While the majority of Australian investors’ portfolios tend to be very equity-heavy, in the current economic environment there may be a case for diversifying across asset classes and increasing commodities exposure. This article looks at four of the key factors supporting a bullish view on commodities in the near-term.
1. Reflation and Releveraging
Economic reflation (a fancy word for stimulating the economy by doing things like increasing the money supply or by reducing taxes) is now in full swing globally, with synchronised growth being seen across both developed and emerging economies. The expansion in global manufacturing and industrial activity to 4 year highs drove demand for commodities through the second half of last year and should continue to provide a supportive backdrop for commodity fundamentals – with periods of higher inflation and global growth having historically benefited commodity prices relative to stocks and bonds.
As commodity prices improve, emerging market currencies tend to strengthen against the U.S. dollar. This in turn lowers funding costs for emerging markets companies and leads to increased lending, which in turn encourages further spending and further growth.
Similar conditions were seen during the so-called “2004-2008 super-commodities cycle”, which saw oil soar to $147 per barrel, EUR/USD at 1.60 and global credit growth 1.4 x GDP growth.
2. Rising Global Bond Yields Have Been a Tailwind for Commodities
While record low interest rates have been a tailwind for equities and bond prices, with the U.S. Fed looking to raise interest rates at least three times in 2018, rising bond yields can be expected to increase the risks of equities and put downward pressure on bond prices. Conversely, historically commodities have been one of the strongest asset classes in rate-hiking cycles.
3. Low Correlation and Underinvestment
The period of ultra-low volatility experienced throughout 2017 may have come to an end. Markets have already seen one spike at the beginning of this year and analysts predict the trend to continue across all asset classes.
Equity and bond prices are arguably currently at very expensive valuations compared to historical norms, whilst commodities sit closer to ‘fair value’. While risks do remain, in a high volatility environment the lack of significant correlation of commodities to other asset classes suggests the risks of a significant pullback on the broad commodity index remain lower.
In addition, investors are still underinvested in commodities relative to “standard” asset allocation metrics and may look to add on dips, especially if equities show signs of weakness.
The chart below illustrates the historical correlation between three BetaShares commodity funds and major Australia equity and fixed income indices:
|Correlation||S&P/ASX 200 TR Index||Bloomberg AusBond Composite 0-5Y TR Index|
|BetaShares Commodities Basket ETF – Currency Hedged (synthetic)||0.07||-0.28|
|BetaShares Agriculture ETF – Currency Hedged (synthetic)||-0.01||-0.16|
|BetaShares Crude Oil ETF – Currency Hedged (synthetic)||0.03||-0.27|
4. Commodity Supply Remains Tight
Due to the difficulties of storage, the majority of investors can only gain exposure to commodities through futures contracts. During times of excess supply, the cost of storage can negatively impact returns (contango).
At present, energy and metal supplies look set to remain tight. Although the number of U.S. shale rigs has increased in response to higher oil prices, this uptick has been restrained. Combined with strong demand growth and high OPEC compliance with supply cuts, the forecast for oil prices remains strong, with global inventories set to fall further throughout 2018.
We have seen evidence of this already as futures curves across major commodities have now entered backwardation, enabling investors to experience a carry pickup when rolling from one contract to the next, positively impacting returns.
(For more information on backwardation and contango, please refer to a previous article on the subject which can be found here.)
Having lagged as an asset class for nearly a decade, now may be the time to reconsider commodities when constructing portfolios. Renewed global growth, a weaker U.S. dollar and rising bond yields could prove strong tailwinds for the commodities sector, while the increased risks to other asset classes may prove diversification as essential to maintaining strong risk-adjusted returns through volatile markets.
Investors looking to implement a positive view on commodities can do so through: