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Material gains

Commodities: As commodity prices become decoupled from equities, certain resources should again prove their worth as part of a diversified portfolio this year

By Kerry Craig | Published Apr 16, 2014 | comments

After a lacklustre few years, commodities have had a short but strong run over the first few months of 2014.

Unfortunately, the recent bounce in the prices of selected resources probably does not represent the start of another bull market for commodities, but rather reflects more idiosyncratic influences on the supply-and-demand outlook for individual commodity groups. Broadly, commodities are unlikely to make up for past losses in 2014, although they should have a better year as the global economic outlook strengthens.

The Dow Jones/UBS Commodity index was up 7 per cent over the first quarter of 2014. As always, though, the devil is in the detail, and looking beyond the headline performance in commodities, just as with other asset classes, will become increasingly important this year. The big winners in the index were soft commodities, with corn and wheat gaining 19 per cent and 15 per cent respectively over the quarter. Meanwhile, the industrial metals (copper and lead) and the energy commodities (oil and coal) lagged. The decline in these economically sensitive and cyclical commodities last year and so far this year reflects the state of, and perhaps the near-term outlook for, emerging markets.

By holding commodities an investor may be taking a view that the global economy is getting stronger, especially emerging markets, but this is not the case right now. However, commodities play two other important roles in a portfolio: given their low correlation to bonds and equities, commodities are a very useful way of reducing overall portfolio risk; and for investors who fear inflation, commodities provide an excellent hedge to rising prices.

During the financial crisis, sharp spikes in volatility and large swings towards risk-off investing meant risk assets became much more highly correlated, with commodities and equity prices moving in the same direction. However, as financial markets have become calmer and investors more rational, the prices of commodities and of the companies that produce them have diverged, and broader correlations have returned to more normal levels. As a result, commodities once again are looking like a key component of a diversified portfolio.

As with many other asset classes, the key to investing in commodities is to understand what will drive the prices of the individual assets.

Industrial commodities are largely a leveraged play on emerging market growth, especially on China. With growth in China slowing down – although the economy is far from contracting – there is still downside risk for industrial commodities such as iron ore and copper. Adding to copper’s woes is that it has been used as a source of collateral in Chinese financing deals. As the price falls, so does the metal’s attractiveness as collateral, leading to further declines in the price.

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