Commodities can offer challenges but also a rich seam of diversification possibilities in multi-asset investing, says Aron Pataki, one of the portfolio managers on Newton’s Real Return strategy.
Commodities can be used for both diversification purposes and as hedges against certain outcomes. When these two objectives align, there is a strong case for using the asset class within a portfolio, according to Pataki. A constant diversifier, gold can be used in risk management to protect against infrequent or unlikely but significant negative events that are often referred to as “tail risks.” Gold has the virtue of not being significantly correlated with changes in the price of other mainstream asset classes.
Unless commodity exposure is obtained through a listed equity, such as a mining company, commodities do not necessarily produce cash flow so the bar to investing in them for a portfolio manager can be high, says Pataki. When investing in commodities, the use of derivatives is also often necessary and this introduces counterparty risk into a portfolio. By their nature, derivatives do not fall into the category of simple and transparent instruments, he comments.
The “commodity complex” can be subdivided into specific categories, notes Pataki, adding that these are pro-cyclical commodities (industrial and energy-related commodities, such as iron ore, copper, oil & gas), precious metals (e.g., gold) and soft (agricultural) commodities, such as wheat, corn and sugar.
The past decade can be described as having witnessed a “super cycle” for commodities, when China grew very rapidly and stimulated its economy through investment in infrastructure that required the extensive use of raw materials. The unprecedented stimulus encouraged a credit bubble after the global financial crisis that authorities are now trying to deflate in an orderly fashion. This process and changes in the structure of the economy have the potential to exert a continuing impact on demand for commodities. Understanding how Chinese demand for commodities will change—if and when the country’s economy rebalances away from investment and exports towards consumption—is key in identifying the driving forces of future commodity price changes, says Pataki. Over the longer term, the relative availability and cost of supply is also very influential in driving commodity prices (not just the rate of demand growth).
FROM “SUPER CYCLE” TO “SUPER DOWNTURN”
Commodity producers tended to overinvest as they extrapolated the trend of China investing in infrastructure into the future, believing it would go on forever. Faced with a new reality, the management of such companies is typically doing what it is supposed to do, says Pataki. That is, harvesting cash flows rather than investing in new production. Capital expenditure has been cut back and is running below economic depreciation.
In contrast, the “sell side” has yet to “capitulate” and is still prone to cry “buy, buy,” says Pataki. When producer margins trough and the sell side does indeed capitulate, there are likely to be some buying opportunities, he comments. There is a need to see a deleveraging-driven demand pullback in China and consolidation among producers, even some defaults. So-called “zombie companies” (those which should be by rights dead) continue to stagger on as the initiatives of the central banks and governments in the wake of the financial crisis have inadvertently relocated capital to failing companies as they sought to boost economies by buying assets.
As the commodity super cycle has evolved into a “super downturn,” many prices for commodities have halved from their 2011 peaks but some remain well above levels seen 15 years ago, says Pataki. This extreme range has contributed to long-term uncertainty, leaving investors unsure how best to forecast what commodity prices might do.
SHALE OIL AND GAS
After the credit crunch, central banks flooded the world with cheap dollar liquidity that was used to build out capacity, notes Pataki. Taking the example of the U.S. shale oil and gas industry, this cheap dollar liquidity was used to increase production at a time when the rate of demand growth was slowing, particularly in China and the emerging markets. With a prevailing consensus that commodities provide a good hedge against inflation in the inflationary world that was thought likely, investors were encouraged to “flood the asset class,” which unsurprisingly collapsed, says Pataki.
However, even with the collapse in oil prices, the shale industry has not been wiped out, he says. Just as it was possible to shut a valve quickly, it can equally be reopened quickly. If the price of oil rallies above breakeven levels (that are falling due to efficiency gains), then a lot of new shale oil production will be switched on, capping prices. Members of the Organization of the Petroleum Exporting Countries are finding it difficult to agree on production cuts that could stabilize the price of oil. Iran, in particular, is returning to the market and anxious to regain market share after having been long shut out as a consequence of sanctions.
STORE OF VALUE
Gold (see box) can be used to hedge against a very wide range of outcomes, says Pataki, as well as against the policy errors of the authorities and against currency debasement. In the event of future inflation, it can be a store of value (useful for the preservation of capital, but it can also work in a deflationary environment. With negative interest rates in Europe and Japan, the opportunity cost of owning gold has come down substantially: some 40 basis points per annum for holding cash deposits in Europe with the European Central Bank, whereas owning physical gold might cost around 10-15 basis points annually, he notes.
Rather than owning physical gold, it is possible to gain geared exposure to the broad price of gold through holding gold mining companies, notes Pataki. Generally, gold miners have cash flow streams and should pay dividends, whereas physical gold is a non-yielding asset. There are advantages in gaining exposure to gold through listed equities. Not the least of these is that doing so imposes the obligation to do fundamental analysis in order to, say, avoid companies that are financially levered or have operational gearing to the price of gold.
Within multi-asset portfolios, soft commodities can be used as diversification tools because they tend to be less correlated with business cycles or financial risk than industrial and energy commodities. Soft commodities are also supply-constrained. Production is limited by the amount of arable land available and competition between crops, as well as by continuing
adverse weather conditions and water constraints affecting supplies. For instance, a heatwave in California could put pressure on the provision of wheat and grain and further have an impact on global supply, notes Pataki. A drawback is that soft commodities can only be accessed through derivatives or structured products. Such commodities always have a storage cost and this can affect the yield.
Good as Gold?
Gold represents a “real” asset and there is a finite supply as there is only so much gold that can be dug out of the ground. For that reason, gold cannot be replicated, so it is not subject to debasement in the way that currencies can be. The authorities would seem intent on reducing the value of fiat money so that their individual economies can get a competitive advantage and physical gold is likely to be a good hedge against such action. (Fiat money is currency a government has declared to be a legal tender but that is not backed by a physical commodity.) Owning gold is also a way of providing distance from the financial system as it sits outside that system, as is thus less prone to manipulation by central banks than fiat money. Gold can also act as a barometer for confidence in an economy and by extension in fiat money. In terms of risk, gold’s liquidity means investors can easily translate their gold holdings into currency.