Commodities: An Investment Framework, Part I

Global commodities prices have recently declined sharply, along with a general ‘risk-off’ trade in financial markets. But commodities were already in a multi-year downtrend prior to recent developments and have generally performed poorly since 2011. In this, Part I of a series on commodities investing, I provide a framework for understanding what commodities are, what they are not, and whether and how they could or should be included in a diversified investment process. In brief, I believe commodities can play an important role, but not the role most popular with investors in recent years.

Commodities as an Asset Class (or ‘Anti-Asset’ Class)

So what exactly are commodities? Commodities represent the raw inputs into economic goods. As such their prices, driven by supply and demand, are normally caught in the business cycle to an even greater extent than the equity or bond markets. This is due to their raw nature. They do not represent a claim on a long-term stream of cash flows across one or more business cycles, as most securities do, rather merely the immediate value they provide as an economic input factor. Therefore, it is a stretch to consider commodities an ‘investment’ at all and, for those not naturally exposed to commodities prices, buying or selling commodities appears more akin to speculation rather than something that should be considered a core, strategic part of a robust, diversified investment process.

However, in the early 2000s – partly because ETFs tracking their performance were developed – it became fashionable for institutional investors to allocate a small portion of their portfolios to commodities (at least under certain conditions). Commodity basket indices were also created and made investible through dedicated tracker ETFs, such as the GSCI, DJUBS (now BCI), CCI, CRB or other, less well-known indices. These were all intended to provide a convenient form of commodities investment diversification.

Throughout this time there have been two main cases made for investment in commodities: diversification, and the so-called ‘supercycle’. Let’s consider both in turn.

Diversification Myth

You can measure the diversification properties of commodities through a historical time-series analysis. What you find is a degree of diversification, in particular for non-industrial commodities, but also to some extent for those used primarily as inputs into various industrial processes. Basic portfolio theory would thus appear to justify the suggestion that investors consider at least making a small allocation to commodities.

The problem with the theory, however, it that it doesn’t hold up well in practice for several reasons.

(1) Although commodities may not be perfectly correlated with cyclical financial assets, those for industrial commodities are still quite high, implying only tiny diversification benefits – if any.

(2) Some commodities tend to carry negatively, in part due to their substantial storage costs, an implied negative yield for anyone holding a position, whether actual or synthetic.

(3) Commodities markets are hugely dependent on specific, real-time knowledge of factors well outside the normal expertise of investors in financial assets, such as weather patterns, logistical constraints, local market issues such as refinery maintenance or mill processing for grains or seeds, and occasional innovations impacting all of the above. In all such cases, top-down ‘macro’ investors in commodities are at a pervasive, persistent disadvantage in terms of asymmetric information vis-à-vis on-the-scene commodities specialists.

You might think purchasing exposure to one of the broad commodities indices would filter out the noise of any specific market and gain you at least some diversification benefits. But this depends on the choice of index. The GSCI is about 60% energy and another 10% industrial metals, so basically an approx. 70% highly correlated, cyclical play on global demand.[1] The BCI (former DJUBS) index is somewhat better diversified but still quite cyclical overall. The CCI, by contrast, is an evenly weighted basket of both industrial and non-industrial commodities, and so is a better design to achieve passive diversification. This superior diversification, however, does not overcome the other drawbacks such as negative carry and information asymmetry.

There do exist a few ‘smart-beta’ commodities indices which seek to capture systematically the implied positive carry of commodities in backwardation and in some cases also go short those with implied negative-carry contango as a means to enhance returns. But the returns so generated are then highly correlated to general, market-directional ‘risk-on’ or ‘risk-off’ trades, and so the question must be asked: is extracting risk premia from commodities in this way is a source of diversification at all?

An honest answer would be ‘no’, in my opinion.

The False ‘Supercycle’ Supposition

Back in the 2000s it was frequently claimed that the historic emergence of certain large economies, such as China and India, heralded the onset of chronic shortages in basic commodities and associated industrial capacity as vital inputs into the basic food, clothing and shelter requirements of workers in these countries. The argument was generational, perhaps multi-generational, in that it would take decades of wage growth for workers in these countries to catch-up to their counterparts in the developed world. The associated structural demand for raw materials would thus ensure a scarcity-driven bid throughout – one that would be somewhat decorrelated to the typical business cycles in the developed world. That was the Supercycle theory.

I disagreed with it at the time because it did not have any historical precedent. Indeed, economic history shows that periods of sustained, rapid economic growth tend to be characterised more by commodity price stability or mild deflation, rather than inflation, as productivity increases. This was the case, for example, during the industrial revolution, in which all developing economies were ‘emerging’.

Chart 1: Long-Term Commodity Prices: Energy and Industrial

Source: EIA, IMF, St Louis FRED, Macro Hive

I suspect the Supercycle theory was promoted as a marketing gimmick for certain emerging market and commodities investments. Consider: it became fashionable in the early 2000s, and it is perhaps not a coincidence that it was around this time that the US dollar peaked in trade-weighted terms versus other currencies. As the Fed and other central banks slashed rates in 2002-03, there was an associated acceleration in global money supply growth, followed by credit growth, and a number of housing bubbles formed in the US and elsewhere.

This period was, therefore, characterised by a general fiat currency debasement versus real assets. The trend was briefly interrupted during the global financial crisis of 2008-09. But after a record amount of global fiscal and monetary stimulus was thrown at economies, commodities prices started rising again, into 2011. However, from 2012, they have trended gradually lower, with a few notable yet idiosyncratic exceptions such as palladium. And even amid rapid population growth, food prices haven’t risen by much through the decades. Adjusted for inflation, they have in fact declined.

Chart 2: Long-Term Global Food Prices

Source: IMF, St Louis FRED, Macro Hive

It is thus easy to dismiss scarcity as the explanation for the Supercycle. Yes, commodity demand has risen over the years along with global economic growth, especially the contribution from emerging markets such as China and India. But real supply has risen to meet real demand. Scarcity in and of itself has had little if anything to do with rising prices. Consider some additional evidence: you can purchase today as much or more oil, industrial metals or food with an ounce of either gold or silver as you could a generation ago.

Further evidence for this view is provided by a much-discussed 2013 study of long-term commodity prices by Professor David Jacks. He observes that commodity price volatility, including that associated with so-called Supercycles, has increased dramatically since the global economy moved away from the gold-backed fixed exchange rate regime of Bretton Woods. That is (though Jacks doesn’t explicitly make this connection), large commodity price swings are not primarily scarcity-driven phenomena but rather macroeconomic and monetary. To paraphrase Milton Friedman, “The Supercycle was, always and everywhere, a monetary phenomenon.”

The Proper Role For Commodities

If the Supercycle was just a myth, and commodities investing generally confers little diversification benefit yet with major disadvantages, there would seem to be only a slim case for investors having any core exposure at all. But I believe that commodities do, in fact, have an important role to play in a robust investment process. First, there are the timeless and proven diversification and store of value properties of gold and other precious metals, which as I argued in my recent series on gold, do indeed belong in any well-diversified portfolio, and with a low double-digit percentage share for conservative investors.

Second, there are specific economic conditions under which commodities in general tend to outperform financial assets. Consequently, rotating opportunistically into commodities can enhance returns. In Part II of this series, I will explore those conditions in some detail, and look more closely at the relative investment characteristics of certain sectors across the commodities spectrum.

[1] This ~70% is simply the notional component. As energy and industrial metals are also more volatile, on average, than some other components of the index, their overall risk contribution is higher still.

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)