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Real Assets: A raw deal from raw materials?

Poor performance is causing some investors to question why they got involved in commodities. But Martin Steward finds that now could be just the wrong time to sell

After a promising bounce-back from the price collapses of 2008, holders of commodity-futures index positions have spent two years in the doldrums. A Barclays note from June this year found that the commodity rebound from the 2007-08 downturn had just become the weakest since the 1960s, falling behind the lacklustre bounce from the recession of 1973.

That, along with big falls in bond-market inflation expectations, underperforming emerging economies, a general uncertainty about the next wave of global growth, and full-scale crashes in headline-grabbing commodities like gold, has made some question the case for holding this asset class.

“Lose 10%, and investors will question any asset class,” says Jason Lejonvarn, commodities strategist at Hermes Fund Managers.

A few questions keep coming up. Can the price appreciation of the past decade be sustained with slower investment and growth, from China in particular? Do commodities still offer portfolio diversification benefits? What does the end of a 30-year bull market in interest rates mean for the asset class? Add up the damage done by negative roll yields from futures, and the reputation risk associated with accusations of the harm that commodity speculators inflict, and the tone around commodities can change very quickly.

Liquidation

Some moves by big, influential investors have not helped, either. They do not come much bigger or more influential than CalPERS, whose commodity allocation fell from $3.5bn (€2.6bn) in September 2012 to $1.3bn by March this year, in favour of inflation-linked bonds.

Later comments suggested that this was a tactical rather than strategic move – but other big US pension funds have been more explicit in their doubts. “Due to the volatility within commodity investments, the changes focus on a shift of approximately $800m to strategies that better protect TRS assets from inflation,” said the $40bn Illinois Teachers’ fund as it terminated its five year-old mandates.

In Europe, Ahold Pensioenfonds recently told IPE it was weighing-up a decision about its loss-making commodities allocation as it awaited “the outcome of a new asset-liability management study”. Faced with the questions above, another Dutch pension fund says it is mid-way through a strategic investment review, and that “commodities are one of the topics we will look into again, for most of the reasons you cite”.

Of course, one can find other investors, like The Indiana Public Retirement System and the Texas Permanent School fund, that have moved the other way recently. Lejonvarn says that Hermes has had one large European pension fund commit to a mandate this year and one large US pension fund invest (CalSTRS, making its first allocation); only a single sovereign wealth fund has pulled out. Towers Watson’s latest Global Alternatives Survey reveals that five ‘direct commodities funds’ managers made its Top 100 alternative asset managers ranking for pension funds in 2011, but only two did so for 2012; but those two managers saw their pension assets increase by 11%.

But some investors have clearly had enough. Barclays observed that the $9.1bn outflow from commodities recorded in April was the second-biggest on record, for example – with the caveat that this was largely about liquidation of gold products.

So what happens when we ask those questions that investors are asking themselves?

Let us begin with interest rates. While commodities themselves generate no interest, the collateral supporting futures does: it can deliver a considerable chunk of the total return and will rise along with rates. Furthermore, George Cheveley, portfolio manager on Investec Asset Management’s Commodities & Resources fund, points out that expectations of rising interest rates usually imply rising growth and inflation, too.

“Commodities are a significant component of those changes in inflation,” he argues. “So it’s all very well saying, ‘I want to be out of commodities because interest rates are going up’ – don’t you want to be in commodities, first?”

Rising US rates and a strengthening US dollar tend to mean weak commodity markets. But again, Cheveley points to evidence that the earlier stages of dollar rallies can coincide with commodities strength – again because dollar strength often boosts US consumption.

This touches on the China question, too. While monetary tightening there is more about pricking bubbles than containing incipient inflation, and will almost certainly press down on materials like iron ore and steel, increasing the share of consumption in the economy will mean something very different for food commodities and precious metals. And even a lot of the copper that makes its way to China ends up in manufactured goods sold in the US.

The interest rate environment also affects the supply side of the equation. The decade leading up to the financial crisis was characterised by falling rates and rising commodity prices thanks to global growth on the demand side and a generation of low investment on the supply side. That made big investment projects look attractive; the money got borrowed and spent, then the growth outlook – and prices – declined. People like Cynthia Carroll, former CEO at Anglo American, started struggling against the tripling of costs for iron ore mines in Brazil that have yet to pull anything out of the ground.

“First, companies cut new capital projects,” says Lejonvarn. “We see this a lot in Australia. Then they delay or shift the scope of current capital projects; and finally they reach a point of having to cut current production.”

Rising rates, in the early stages of this cycle, can actually further depress prices: a strengthening dollar and weakening local currency pushes up local costs of production, but also incentivises producers to sell inventory quickly, to get their hands on those dollars. But thereafter the rising cost of capital for new projects begins to work in concert with falling prices, to lower investment.

“Past decisions were taken based on assumptions of ever-rising prices that haven’t materialised,” says Ewen Cameron Watt, chief investment strategist, BlackRock Investment Institute. “Out of this, in due course, a new cycle of higher prices that stimulates supply again will inevitably grow.”

Cheveley agrees. “Mining companies have had a classic margin squeeze for the past 18-24 months because costs continue to go up even after prices have fallen,” he says.

“Now, with rising rates, we might expect an environment of falling or flat costs and rising prices, because of economic recovery combined with that cost lag. At that point people start to realise that perhaps those margins weren’t so bad after all.”

Note how the discussion has shifted, in this part of the cycle, to focus on the supply side. That feels very different from all the talk of a China-driven ‘supercycle’. And that change is potentially significant for portfolio diversification.

Bob Greer is real return product manager with PIMCO and a pioneer in making commodities an investable asset class. He recalls that the title of his 1978 article for the Journal of Portfolio Management defining a commodity index was ‘Conservative Commodities: a Key Inflation Hedge’.

“But diversification was also a key part of the argument, even back then,” he adds. “High inflation is not so much the enemy of stocks and bonds as the change from low inflation to high inflation. And it is energy and food that are the primary drivers of changes in inflation as it is variously measured.”

Long-run data cited by Hermes makes the case: the S&P GSCI index has exhibited around 0.15 correlation with global equities and pretty much zero against bonds. The same data suggests that commodities outperform all other asset classes during high inflation.

But the long run is all very well when most pension funds have made their commodities allocations within the last 10 years: the past five saw correlation with equities leap during the massive risk-asset sell-off of late 2008 and continue to climb into 2011-12

“There is not a lot of free lunch out there from any asset class,” Ljonvarn concedes. “But while commodities did trend higher against equities, they remain lower than some other alternatives like hedge funds, listed property and domestic equities – and, moreover, they are trending down quicker.”

Figures 2 and 3 illustrate the point. The first chart, of the 24-month rolling correlation of equity and commodity monthly returns, shows the gradual trend downwards since 2011. Shorten the rolling window to 12 months and the change is even more apparent.

Of course, this is simply to say that equities have outperformed for 12 months while commodities have slumped. But why have commodities fared so poorly? The bears’ argument might be that equities are swimming on a tide of central bank liquidity while commodities are sinking under the weight of weak growth fundamentals. But that is a demand-side argument, and it is difficult to segregate the two market views on that basis. It seems more likely that we are seeing supply-side dynamics grow in significance.

“Towers Watson’s view is that commodities tend to keep pace with inflation over the very long term,” says Alasdair MacDonald, the consultant’s head of the investment strategy.

“But that includes periods during which commodity markets are driven by constraints on supply. Following many years of new investment I think we are seeing a move away from a market in which supply was the constraining factor and prices were mainly determined by demand – effectively moving with economic growth. When you move into a world of the vagaries of supply, you may well see greater diversification benefits from more idiosyncratic factors.”

Greer agrees. The correlated sell-off of risk assets in 2008 was about an expected collapse in demand, he notes. “But changes in supply expectations – a freeze in the coffee-growing regions of Brazil, a labour strike in the copper mines of Chile or power outages in South Africa – generally have little to do with what’s driving the prices of stocks and bonds, precisely because they will be very idiosyncratic.

Intra-commodity correlation should decline, too, Cheveley observes. Investment decisions made long ago in the iron ore and copper worlds mean that supply is growing quickly today. But zinc and nickel prices peaked in 2007 and never really recovered from the crash of 2008, leading to slowing investment and the prospect of much tighter markets over the coming two to three years.

“In 2007-09 you just had to make the right call to be long or short the whole sector, whereas now supply, which is about the fundamentals, will distinguish pricing much more than demand, which is essentially about the macro,” he concludes.

Answers

So the answers to those opening questions are perhaps a little unexpected. Nothing is guaranteed, but while China’s economic transition will certainly change the commodities story, it will not necessarily kill it; rising rates will add to the total return on futures and will eventually begin to tighten the supply that has become very loose in certain commodities; and the general shift of emphasis from demand to supply drivers should boost the diversification effect.

But in the meantime, those same forces will manifest as softer prices – and a return to a less exciting ‘cycle’, as opposed to ‘supercycle’, over the longer term.

“Has there been a change in tone?” asks Watt at BlackRock. “Of course, and it’s been an interesting one.”

He recounts a recent conversation with an institutional investor who was worried that his commodities allocation had stopped diversifying – just as it had actually started to diversify again.  

“Some regard commodities as a diversifier and some as a return-seeking asset – and a few of the former had started to think like the latter,” he says. “The reason for that was the dominance of the supercycle story. As the dollar has strengthened and some parts of the commodities complex have responded to the slowdown in China, and indeed as we have seen a supply-side response to higher prices, some of those supercycle ideas have been challenged.”

MacDonald notes that investors who allocated for diversification were “positively surprised” by the performance of 2009-11. They should not allow that to turn into negative disappointment following a period of (diversifying) poor returns. No one likes to lose money. But investors thinking through potentially big decisions on their commodities allocation should reflect upon their reasons for making the allocation in the first place.

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