Commodities…Part of the Problem or Part of the Solution

We have commented in past issues of Insight on commodities as an asset class that we continue to introduce into client portfolios and the implementation vehicles that we use for our clients’ investments in them…as recently as last quarter. However, recent market events have provided a dramatic reminder of the unique relationship between commodities, the rest of the economy, and the behavior of financial markets.

Over the course of a few days in mid-September, commodity prices rebounded sharply on fears of a financial market meltdown. The market action, particularly in gold (which experienced the largest one day price increase in history) reminds us of the complicated relationship between commodities and the economy. Commodities are both inputs to fundamental economic processes and some can have a separate role as a store of value.

Over the last two months, concerns about a weakening global economy have pushed down the price of oil and other commodities used as inputs. The price of oil fell nearly 40% from its high of more than $147 on July 11th to $90 on September 16th, recovered to the low $100’s and dipped again below that mark as the third quarter drew to a close. While one can debate whether these declines were the result of speculators getting nervous or pure supply-demand factors, it’s clear that a weakening global economy has had an impact, particularly a slowing in the emerging market countries that drove much of the concern over increased demand earlier this year. On the other hand, concern about the falling value of “financial” assets (and the negative impact that would have on economic activity) has driven up the demand for at least some “hard” assets in recent weeks, because their value is thought by some as more certain.

Our Reaction and Outlook

Commodity prices and returns continued to decline sharply in August and early-September, led by a sharp fall in the price of oil. However, prices began to ramp up again in mid-September, again led by oil, but followed closely by gold and others. Where it was opportune for tax purposes, we rebalanced away from commodities several times during the spring and summer as prices rose, but recently added to many client’s commodities positions as prices fell. This volatility is the reason for our narrow rebalancing bands (+/- 15% of the target allocation) around commodities.....they move quickly, so to capture re-allocation benefits, you must keep a relatively tight leash on them.

Despite the recent declines, we believe that the secular commodity bull cycle is far from over as the severe supply constraints that have led to high and rising prices in recent years remain intact. The recent investments in supply infrastructure will take many years to become productive, and may not even offset the decline in production of existing assets. Still, while we think it’s a good fundamental bet, one cannot be sure that commodities prices generally will rise.

That uncertainty about the future price of commodities does not dissuade us from pursuing modest positions for our clients. It is important to remember our primary rationale for including commodities in client portfolios. In exchange for committing our capital in the futures markets and facilitating commodity producer’s hedging their output and commodity users their demand, we expect to earn a premium. This would be true even if commodity prices stay exactly the same. The movement of prices may enhance or offset our reward for bearing that hedge risk, but in the long-run, we believe that that providing capital for hedging activity itself will be profitable.

Much of the wealth-building capacity of our client portfolios depends on the activities of companies around the world which use commodities as inputs. It makes good sense to hedge the price of those inputs – somewhat counter-intuitively, not hedging would be speculation. This is the main reason we include them in client portfolios. On a pure risk/return basis, given our capital market expectations, we wouldn’t invest in commodities at all. Our expectation is that spot-price changes will be one of the lowest returning opportunities over time, with the highest risk (volatility). However, commodities provide a hedge to equity investments that make up the majority of most client portfolios. An illustration of the relationship between commodities and equities, in terms of the business cycle (the S curve), is shown below. Commodities are not always “good” bets, but they are often in counterpoise to other portfolio assets.

Table 1 Phases of the Economic Cycle

Thus, in the first column, as economic activity is reaching its nadir, both equities and commodities tend to underperform. In the next phase, the stock market anticipates the quickening of economic activity and stocks outperform, though the actual demands for commodities is not yet sufficient to improve returns. As the economic expansion continues but before it crests, demand for commodities and the outputs generated from them drive higher prices for commodities and equities. Finally, as the stock market anticipates a downturn prior to its actual occurrence, equity performance falls off in advance of the cyclical decline in demand for commodities. In this simple model, commodities are out of phase with equities about half the time through an economic cycle.

Jason Thomas, PhD, Chief Investment Officer
and Andy Hamilton

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