage opportunities in futures markets. Drivers of return include the ability of managers to exploit the ‘roll return’ from futures contracts.
With regards to diversification, commodity benchmarks have indeed a relatively low correlation with more traditional asset classes over the long run. Consequently, the addition of commodities to equity/bond portfolios results in an increase of risk-adjusted returns.
This might not always be true as most investors experienced in the aftermath of the financial crisis, when a temporary pick-up in the correlation between equities and commodities took place due to a decline in aggregate demand over a number of asset classes.
But during “normal times”, commodities are usually responding to more fundamental supply/demand factors including geopolitical instability (think oil), mining strikes or weather (e.g El Niño effects on grains).
As mentioned above, commodities are also considered as an effective way to hedge a portfolio against any inflation shocks. Food and Energy prices tend to be the drivers of inflation which means that any unexpected volatility expressed by CPI (Consumer Price Index) moves will generally translate into positive returns for commodities. But as commodities are also priced in US dollar, their prices tend to rise when the value of the dollar falls.
How can investors get exposure to commodities?
Derivatives such as Futures and CFDs are attractive instruments to play this theme.
ETFs (exchange traded funds) or ETNs (exchange traded notes) have expanded the availability of investments providing exposure to single commodities and commodity-linked indexes. At the same time, these instruments have exposed investors to a new set of risk factors that may be unfamiliar to the average investor (e.g “roll cost”, credit issuer risk for ETNs, etc.). The largest ETF in size is the SPDR Gold (GLD), with a market capitalization of nearly $70 billion. Besides Gold, the largest instrument is the DJP iPath Bloomberg Commodity Index Total Return ETN (nearly $1 billion in Market Cap).
The simplicity of the passive or index funds usually offers comfort to investors - as they know that they are investing in an instrument that tracks an index.
But investors can also use actively managed funds to get exposure to commodities. Indeed, commodity returns may be enhanced through active management seeking to avoid the inefficiencies of passive commodity indexing as well taking advantage of any additional opportunities within these complex markets.
Commodity markets can offer attractive alpha opportunities to astute managers. This is especially true for those who can design a portfolio that combines both fundamental trades and structural trades that seek to capture recurring risk premiums and that invest in non-directional return sources using techniques such as arbitrage, momentum, volatility and roll yield.
Actively managed funds can also invest in a less constrained way than passive funds. For example, commodity ETFs tend to be weighted to commodities with the largest trading volume or greatest consumption globally, much like equity indices that are weighted to the largest market capitalizations. This means that investors are usually exposed to overweight or concentrated positions in energy commodities. Active managers are not.
Moreover, active managers don’t necessarily rely on prices rising. Employing a ‘relative value’ approach and trading price inefficiencies between related instruments is an example of this.
With equity markets at all-time highs, volatility close to historical lows and the fact that we’re well into the 9th year of a commodity bear market, the commodity asset class is worth a look.
In 2020, global governments have responded with trillions of dollars in liquidity and stimulus to help mitigate the virus’ impacts. As the impact of the virus eventually passes, the monetary and fiscal measures put in place today could create a shift from the deflationary psychology that has gripped markets over the past decade to a new period of inflation. Very few investors are positioned for such a move. The other effect could be a rerating of real asset prices generally and particularly commodities. As shown in the relative price chart earlier, following the recent oil price collapse, commodity prices are now basically as radically undervalued as they were at their lows in 1969. Investors might thus be well inspired to have to closer look at the space.
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