Commodities thrive despite downturn

Several cyclical and structural factors are beginning to play an increasingly important role in driving the strong performance of commodities. But can this positive trend continue?

Commodities have performed strongly this year, rising nearly 14% by the end of August according to the DJ-UBS Forward All Commodities index. Several sub-sectors such as industrial metals and individual commodities including oil, silver and sugar showed even stronger double-digit returns. This performance extended the already significant gains made over the past 10 years, with the broad commodity index up 270% compared with a 7% fall in equities (as measured by the FTSE 100), an 82 % rise in bonds (as measured by the Barclays Capital Bond Composite index) and a 24% fall in real estate (as measured by the UK EPRA Real Estate index). These returns have been achieved with an annual volatility of about 15%, lower than that of most developed country equity markets. A key question being asked by investors is: what has been behind commodities’ strong performance and can it continue?

It is first necessary to distinguish between the cyclical and structural factors that are driving returns. Near-term returns are almost always driven by cyclical factors. The current strong rally in commodity markets has coincided with a more rapid than expected improvement in business cycle lead indicators. Commodities most geared into the cycle, including copper and other industrial metals, gasoline and oil, have been some of the strongest performers, while more defensive commodities, such as gold, have lagged behind.

Although cyclical factors will likely have the largest impact on returns in the short-term, there are a number of structural factors that are beginning to play an important role in driving commodity performance. Even if investors’ bullish cyclical expectations are not met and a broad-based risk asset correction occurs, several structural factors are likely to continue to underpin medium to long-term commodity return performance.

The first is concern about the rapid deterioration of developed economy fiscal balances and the surge in government projected debt. With major market debt burdens expected to rise in the next few years (with America, Britain and Japan of particular concern), there are fears that governments may find inflationary policies and/or currency depreciation the most politically palatable way to reduce debt burdens.

Certainly the unconventional methods now being used by major central banks to ease monetary policy through quantitative easing and the sharp increases in government debt have done nothing to ease investors’ fears. Historically, commodities and other hard assets have tended to perform strongly during periods of high inflation and dollar weakness, acting as one of the best hedges against these risks.

The second key development has been an increasing investor focus on counterparty risk. The failure of Lehman Brothers, significant losses at major financial institutions and rising corporate default rates have caused investors to re-assess their counterparty exposures and reduce their positions in structured products and other illiquid investment vehicles. As commodities are tangible hard assets, they often act as safe havens during periods of financial and economic uncertainty.

Historically large investment banks and specialist houses have dominated commodities investment. Because of the high entry costs, complications and risks involved in direct futures or physical investing, small- to medium-sized institutions as well as retail investors have not had access to the commodities markets. However, with the creation of exchange-traded commodities – stock exchange-listed securities that track the performance of commodity returns – which started about five years ago, commodity markets have opened up to a broad range of investors.

Emerging market demand for commodities has continued to grow strongly, despite the economic downturn affecting most of the developed world. China has been the key source of demand growth, but India, Russia and a number of other emerging economies are also playing an important role.

With most commodities becoming increasingly scarce, prices will likely need to rise – both to stimulate new investment and production, and to ration demand.

In the near term, if business cycle indicators start to disappoint, commodity prices will likely correct along with other cyclical assets. However, strong demand for hard assets to hedge against currency and inflation risks, together with price-supportive long-term supply/demand fundamentals, should help soften the downside and continue to underpin strong long-term returns.