Ben Kumar, Investment Manager.

17 February 2017.

Over the last 12 months, commodities have been surging in value, with the Bloomberg Commodity Index rising 14% in US Dollar terms. On the back of this, we’ve seen a flood of articles proclaiming the return of a bull market, and extrapolating out last year’s returns into a bright and glorious future.

It is probably worth a bit of context here. In January 2016, the Bloomberg Commodity Index hit lows not seen since the 1990’s. At this time last year, you would have been looking at one year returns of -25%, three year returns of -45% and five year returns of -55%. In the same vein as above, we saw a stream of commentators proclaiming that commodities were dead forever as an asset class, and to avoid them at all costs. Lots of the current arguments for a continuing rally involve rising consumer demand fuelled by global growth. Yet a year ago, many analysts were bemoaning the amount of oversupply in a sluggish growth environment. Some of these pieces were written by the same authors.

Predicting a commodity price is almost impossible. Decades ago, it was merely very difficult – an analyst would try to assess economic growth, and then puzzle out the impact on, say, the oil price. Now though, they have to consider more than just the fundamental economics.

As portfolio construction theory took hold throughout the late 90’s, with the benefit of having low correlation to both equity and fixed income, commodities became viewed as a mainstream asset class. Investors included them in their portfolios as a matter of course, based on the very sound benefits of diversification. In general, investors would buy a basket of commodities tracking an index, or simply an Exchange Traded Fund (ETF), rather than making specific commodity picks themselves.

This trend of passive, broad commodity investment (which continues today) has changed the market – commodities have become partly financialised. An individual commodity’s price is no longer just dictated by real world supply and demand, but by the investment flows as well. A shift in allocation by a large pension fund, or a rebalancing of the index could have a serious impact on the price of the underlying commodity, regardless of the fundamentals. On top of that, lots of trend-following strategies exacerbate price movements, often using leverage to do so. Anticipating the feedback loop among all of these moving parts becomes pretty challenging.

“Many forecasters take the near past as a guide, and then adjust it depending on their optimism/pessimism.”

As a shortcut therefore, many forecasters take the near past as a guide, and then adjust it depending on their optimism/ pessimism. Using the recent past as a guide looked great in 2012 and 2013 – lots of slaps on the back for correct calls. However, using the same methodology failed miserably in 2014, and again in 2015. The chart below shows the price of Brent Crude Oil, with the red X showing the end-of-year estimates analysts made the year before – so the first X shows the estimate made in December 2011 for the oil price at the end of 2012. In general, the forward-looking estimate looks an awful lot like the price did on the day the analysts made the prediction.

The Price of Brent Crude Oil

It feels like the majority of views are still being informed by what happened last year, and adopting a narrative that fits this, rather than representing a genuine understanding of a hugely complex market. The old patterns are still there; the bias towards recent data. The price of oil at the start of this year was US$56; the median forecast for the end of the year is US$56.

Portfolio Positions

• Given the above, one might well question our current allocation to commodities, of 4% in a Balanced portfolio.
• A tactical allocation to broader commodities is indeed hard to justify – particularly given the cost of maintaining investments in the various indices at the moment, running at well over 3% a year in some cases.
• Our current allocation is entirely in gold, which we view as distinct from the broader commodity market. Our gold position is there to act as a safe haven, both against political uncertainty and inflation.
• We also have a commodity-related position in our Alternatives: Market Neutral allocation – the BNP Commodity Carry Note. This strategy actually looks to benefit from the financialisation of the commodity markets mentioned. The rise of passive products mentioned above means that there is now a large amount of money invested according to specific index rules. This creates waves of buying and selling every month at rebalancing day – something which this strategy anticipates, and profits from, whilst taking less of a view on the direction of the broad commodity market.

Please get in contact with us for more details on the specifics.

 

 

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