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Commodities: Tactical not Strategic

Commodity prices enjoyed a historic advance before the Great Recession as global economic growth expanded. Despite a rebound in growth after the Great Recession, an index of commodity prices now stands at the same level as it was in 1975. The natural question is to ask what the role of commodities is, specifically a commodity total return index, in a diversified portfolio. For long-term buy and hold investors, there is no role. Opportunities may arise, however, over shorter periods for investors with the ability to time the next commodity cycle.

The main arguments for the inclusion of commodities in strategic asset allocation are the diversification benefit and the real returns that protect against inflation. The latter case is only partially applicable: commodities account for only 30% of the CPI index and thus provide just a partial hedge of inflation. Further, the cost of diversifying the portfolio with commodities is high: an average return that is between 300 and 800 bps lower than the other asset classes. There are exceptions to these conclusions: crude oil and gold have performed well compared to other commodities, however, their risk is higher and the returns lower than equities. While oil may provide a leading indicator of equity market performance, the low efficiency of oil and gold makes market timing a critical element for successful investing with them. For long-run investors, the conclusion is clear: buy the business, sell the commodity.

Notable in the annual data from 1900 the following observations:

  • Commodity returns are cointegrated with real per capita economic growth and return -1.3% in real terms.

  • Commodity price volatility ranks between long bonds and equities.

  • Real GDP per capita leads commodity spot prices implying growth drives prices

  • Commodity prices lead changes of inflation

  • Short-run dynamics in commodity prices lead to significant deviations from the trend that may provide cyclical investment opportunities

The observations follow the intuition of how the supply and demand forces work in the real economy. Increased growth leads to increased demand for primary commodities. The natural lags in production and capital investment drive demand to exceed supply in the short-run, which causes cost-price pass-through to the final consumer. Price increases moderate demand, while increased production capacity augments supply. These actions result in a down cycle side with falling prices and commodities. Thus, the cyclical fluctuations in commodities are a function of elastic demand meeting inelastic supply. While this dynamic can provide cyclical opportunities, the long-run conclusion is stark: productivity enables the ability to do more with less. To the extent that productivity will remain positive, then commodity returns will be negative. If the promise of alternative energy and additive manufacturing deliver, an even direr price decline may result.

Global growth is moderating; specifically, the Chinese growth rate falling from 10% to sub 7, and commodity prices are in a significant retreat from their previous highs. This outcome is a material event since China (and to a lesser extent India) augmented global economic growth and increased the demand for commodities. Beneficiaries of the heightened commodity demand were Brazil and Russia in the emerging economies, while the developed country leaders were Australia and Canada. The diminished demand has mainly exposed the lack of economic diversity in Brazil and Russia and may lead to lower economic growth. While Australia and Canada have survived due to more diversified economies, the sky-high property prices and reliance on energy commodities leads one to ask whether it is a question of when, not if, their growth will slow. They will almost certainly face higher economic volatility. Only time will reveal the answer.

Read the full report on commodities here.