Commodities: Beyond oil
Lynn Strongin Dodds considers the extra diversification benefits available from commodities with weaker links to the industrial cycle
Although precious metals and especially gold have been a firm feature in portfolios, the more volatile soft agricultural commodities have often been left out of the mix. This is starting to change as investors look for inflation hedges and assets that are less correlated with other baskets of commodities.
Going back as far as 1970, correlations between commodity and equity returns have been low or negative for most of the time. While this changed dramatically in 2007-08 when most asset classes fell in tandem and correlation averaged as high as 0.80 or 0.90 with equities, that has broken down again since.
According to figures from State Street, the S&P GSCI Total Return and the DJ-UBS Commodity Total Return indices respectively showed correlations of 0.24 and 0.32 with the MSCI World index between 1991 and 2009. Looking in more detail, soft commodities had a 0.36 correlation with the DJ-UBS, while precious metals came in at 0.44. Research from Attain Capital Management also notes that between 2000 and 2010 the cross correlation between 11 commodity markets (crude oil, heating oil, natural gas, wheat, corn, soybeans, sugar, cotton, copper, live cattle, and lean hogs) was a low 0.18. IPE has carried out its own correlation analysis using Deutsche Bank's DBLCI commodity indices.
This is mainly because sectors such as agriculture, precious metals, energy and industrial metals march to their own tunes. - seasonality in the case of agriculture and risk aversion in the case of gold, for example. The non-industrials in particular are, not surprisingly, less linked to the industrial cycle because they are not used in manufacturing.
"The main drivers for agricultural returns recently have been weather-related supply disruptions, which are inherently unpredictable," says Kevin Norrish, managing director, Barclays Capital commodities research. "In comparison, energy markets, especially oil, have a much stronger structural bull case with the influence of declining reserves and rapidly rising emerging market demand being much more influential. Exposure to oil also provides investors with protection against geopolitical risks and the damage that soaring energy prices can do to other parts of their portfolio."
Pau Morilla-Giner, who oversees alternative investments at London & Capital adds: "It is not a bad idea to overweight to a cyclical or countercyclical element in the portfolio. The important thing is to have different sources of return. That is the beauty of soft agricultural commodities and precious metals. Their returns are not based on the growth of Europe or the US, but the underlying trends of consumption in emerging markets and weather patterns. These are the main factors driving the prices."
Michael Banks, a commodities analyst at Hermes Fund Managers, also believes in spreading the risk. "Industrial inputs like oil and industrial metals move at a different point of the business cycle," he says. "At the early stage of the economy, equities will do well and commodities respond much more slowly. Prices will start to take off when growth is stable. However, it is not a case of underweighting or overweighting different commodities. The best plan is to have a broadly based diversified portfolio with about 30% in energy, 30% in agriculture and the rest in industrial and precious metals so that the investor can benefit throughout the economic cycle."
Koen Straetmans, senior strategist, real estate and commodities, from ING Investment Management also advocates a broad mix over different segments because of the lower correlations. "For example, energy is more correlated with industrial metals than agricultural or precious metals," he notes. "However, they are all correlated to their own cycles and not the broader equities market. The correlation agricultural has to oil prices is via fertilisers and transportation costs but, in the main, the drivers are different."
For many years, these volatile soft agricultural commodities were out of favour. However, a recent Barclays Capital survey of 100 European institutional investors showed them now firmly on the investment radar. In fact, grains were voted as the second commodity group most likely to be the best performer in 2011, due to crop shortfalls on the back of severe weather conditions last year and low stocks for certain food staples, particularly corn.
The latest figures from the UN's Food and Agriculture Organisation's (FAO) food price index, which tracks the wholesale cost of softs, showed a 2.2% hike in February, a record in real and nominal terms since the body started monitoring prices in 1990. The commodities that stood out included coffee, the price of which has skyrocketed 94% over the past year, corn, which has soared 88%, and wheat at 74%. Most recently, cocoa prices have rallied 37% since the Ivory Coast's disputed election in November but prices hit a 32-year high as political violence escalated in recent weeks in this top-producing country. Cotton also set new records - $2.1270 a pound for the benchmark May contract on the IntercontinentalExchange market - due to smaller-than-expected crops from India, China and Pakistan.
Weather and geopolitical risk are well-documented drivers of prices. The past few years has seen greater frequency as well as severity of weather conditions. Fires have destroyed the wheat production of major exporters such as Russia and the Ukraine, while floods, cyclones as well as fires have swept through Australia's farmlands. Meanwhile, China has been suffering from a severe drought in its northern wheat belt and the US grain crops have been battling freezing temperatures.
These conditions have been set against a tide of rising demand from the emerging markets, with China having the largest appetite, particularly for soybeans and corn. According to national reports, China is projected to import as much as 13.5m tonnes of corn from overseas producers by 2015 and a staggering 51m tonnes of soybeans this year, up from 10m a decade ago. The country now accounts for 60% of global soybean imports, in addition to approximately 20% of world-traded soybean oil. The view is that growth is likely to be replicated in other commodities as China's population's appetite grows and changes.
Corn will also benefit from increasing demand for biofuels such as ethanol. Thanks to heavy government subsidy - and despite the recession - the US ethanol industry has flourished and is expected to account for almost 40% of America's corn harvest in 2011. In fact, the United States Department of Agriculture (USDA) predicts that demand for biofuels in general will continue to grow as governments around the world encourage its use through tough regulations.
"At the moment, there are low stocks and insufficient production," says Jacques Blatter, portfolio manager, who oversees Harcourt's commodities fund. "Demand continues to be robust and the margins of processors in certain commodities, such as corn and soybeans, remain under pressure. As a result, there is still significant upside to price over the next 18 months."
In fact, the price of corn hit record highs in March due to a projected shortage before the next US harvest, with CBOT May corn futures touching $7.65 per bushel. Yellow corn, consumed mainly as animal feed and for ethanol production, has risen 120% in the past year as stocks have dwindled to 15-year lows in the US, the largest exporter.
Meanwhile, the value of precious metals has risen by 365% over the past decade, nearly double the increase for the next best performing asset during the same period - residential property. Silver outperformed the other precious metals in 2010, with prices rising by 80%, more than two- and-a-half-times the increase in gold prices and four times the 20% rise in the value of platinum. Whereas platinum and palladium feed into the industrial cycle (particularly via sectors such as telecoms and car manufacturing), silver has industrial uses but also acts like gold as a safe haven in times of turmoil and currency debasement. Although prices have hit new highs, historically it has not shone as brightly as gold because of its supply-and-demand dynamics: according to the Silver Institute, 709m ounces of silver was produced in 2009, almost nine times the 80m ounces of gold.
"Precious metals have been attractive because of the low interest rates and fears over inflation," says Bradley George, Investec's head of global commodities. "They are real assets and easy to store and have different drivers than other commodities. I think gold prices are likely to move higher, while platinum and palladium markets could get tighter as our forecast numbers show there is increasing demand for auto catalysts."
Other participants, though, only focus on gold. "Gold is probably the least industrial commodity since it has very little use in industrial applications," argues Norrish. "Even silver can be used in solar panels and in photography. This is not the case for gold, which has been traditionally seen as a hedge against financial market uncertainty."
There is no doubt that gold has had a spectacular run over the past few years after the stock market crash, followed by fears over the sovereign debt crisis. The CBOE Gold index, for example, increased 30% in 2010, and on 7 December gold futures reached a record $1,432.50 an ounce. And sure enough, the commodity looked like it had lost its lustre at the beginning of the year until unrest in the Middle East and growing fears over inflation gave it a new lease of life.