Bumpy ride on the super-cycle

Three years ago retail investors were being sold the potential upside of commodities. Sonia Speedy finds mixed views on when the gravy train will next leave the station

Commodities became a hot investment area in the post-dot.com boom thanks to rising demand from emerging markets – spearheaded by the seemingly insatiable China. Anticipated supply shortages caused by a previous lack of investment only exacerbated the situation and prices stormed ahead. Before this, however, commodity prices had been falling in real terms, as technological developments slashed production costs.

But the surge in prices hit a brick wall in 2008 in the form of the global financial crisis. The air hissed out of the commodity bubble and prices crashed in anticipation of global recession. However, the tide turned this year and prices have been picking up. So is it time for retail investors to pile in?

Bespoke investment management firm Quilter’s equity research analyst Liz Dhillon puts the rebound down to China restocking ‘hard’ commodities and a surge in prices of ‘soft’ commodities like sugar and cotton due to weather factors and a lack of investment. But fears are now surfacing that the rebound may be about to run out of steam.

Whitechurch Securities managing director Gavin Haynes describes commodities as an extremely sensitive area, largely driven by the growth of emerging markets and expansion in infrastructure.

“It obviously had a phenomenal run up until the middle of last year, but then we’ve seen a dramatic correction in commodity prices pretty much across the board,” he says.

“As it appears now that we’re not going into armageddon, that we’re not facing a global depression, we’ve started to see quite a strong recovery in the area.”

But the question remains: just how sustainable is this recovery?

“Really it’s very highly correlated to whether demand in the US can recover sufficiently to provide sustainable growth going forward or whether the bounce we’ve seen over the last six months peters out if the economic recovery is not seen to be sustainable,” Haynes says.

Commodities are a cyclical investment that offer a hedge against inflation, and also a useful means of portfolio diversification. It is considered that commodities are currently in a super-cycle that some believe will last another decade or more. However, commodities can be highly volatile, as City Index market strategist Joshua Raymond explains.

“We’ve seen the price of gold rally in the last three months from just over $900 to $1,070 (an ounce),” he says.

“Crude oil last year went well over $140 (a barrel), but then within three months it crashed down to just under $40. This again shows you the volatility within commodity prices.”

Dhillon says most investors focus on ‘hard’, or mined commodities such as metals, coal and oil due to the fact those in the ‘soft’ category – such as agricultural products like wheat, soya and cattle – are seasonal, subject to deterioration and vulnerable to the weather.

While gold is currently hitting the headlines, Haynes describes it as a difficult commodity to predict due to the fact it is driven by investor sentiment as opposed to industrial demand, as fossil fuels or base metals would be.

“Just because economic activity is improving it doesn’t mean that you need more gold,” he says.

“Gold is obviously used by investors as a hedge against currencies and particularly dollar weakness. We’ve seen the dollar weakening and therefore investors have been using gold as a safe haven,” Haynes says.

So where does the market go from here? Dhillon believes it is possible that the commodity rebound has run its course in the short term.

“Particularly as Chinese restocking is believed to be complete, for the time being at least,” she says.

She says a large proportion of the anticipated economic recovery is arguably already reflected in commodity prices. However, Catherine Raw, BlackRock fund manager in the natural resources team, says the developed economies have yet to restock. “It’s our expectation that this time next year they will have restocked and you’ll see commodity prices having performed very well. Prices are likely to average higher next year than they have this. But what happens in the next six months is hard to predict,” she says.

Raw sees China as the main driver for commodity demand going forward, with GDP growth of around 9 per cent this year expected and closer to 10 or 11 per cent next year.

“The infrastructure development that we’re seeing isn’t short term and is going to take months if not years, and the commodity consumption associated with that is therefore going to be prolonged,” she says.

Dhillon too is more positive about the long term. “Economic growth and development will continue, as will the inexorable demand for raw materials. Ultimately, the supply of most hard commodities is finite, with costs rising as access becomes more difficult,” she says.

“Environmental constraints and land use limitations will also put pressure on the soft commodities with food supply issues becoming of increasing concern.”

While China may be key, demand from the rest of the world is still required and is a larger market when taken as a whole, Raw says.

“So you do need the rest of the world to start picking up for the bull market – that we believe we have been in since 2001 – to continue and to see higher commodity prices over the next two or three years,” Raw says. “It’s something we do believe will happen, it’s just the timing of whether it is in the next six, 12 or 18 months that is difficult to predict.”

Axa Investment Managers strategist Herve Lievore says recent experience shows it is dangerous for investors to focus only on long term themes – such as the appetite of China for commodities. “The investor has to focus also on the short term volatility,” he says. He believes now is a good time to play the cyclical rebound by investing in this area – just as long as the focus is on the right commodities. He describes base metals as slightly overpriced at present, but believes gold is a good short-term bet.

“Gold and more generally precious metals are currently one of the best bets because of the growing perception of risks associated with the various monetary policies implemented in countries such as the US and UK,” he says.

However, he warns to be wary of currency reappreciation – particularly the dollar – when UK and US central banks start to implement their exit strategies.

Lievore believes it is unlikely a surge in inflation will be seen in the coming years and so gold may then return to price levels closer to $800 – $900 an ounce.

He believes the equilibrium price for oil is around $80 per barrel, which it is currently nearing and which Lievore describes as sustainable. If the global recovery is confirmed he believes crude oil prices will go to $90-$95 in a year’s time and possibly beyond $100.

Investors can buy physical commodities, but while feasible with the likes of gold it is less realistic with other commodities. The rise of exchange traded vehicles (ETVs), which offer investors exposure to broader commodity indices, sub-sectors such as energy or precious metals, or individual commodities like gold or corn, provide a form of exposure to commodity price movements, but without having to fill a warehouse with copper.

“The market has moved one step further with leveraged and short products for investors who want geared exposure or to take advantage of falling commodity prices, but this latter category is arguably a step too far in terms of risk for the traditional portfolio investor,” Dhillon warns.

The futures market offers a further investment avenue and there are ETVs and commodity indices available in this space. Raymond throws Contracts for Difference (CFDs) into the mix, offering retail investors the chance to speculate on commodity price movements.

The most common option, however, is through equity exposure, be it buying shares in the companies that produce commodities, or in funds that do similar. While equity performance may not correlate directly with the underlying commodity, it does offer the benefit of growth potential and yield.
However investors choose to invest, those boarding the commodity train should be sure to fasten their seatbelts for the ride ahead.

ADVISER VIEW

Commodity super-cycle?

Mark Dampier, head of research, Hargreaves Lansdown

“I am a believer in the super-cycle because the numbers are just huge in terms of population sizes”

Mark Dampier, head of research at Hargreaves Lansdown, believes there is an underlying demand for commodities, but expects to see a few “hiccups” along the way.

“I am kind of a believer in the super-cycle simply because the numbers are just huge in terms of population sizes. It will carry on, but with some hiccups as we’ve seen and some of those hiccups can be pretty big when they come,” he says.

However, the underlying foundation of demand will remain in place due to the current urbanisation underway in the developing world, he believes.

But Dampier warns that those buying specialist commodity funds should bear in mind that most standard unit-trust portfolio clients will have some commodity exposure already.

“Unless you’re in income funds, which can’t really get commodities because they don’t yield very much, a normal straightforward portfolio is bound to have mining, oils and commodities in it because it’s a large part of the sector now,” he says. This is unless the fund manager is “completely anti” the asset class, he says.

Dampier favours funds such as JP Morgan Natural Resources, the Blackrock Gold and General fund and Junior Oils.