Commodity fundamentals shift

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Our Tactical Allocation Committee has recently revised down our commodities allocation (from neutral to underweight) as there appear to be better risk-adjusted prospects in other asset classes. However, we still see select opportunities and believe there are benefits to holding commodities in a portfolio.

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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

 Commodities have underperformed so far this year

As an asset class, commodities have lost some of their lustre this year. Although prices have rallied over the past month, the Dow Jones-UBS Commodity Index is down about 5% year-to-date. In our view, the likelihood of a long-term substantial rally across the commodities complex remains low and the reasons for this are threefold.

China: The growth pattern of the world’s second-largest economy is not only changing – moving from an investment to a consumption-driven growth model – it is slowing as well (albeit at a glacial pace). This has consequentially slowed demand for raw materials. With the Chinese government appearing more willing to tolerate lower growth, more moderate levels of growth in commodities demand will likely be seen going forward.

Figure 1: Dow Jones-UBS Commodity Sub-Indices year-to-date
Indices, rebased Jan 2013 = 100

Source: EcowIn

Supply prospects: Demand growth has slowed at a time when the outlook for supply across many commodities has improved, due to a natural rebalancing of the market. Commodity prices have been significantly higher than historical levels for a prolonged period. When this occurs, the incentive to boost production capacity (via expanding projects or implementing new technologies) increases. Faster supply growth will increasingly impact prices of several commodities.

US monetary policy: The expectation that the US Federal Reserve (Fed) will start tapering its quantitative easing programme could also weigh on commodities. Although US monetary policy is expected to remain accommodative, Fed chairman Ben Bernanke has suggested that the Fed will likely begin to reduce its asset purchases this year, on the proviso that the US economy remains strong and unemployment falls. As monetary conditions normalise, fears of inflation will fall, expected real interest rates will rise and the dollar will likely strengthen, which could be negative for commodity prices.

 …However, sub-sector performance will likely diverge

With these three factors unlikely to abate any time soon, the outlook for commodities appears uncertain. However, fundamental balances within individual markets differ and, because of this, we will likely see divergences in sub-sector performances.

Energy: Energy has outperformed and remains our preferred sub-sector this year. In particular, oil fundamentals have tightened recently as political instability in key producing regions has resurfaced. Looking ahead, developments within the following countries will likely be pivotal for the oil market:

  • Libya: Labour strikes and protests have caused substantial disruptions at some of the major oil export terminals. Output in July was about half the country’s normal level of production, and has reportedly fallen further since. Ongoing protests and militia activities remain downside risks to supply.
  •  Iran: As Iran’s nuclear programme has continued, the US House of Representatives has passed further sanctions (the latest round is expected to remove a further 1mb/d of Iranian oil from the market) and similar discussions are expected in the coming months. If further sanctions are implemented, the tightness in supply could be exacerbated.
  • Syria: Although not an important oil producer (current output is estimated at around 50kb/d) the recent escalation in the Syrian crisis and the rising probability of (limited) military action has boosted oil prices higher. If the conflict spreads to neighbouring countries, sectarian violence could intensify which could put oil production facilities at risk in the near term.
  • Iraq: Pipeline attacks, as a result of renewed unrest and escalating violence, have weighed on Iraqi oil output recently. While production is still robust at around 3mb/d, the energy sector is likely to continue facing significant security issues, particularly if the Syrian conflict worsens.
  • Nigeria: Ongoing oil theft and pipeline outages have hampered production and this will likely remain a risk to long-term supply prospects.
  • Egypt: Concerns that unrest could affect oil flows through the Suez Canal have also supported prices. Although there have been no disruptions to oil flows – and we do not expect any to occur – the region remains fragile.

Figure 2: Labour strikes and protests have hampered Libyan oil production

“Commodities can be susceptible to sudden supply shortages, making it a useful hedge against an escalation in geopolitical tensions”

Source: Bloomberg

While each country represents a relatively small percentage of global oil supply, the culmination of these risks is significant for oil markets. Global spare capacity is at more comfortable levels compared to last year; however, with geopolitical tensions rising and production outages weighing on global supply, the oil market balance in the short term appears vulnerable, in our view. On a long-term basis, we retain our view that oil prices will remain underpinned by constructive supply-demand fundamentals.

Industrial metals: Prospects for an improvement in the industrial metals space appear unlikely as the slowdown in Chinese demand for raw materials remains a bearish factor for prices. Over the past month, prices have rallied as Chinese economic data has improved (industrial production rose 9.7%y/y in July). However, we do not expect this to last. The predominant driver of the recent rally was short-covering and with many markets still in surplus, prices are likely to weaken over time (notably copper and nickel).

Precious metals: Despite the recent pick-up in precious metal prices, many investors holding physically backed gold ETFs are doing so at a loss, and further liquidation of these investments remains the biggest risk to prices. In our view, as global growth picks up and monetary policy begins to normalise, demand for assets that benefit from improved economic activity will weigh on investor demand for gold, causing prices to trend lower over time. However, we would caution against getting too bearish on the precious metals sector as a whole. Platinum and palladium (not included in the Dow Jones-UBS Commodity Index) do not suffer from the same weak fundamentals as gold, and we expect solid demand growth from the auto industry and restricted supply to boost prices in the short and medium term.

Commodities still have a place within a diversified portfolio

Given the underperformance of commodities relative to other asset classes, many have called into question the validity of holding commodities as part of a portfolio. Although we are underweight in the sector, we still expect the index to pick up modestly in the years ahead. And, within a diversified portfolio, having a small allocation to commodities can be beneficial. Commodities can be susceptible to sudden supply shortages, making it a useful hedge against an escalation in geopolitical tensions (as discussed earlier, the renewed unrest in the Middle East is a notable risk). Furthermore, the correlation between commodities and other asset classes has declined substantially and we expect this trend to continue, making them a useful tool to help diversify a portfolio across a long-term horizon.

Figure 3: The correlation between commodities and equities is declining