The Commodity Carve-out

John Leiper – Head of Portfolio Management – 12th June 2020

Commodities are nothing if not cyclical. They rise and fall in value with remarkable consistency over time.

This is represented in the chart below which shows the year-on-year percentage change in the S&P Goldman Sachs Commodity Index, which is a broad basket of major commodity futures rolled into one composite index. This index is now at a cyclical low, as shown by the blue arcs at the bottom of the chart. 

The mechanism through which this cycle operates is supply and demand. If supply falls, prices rise, bringing commodity producers on-line thereby increasing supply and reducing prices … and so on.

However, commodities do not exist in isolation – they operate within the broader global macroeconomic cycle. This is shown in the chart below which tells the same story, which is that commodities move in cycles and are currently cheap, in this case relative to equities. Further, commodities tend to outperform equities coming out of recession, like the one we are in now, as indicated by the light grey bars.

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Whilst the last decade was characterised by deflationary headwinds, a strong US dollar and falling commodity prices we believe we are at the start of a new macroeconomic cycle. As such, the next decade will see the reverse: the return of inflation, a weaker US dollar and commodity price appreciation.

Bear markets are the authors of the next bull market and the recent corona crisis leaves commodity prices at 17-year lows and ready for lift-off. To understand why, take a look at the gold/oil ratio as shown at the bottom of the chart below in yellow.

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Since 1997, there have been four phases where this ratio has climbed from below the solid white line to a substantial peak above. These phases are identified by the circles which represent the dot-com bubble, sub-prime mortgage crisis, eurozone slowdown and current corona crisis. The first circle in each phase represents peak-inflationary-optimism… the “pride before the fall”.  The second circle in each phase represents peak-deflationary-pessimism… that “down and out” feeling you get at market bottoms. In each instance, when moving from the first circle to the second, gold has outperformed oil as fear rises and risk aversion sets in. We participated in the most recent move via our allocation to both physical gold and commodity equities in the gold mining sector.

Moving past the second circle represents renewed optimism as markets price in economic recovery. This is currently the case and consistent with oil outperforming gold.

The key takeaway from this chart is that the “down and out” second circle, which we have now passed, has consistently flagged the bottom in commodity markets in each of the last three phases. As such, now is the time to carve-out a specific allocation to commodities across multi-asset class portfolios.

The case for commodities is bolstered by the likely return of inflation (click on the link for more information). The monetary and fiscal policy response to the corona crisis has been to treat it like a demand shock, by pumping huge sums of money into the economy. But this is a supply shock which morphed into a demand shock due to government imposed lock-down. This means that when demand does pick-up there will be more money chasing fewer goods and services leading to higher prices.

As shown in the chart below, there is a strong historical correlation between inflation in the real economy and commodity prices and our model points to an increase in both over the coming years. It is also reassuring to see that our “down and out” circles, which we used in the chart above to identify the bottom in commodity markets, also occur near the bottom in US CPI inflation.

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This supply demand dynamic, which leads to inflation, is amplified for commodities. This is because commodity production is capital intensive and subject to complex logistics which have been disproportionately affected by lock-down. Taking copper as an example, mine closures and inventory drawdown has caused supply to fall at a far greater rate than demand. Further, we expect demand for copper to rise going forward as stimulus packages target ESG-specific sectors of the economy, such as renewable energy and electric vehicle production, which utilise copper-intensive technologies. As such, and following the move through the second “down and out” circle, we recently added copper exposure to our higher risk funds.  

Our long-term outlook for a weaker US dollar (read more here) is also bullish commodities. This is because commodities are predominantly priced in US dollars, and therefore cheaper to purchase outside the US when the currency is weaker. Recent price action has seen the US dollar break out of its upward channel and fall through the 200-day moving average which could indicate a new downward trend.

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Commodities are a broad church. The five key sub-sectors are precious metals, industrial metals, energy, agriculture and livestock. Metals have already started to move higher and we have exposure to this sector via gold, silver and copper. Whilst energy has also rebounded from recent lows, agricultural commodities continue to lag, holding down the broad index. However, it will not be long until agricultural products play catch-up and we are actively exploring options in this space.

The key risk to our view is a resurgence in the virus and a deeper and more prolonged recession than currently priced-into markets. That remains a distinct possibility, as it does for all risk assets. This could lead to greater volatility in commodity prices as we move through this bottoming process and therefore risk management remains key. However, we fundamentally believe that the next decade will look very different from the last and that commodities should do very well in the next phase of the economic cycle.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.