Standard Life Investments

Published Article

Investment Week - A Tactical Play for Commodities


This year investment returns have not been kind to those investors who have tried to play last year's winners. The best performing asset class in 2014 is real estate, followed by commodities and inflation-linked debt. The arguments for property are well-known - the superior income yield compared with other assets and the broadening out of the economic recovery are positive drivers. As for the other two, both also represent real rather than financial assets and tend to come into their own when there are perceived macroeconomic or political problems or doubts about valuations on the financial side, such as inflationary pressures or valuation bubbles.

This article considers the pros and cons of increasing tactical weighting to commodities in general or to some commodities. Shorter-term or tactical considerations include what is changing in the markets, what is priced in and the triggers for future moves as well as the case being made on either side of the debate. We also need to think about whether commodities are likely to move together or whether the factors at work will affect sub-groups or individual commodities. This involves looking at investor behaviour – in the aftermath of the financial crisis, the broad-based moves in commodity prices reflected investor interest at an asset class level. Investors were buying index funds and ETFs for diversification purposes rather than taking views on the subgroups, energy, precious metals, industrial metals and agriculture, or on individual commodities. Those positions were largely unwound in 2012 and 2013, coinciding with or following underperformance by the asset class.

As far as investor positioning is concerned, sentiment towards commodities seems to be improving. The tactical question is whether the recent positive momentum will be sustained. If there is fundamental underpinning for various moves it is more positive than short covering on the part of speculators. If the latter, then once positions are squared further potential is limited. For risk managers, correlations between different commodities and between equities and commodities have fallen. This increases the potential for exposure to particular commodities to act as a diversifier of risk within a multi-asset portfolio. From a behavioural perspective, the positive outlook for commodities is by no means shared by all - it is not a consensus or crowded trade.

Turning to the investment environment, the change in leadership illustrated in investment returns is indicative of a turning point in the monetary cycle, with leading economies moving away from accommodation and easy money to a phase where interest rates start rising. What should this mean for commodities? The evolving interest rate cycle is not supportive. As interest rates rise, the opportunity cost of holding non-interest bearing investments, such as commodities, also increases. Rising rates in the US ahead of other economies can also result in relative strengthening of the dollar, which is inversely related to commodity prices as they are priced in US dollars.

Looking more closely at the sub groups within commodities, there may be a seasonal argument for favouring US oil on a tactical basis. During the US summer driving season, between April and September, oil inventory levels tend to be run down as people drive more, using more gasoline, and at the same time supply is more prone to weather disruptions – such as hurricanes in the Gulf of Mexico. Tactical positioning to take account of this seasonality has worked in eighteen of the past twenty seven years. Elsewhere, industrial metals and commodities associated with the economic cycle – lumber and rubber have lagged this year and there is little about the global economic outlook that suggests a significant surge in demand on the horizon either from the developed or the developing world.

Metals present a particularly complicated picture. The demand for some industrial metals, such as copper and iron ore, has been distorted by widespread practice of using commodities as collateral for loans in China. When this element is taken out of the market, as a result of government reforms, the demand that remains is weak and vulnerable to any further slowdown. Elsewhere the strong performance of nickel is largely due to trade disruption after Indonesia banned exports of the metal ore. In the precious metal camp, palladium's performance may be influenced by Russia being the main source of supply and both platinum and palladium production has been affected by strikes in South Africa. Despite no shortage of political turmoil gold has not responded as a safe haven.

Overlooked assets can be a fertile source of substantial investment gains. Technical aspects of the markets and investor positioning are key considerations when making tactical calls. Investors also need to judge the extent to which the longer-term fundamentals and changes are priced in as well as short-term drivers. A highly selective approach to commodities looks sensible at this phase of the US monetary cycle against a backdrop of slowing Chinese demand.

Frances Hudson, Global Thematic Strategist, Standard Life Investments