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Question of the Week - August 3, 2015

Question of the Week - August 3, 2015

Guest Post - Monday, August 03, 2015

Commodities appear to be challenged again. Do they still offer any benefits?

Commodities are a very unique asset class. Rather than considering them as one group, it’s more relevant to break them apart into their various categories. However, the asset class as a whole does have some commonalities—for instance, positive correlations with inflation (especially surprise increases in inflation) as well as an inverse relationship with the value of the U.S. dollar (as inflation and currency valuations are related).

Investible commodities are technically futures contracts and other related derivatives that trade based on pricing for physical goods—many of which we use on an everyday basis. How commodities perform on a relative basis to expectations is largely based on what index one chooses to use. Energy prices naturally dominate weightings, so rising oil prices tend to benefit the energy-heavy GSCI index over others, while falling oil favors the Bloomberg index over GSCI, etc. The table below serves as a reminder of how these compare.

Groups

Examples

S&P GSCI

Bloomberg Commodity

Credit Suisse Commodity

Energy

Crude Oil, Nat Gas

71%

31%

54%

Precious Metals

Gold, Silver, Platinum

3

16

8

Base Metals

Copper, Zinc, Nickel

7

17

12

Agriculute

Wheat, Corn, Cotton

13

31

21

Livestock

Cattle, Hogs

6

5

4

Individually, commodities have their own characteristics noted below, which are largely based on supply/demand dynamics. This may sound simplistic as all assets react to these factors, having no other metrics to worry about (like cash flows/dividends), commodities have been thought of as having a ‘purer’ relationship to the economic laws of: (1) lower demand/higher supply = lower prices and (2) higher demand/lower supply = higher prices. Some of these drivers are illustrated below:

  • Crude oil reacts both to global GDP growth (positive for demand) as well as geopolitical uncertainty (threatens supply, thus raises prices)—an extreme case of the latter being the oil embargo of the 1970’s and lines to buy gasoline. Lately, shale and fracking technologies have raised estimated supplies, keeping a dampening effect on price. This is something many have hoped for, but offers a mixed blessing as energy is a large sector in the economy these days, and job growth is sensitive to pricing.
  • Natural gas, which we tend to have a large supply of, reacts mostly to demand and short-term storage factors. So extreme winter and summer weather events translate to large heating or cooling needs—the more unexpected these blizzards/heat waves are, the bigger the effect on perceived short-term gas inventories. Natural gas is historically one of the more volatile individual commodity groups.
  • Precious metals, like gold and silver, react to a variety of unique dynamics. These are consistently being mined (it’s expensive to shut a mine down and reopen it), so supply has growing slowly, but very slowly, so demand is typically the key shorter-term factor. A longer-term trend has been increasing gold demand from India and China, where the metal has cultural significance, is often used for gifting and a traditional store of value (in absence of many other good alternatives). Shorter-term, gold demand rises when investors seek out certainty during episodes of inflation (when currencies aren’t trusted) or general global panic (when any financial assets have problems being trusted). This is also true of silver and platinum somewhat, although these have industrial uses as well, in electronics and auto emission systems.
  • Base industrial metals, such as copper, zinc and nickel, aren’t that rare, so supply isn’t typically a key issue. However, one exception would be one-off/single-country export restrictions (which has happened—mostly recently nickel from Indonesia). Instead, demand related to economic growth, notably from China and other emerging market countries as major consumers of these metals, has been a key driver of sentiment.
  • Agricultural commodities are wide-ranging in type, but corn, sugar, soybeans and wheat tend to be among the most heavily-traded contracts. Demand for foodstuffs tends to be fairly predictable year-in and year-out, so supply (from seasonal harvests) is the key independent variable. While the world population is expanding, so is the efficiency is producing higher yields in shorter periods of time and in less space. If exceptionally extreme dry or wet weather hits key growing regions like the U.S. Midwest or Brazil, then worries over inventories rise and could drive up pricing. Geopolitics can enter this as well, such as a few years ago when a Russian drought resulted in the government’s limiting, then ban, of grain exports to protect domestic supply. A more subtle example is demand for corn to satisfy needs for ethanol fuel, per specified mandates.
  • Livestock is usually considered to be a sub-set of Agriculture, but can also be listed on its own. Demand has been steady, with long-term growth drivers being growing wealth in emerging nations, which improves the ability to purchase animal protein. Supply factors aren’t typically an issue, but wildcards can include diseases like avian flu and the like (such as this year), which can reduce supplies quickly and unexpectedly.

It’s important to preface this conversation with the reality that commodities generally represent between 3-6% of our recommended asset allocation portfolios. This is a relatively minor weighting, but when looking line-by-line on a performance report, dramatic results in any asset class can create a higher perception of importance.

When do commodities benefit us? They can work in times when many other portfolio components don’t work, such geopolitical turmoil, rising energy costs, a weak dollar and/or changes in inflation expectations. If we look back to recent decades, and even in recent years, these have always been legitimate fears in the investment world that could easily disrupt an economic cycle. Recently, with a slow global recovery and relative lack of geopolitical turmoil, and a glut of newly-sourced oil supplies, we’ve had things pretty easy as of late, so none of those circumstances have reared their ugly heads, so commodities have been cast aside.

Nevertheless, no good thing lasts forever. Like auto or homeowner’s insurance, which we buy sometimes begrudgingly, it exists to hedge against unforeseen risks. Commodities in a portfolio work in a similar way.

Source: Fidelity Investments

This is a complex conversation with few absolutes, and it can end up as a more complicated story for clients who are bombarded with ETF advertisements claiming rock-bottom fees and easy market access. These, of course, don't include spreads and other trading costs, as well as what a client might be gaining or losing by making the active or passive call. Only being armed with complete information can a constructive conversation be had and the most effective client decision made.

Additional Reading

Read our Weekly Review for August 3, 2015.

Read the previous Question of the Week for July 27, 2015.

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