Strategy Bulletin  

05/08/2014

WHY COMMODITIES ARE BACK IN FOCUS

This year has seen Commodities come back on investors’ radar screens. Commodities started 2014 with a strong rally, after negative performance in 2013, and even outperformed other asset classes at some points in the first half of the year. Being exposed to Commodities through futures yields a positive carry again, after nearly a decade of consistent underperformance of futures to Spot prices. Lastly, Commodities act as a diversifier again within portfolios, as correlations with other asset classes declined. Yet, we think it is premature to take a strategic exposure to overall Commodities. Prices are currently driven by supply shocks – unpredictable and temporary by nature – and demand is too weak for now to see a sustainable run-up in the asset class.

The rebound witnessed in the early part of the year has indeed been mostly driven by segments undergoing a supply shock (Wheat, Soybeans, Coffee, Corn, Nickel, more recently Brent and Nat Gas) related to weather or geopolitical issues. As the situation normalized, most of these segments saw sharp price reversals, pushing Commodities from best to worst performer year-to-date in a matter of weeks, with Spot prices on the brink of negative territory (whilst futures remain slightly positive YTD).

Moreover, with the normalization of supply, most futures curves that were in backwardation (i.e. downward sloping, reflecting tight near-term supply) flattened or flipped back into contango (i.e. upward sloping), removing the roll yield advantage or even implying roll costs from being invested through futures. Finally, investors who were exposed to Commodities across the board for hedging purposes failed to see full diversification benefits as correlations amongst Commodity segments have declined as well – one had to pick the right segment to hedge against the right risk.

What falling correlations amongst segments also suggest is that Commodities are driven by fundamentals again. Yet fundamentals, especially on the demand side, are not supportive in the current environment. The rebalancing process between Developed and Emerging economies is almost complete, but both blocs are shifting towards new drivers of growth (production/investment in the West, domestic demand in the East), limiting actual growth levels. Potential growth is also lower than in past cycles due to population ageing, constrained productivity and further deleveraging in Developed economies. These structural shifts are weighing on overall demand for Commodities.

To see a sustained upturn in Commodity prices, we would need to see stronger growth worldwide, especially in China (which accounts for 46% of total consumption of Industrial Metals). Yet, the world economy is only in the early stages of recovery, with significant divergences amongst regions. China is showing signs of a revival, but structural reforms, in particular those aimed at curbing shadow banking are headwinds.

Until the global economic recovery gathers steam, specific supply shocks (e.g. bad crops, geopolitical issues, political/trade barriers,…) will be the main price differentiator within Commodities, warranting a great degree of selectivity. Investors who wish to get a strategic exposure to the overall asset class will thus need to be patient.

SELECTIVITY IS KEY

Others, who wish to get exposed now, will have to be very selective, tactical and bear some volatility.

Looking into segments, Agriculture & Soft commodity prices should stay under pressure as past supply shocks related to weather (harsh winter in the US, droughts in Brazil, floods in Indonesia,…) and geopolitical issues (fears over supply disruptions in Ukraine) are normalizing. Longer term, China’s transition to a consumer-led economy changing food habits towards more meat consumption will support Agriculture prices, but only very gradually and starting from a low base.

The global rebalancing process and slower structural growth in China will continue to act as a headwind on Industrial Metals, given the share of Chinese demand on that segment. Credit issues and associated worries about the unwinding of Chinese Commodity Financing Deals (CCFDs) are a specific drag on Copper, Aluminium and Iron Ore, which are being used as collateral for lending (and often pledged multiple times). Wait for stronger global growth to see a lasting rebound in these metals. Indonesia’s ban on raw ore exports since January (to foster domestic value-added activities) is there to last and should sustain Nickel going forward.

Within Energy, Oil should remain in a broad trading range (between USD 95 – 110 per barrel on the Brent). The run-up in Oil reversed as fears over supply disruptions in Iraq abated (ISIS extremist group progress towards the South threatened Iraq’s Oil production and exports). Risks are skewed to the upside as geopolitical tensions could revive. Downside is limited as most producers need Oil revenues, the US is unlikely to release strategic Oil reserves with Russia staying “clear” from Eastern Ukraine, and the ban on US Crude Oil exports, though loosened, is still in place. Natural Gas prices corrected as the latest Russia-Ukraine Gas dispute was resolved. A lasting surge in Gas/Oil prices seems unlikely given still modest world demand. Temporary runs with heightened volatility could nevertheless occur on supply shocks (for instance if EU/US sanctions against Russia target outright Energy trade between Russia and the EU).

Amongst Precious Metals, Gold is trendless since mid-2013, despite episodes of heightened tensions and volatility (Fed tapering, Emerging FX crisis, Russia-Ukraine crisis, Iraq). Physical demand is insufficient to take over from investor demand as a driver for Gold. The narrowing in Shanghai-COMEX Gold price spreads suggests limited appetite by Chinese investors. The Indian Gold import duty (a 10% tariff in place since 2013 to curb the current account deficit which weighs on the currency and spurs inflation) restrains demand. Central banks’ demand only accounts for 11% of total demand for Gold and is not sensitive to price fluctuations. To see a sustained uptrend in the metal, we should see a return in investment demand for hedging purposes, against systemic risks (like during the European crisis) and/or extreme inflation risks. Silver should follow Gold, but with more volatility. Palladium, to a lesser extent Platinum, are the “odd men out” amidst Commodities, benefiting from both strong demand and tight supply. Industrial demand has revived on the back of stronger auto sales globally and Shanghai’s clean air action plan, which encourages a shift towards clean cars (Palladium being used to manufacture catalysts for fuel cars, Platinum for diesel cars). The introduction of ETFs boosted investment demand, as it provides investors with liquid vehicles to get exposed to the metals. On the other hand, supply is constrained by miners strikes in South Africa. Whilst the recent run-up in Palladium and – to a lesser extent – Platinum may be somewhat overextended, warranting cautiousness in the short term, both metals should see further upside over the long term.

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