Investments in commodities: what should investors expect?

 Commodities have gained considerable attention in recent years, both amongst private and institutional investors. At the same time, this asset class is a relatively new investment category for most investors. Following the quite vigorous increases in prices in the period from 2000 to mid-2008, sharp losses were registered as a result of the global economic crisis. In early 2009, commodities resumed their upward trend, in harmony with the global economic recovery. In light of the development of prices in recent years, it makes sense to undertake a critical review of the arguments which we believe support this asset class and to analyse them in light of the current market conditions.

Rising demand and limited supply are favourable factors for this asset class

Long-term supply and demand dynamics have supported many commodities in recent years, in a world characterised by limited natural resources on the one hand, and permanent increases in demand due to population growth, expanding consumption and the process of economic convergence on the other. One of the dominant global consumers of commodities is China. With regard to some commodities (e.g. aluminium, copper, cotton), China already consumes more than 30% of global demand. Low reserves and the increase in extreme weather events are pushing prices of agricultural products higher. In particular, the structural changes in the Emerging Markets will continue to support commodity prices in the years ahead, even though this upward trend will be marked by occasional sharp corrections, as seen in recent years.

 
To a certain degree, commodities offer protection against inflation

Commodities are limited goods which cannot be reproduced at will. Consequently, they offer some degree of protection against inflation. For example, if production costs for products rise, companies will pass on these price increase in the form of higher product prices. At the same time, in light of the current debt crisis, the physical goods argument is increasingly important for investors, particularly in relation to precious metals. Furthermore, the extraordinary measures of the international central banks (strong expansion of money supply) entail some inflationary risks over the medium term. Consequently, we believe that commodities will continue to enjoy support in the years to come, against the backdrop of worries about inflation.

Positive diversification effect in the portfolio

Broadly speaking, commodities exhibit a low level of correlation with established asset classes (equities, bonds). The focus is on the supply and demand situation, which dictates the medium-term price trends. Individual commodity sectors (metals, agricultural goods, oil, gas, etc.) are also subject to individual price and production cycles and often react very differently to fluctuations in demand. For instance, not every commodity can be produced very quickly in the event of interruptions in supply. It simply takes some time to react to demand for certain commodities, for example until a new mine is started. Does this mean that the commodities market actually moves completely independently from the equity market? No. This is confirmed by the latest turbulence on the commodity markets. For example, when economic conditions deteriorate, this has consequences for demand for commodities (e.g. oil, industrial metals, etc.) as well. Other sectors, such as agricultural products and precious metals for instance, are less strongly affected by such developments. But because certain products within the agricultural sector, e.g. corn, are also used in fuel production, there is a certain degree of economic dependence here as well. Despite the sensitivity to economic cycles, we still see the positive diversification effect of commodities within the context of an investment portfolio as a good medium-term argument for this asset class.

In summary, taking a medium-term perspective we believe that the asset class commodities should enjoy good support due to the structural dynamics of supply and demand. Nonetheless, due to the numerous challenges, such as the debt crisis and inflationary risks in the Emerging Markets, investment in commodities will be accompanied with some temporary, possibly sharp, corrections in the years ahead.

If an investor decides to invest in commodities, two avenues of approach are possible: 1) direct investment in exchange-traded commodities, or 2) investment in equities of commodity producers. Option 1) offers a chance to participate directly in the development of commodity prices. With option 2), investment in equities, the diversification advantage of the asset class commodities is lost to a certain degree, as prices of commodity-producing firms usually follow the overall trend on the equity market, in the event of strong trends on such markets. With this type of investment, investors are still working within the framework of the equity market and are more exposed to company-specific factors, rather than to trends in commodity prices.

 Author: Thomas Bichler, fund manager in the Team Multi Asset Strategies at Raiffeisen Capital Management