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After a strong start to the year, where are commodities headed?

09 May 2019

With commodities starting on an exuberant note, FE Trustnet spoke with several fund managers and analysts to find out what investors should expect going forward.

By Mohamed Dabo,

Reporter, FE Trustnet

Following a difficult 2018 for commodities, the asset class has performed strongly in 2019 and seen fund managers strike an increasingly positive tone towards the sector despite several challenges for commodities prices.

According to the latest Bank of America Merrill Lynch Global Fund Manager Survey, allocation to commodities rose by five percentage points to a net 3 per cent overweight in April, representing an eight-month high for sector exposure.

Recent performance might have justified such a move, however.

As the below chart shows, the S&P GSCI index – a commonly used broad commodities benchmark ­– has risen by 15.85 per cent in US dollar terms since the start of the year, after a loss of 13.82 per cent in 2018.

Performance of index YTD

 

Source: FE Analytics

Indeed, commodities delivered their best quarterly return in nearly three years, said Cohen & Steers portfolio specialist Michelle Butler, and dovish outlooks by major central banks should help raw material prices, even given the relative strength of the US dollar.

She said: “We expect global economic growth to persist, with improving employment and rising personal incomes in the US spurring consumer spending and business investment alike.

“Such conditions should prove broadly favourable for commodity demand, in our opinion.”

“Each commodity has its own unique price drivers,” added Olivia Markham, co-manager on the BlackRock Commodities Income Investment Trust. “However, factors that generally affect all commodities include: the strength of global economic growth impacting demand growth for commodities and the action of natural resources companies impacting commodity supply.”

That outlook could improve further if a positive US-China trade deal is struck, said Nitesh Shah, director - research at WisdomTree Investments.

“The commodity complex was held back last year because the market feared that trade protectionism would hurt demand for commodities,” he explained. “We expect that to unwind.

“Even beyond the relief rally, we expect the fundamentals for base and precious metals to remain strong, helping prices to continue to rise.”

Yet, even if a trade deal is struck – with new doubts raised earlier this week after US president Donald Trump threatened to impose fresh tariffs – there are other headwinds for the sector.


 

“Commodity markets are influenced by two factors: general supply-demand dynamics and US dollar movements,” said George Lagarias, chief economist at Mazars. “Overall demand has been severely influenced by the Chinese economic slowdown, which has had an impact on global trade.

“Additionally, the pullback in overall foreign direct investments, a result of US dollar repatriation, puts further pressure on commodities, as real demand – usually associated with factory production, remains weak.

“Currently, the build-up of headwinds is significant and could put further pressure on commodity prices.”

Christian Gerlach, portfolio manager at Swiss & Global Asset Management, said there are two scenarios that could emerge from the current commodity market environment.

In the first scenario, the Organisation of Petroleum Exporting Countries (OPEC) will succeed in restraining the supply, “which would underpin the overall commodity market quite nicely,” Gerlach said.

“Going forward, this would also provide an inflationary anchor while the world economy potentially slows down a bit,” he explained.

The second scenario is one in which a disinflation drift reoccurs, with Gerlach noting: “In this second scenario it’s better to focus on precious metals, as a disinflationary hedge and slowly unwind cyclical exposure.”

Performance of sterling and euro in US dollar over 10yrs

 

Source: FE Analytics

One of the issues that investors should also be aware of is the US dollar outlook, particularly as the currency has strengthened in recent years, as the above chart shows.

“A strong dollar could be a headwind for commodities going forward,” said Mazars’ Lagarias. “The Federal Reserve has indicated that it is willing to be patient with interest rates, however, based on dollar futures, the market has taken a more aggressive approach and now anticipates rate cuts.

“This is dangerous and could put upward pressure on the dollar, as traders bet that the Fed will be much more dovish than chair Jay Powell has indicated so far.

He added: “A lot of the dovish news has thus been priced in, and it would take a huge effort from the Fed or a serious hit to growth – which is not good for commodities anyway – for a softer dollar scenario to play out.”


 

With each commodity having its own drivers for performance, what should investors wishing to take exposure be paying attention to most?

“Choosing which commodities to invest in will depend on what the investor is trying to achieve and existing exposures in their portfolio,” explained BlackRock’s Markham.

From an equity perspective, while producers have enjoyed strong growth since the start of the year – albeit not as strong as the broad index, as the below chart shows – there is a risk that equities could fall further as the post-financial crisis bull market runs out of steam

Performance of indices YTD

 

Source: FE Analytics

Indeed, Adrian Ash, director of research at BullionVault, said that while equity prices are high – with a positive effect on commodities and other physical assets – it must be remembered that the market is late in the cycle.

As such, investors will need to consider that the what happens with commodities equities when the cycle comes to an end.

Wesley Coultas, investment director at Walker Crips Investment Management, said that commodities stocks tend to be held for incomes they yield and is still relevant for income-hungry investors, but one of the best ways of getting exposure to a particular commodity is through exchange-traded funds (ETFs)

“An ETF will give an investor a broad market access to the price of a commodity at a low cost,“ he said. “If I am particularly bullish on a certain commodity, I will use an ETF that represents the value of that commodity in a portfolio.”

However, there are risks with this too, said Mazars’ Lagarias.

“If the commodity yield curve is upward sloping – as traders call it, contango – this bad for ETFs, which need to pay often in order to roll their contracts, denting returns,” he said.

“The yield curve might be backwarded, of course – short term prices higher than long term prices – which might indicate higher demand for now and price upward pressures, and in this environment ETFs will not have to pay significant rolling costs.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.