4 Reasons Why Investors Should Consider Commodities

4 Reasons Why Investors Should Consider Commodities

BY Alistair Mills | 18 April 2018
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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

Source: BetaShares

 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.)

Summary

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:

2 Comments

  1. Richard Orr  |  April 18, 2018

    /Synthetic ETF’s are High Risk and Liquidity in a Market Correction or Collapse will cause losses for Investors

    1. Jeremy Benson  |  May 29, 2018

      Hi Richard,

      Thanks for your enquiry. You are correct in that some synthetic products are high risk. However, having learnt from the experience overseas, ASIC has adopted far stricter controls on synthetic products in the Australian market and all equity based ETFs are physically backed. The only ETFs that have a “synthetic” label on the Australian market, are three of the BetaShares’ commodity ETFs covering oil, agricultural and broad commodities because as you can imagine, the only reason why derivatives are used is that it is not economically practical to hold and store these commodities (eg live cattle, grain, oil, etc.), in order to create ETF exposure to these assets. Keep in mind that the Gold Bullion ETF is actually physically backed as it is much easier to store gold. However, to protect investors from counterparty risk on the provider used to get exposure to the futures, the three commodity ETFs are 100% cash backed and “marked to market” on a daily basis meaning that the counterparty exposure is limited to one day’s movement.

      You can read more about this topic in an earlier blog post of ours: https://www.betashares.com.au/insights/etfs-sorting-fact-from-fiction/

      As for losses in a market correction, losses on a synthetic ETF will be as a result of declines in the underlying value of the exposure to the futures in the fund, the same as holding the assets directly (eg a barrel of oil).

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