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Tangible strains

This summer, some of the more prominent commodity indices are hitting 13 year lows only ten months after we eliminated commodities from our long-term investment strategy, and our clients’ strategic asset allocation.

After a partial recovery in March and April, prices in several commodities have resumed their downward trend. Is it time to re-evaluate the asset class strategically?

À la recherche du temps perdu

The search for new equilibria in commodity markets continues. Investments in physical production capacity remain unhealthy. Commodity markets still have access to far too much capital relative to future demand and exhibit a declining cost structure.

It seems that the long-term supply overhangs in several of the more important commodity markets require prices to weaken further, or to fluctuate at low levels for the next twelve months, in order to balance supply and demand.

Structural weaknesses

A few months ago we argued that the spring oil rally would lose steam and that long-term fundamentals would regain dominance of commodity market developments.

Let's re-cap the general commodity dynamics briefly:

1. Oversupply following a decade of massive investment in commodity production. New, value-destroying capacity which was planned years ago at high prices is still being added in energy and metals.

2. The desynchronised growth trajectories of major economic players, which disperse commodity demand and implicitly strengthen the U.S. Dollar.

3. Sustained currency devaluation in many emerging economies to rebalance their trade, many of which are commodity exporters and can still produce at stable local prices while international prices for commodities fall.

4. The transition of the Chinese economy from being led by infrastructure investment and manufacturing, to one which is increasingly driven by consumption and services. Recent data suggest that investment contribution to GDP growth declined from a high of 50% of growth, to 15% in the first quarter of this year. This has helped to push commodities targeted by capital expenditure, such as copper, to new lows for 2015.

While these forces rest on complex dynamics, their impact is simple to grasp. Commodity prices will remain under pressure. The length of this adjustment will depend on the swiftness and extent of future price declines.

In case you are wondering, the Organisation of the Petroleum Exporting Countries (OPEC) has not cut crude oil supplies as prices have fallen. In fact, OPEC production recently hit new highs.

Might the barbarous relic return to strength?

In our view, gold is a currency, not a commodity. This is because the fundamentals of gold are entirely different from those of energy, metals and agricultural commodities. They are even somewhat different to other precious metals such as palladium.

Gold prices tend to track consumer prices over very long horizons as the real price of gold has generally been constant over time. For a while now, the moving average price of gold has been above its long-term consumer price trend line, which means that the long-term outlook for gold is modest.

The price of gold has tended to move in lockstep with real interest rates. Why? The “opportunity cost” of holding gold is whatever you could earn from the most conservative stores of value - bank deposits and government bonds. When short- term interest rates and bond yields are low, one forfeits little by owning an asset such as gold that pays no current income. Currently and for some time to come, interest rates are low and will continue to be.

Short-term interest rates and bond yields are turning negative, or in some countries becoming even more negative than before, when adjusted for inflation. This - the global real interest rate - is the key variable to the gold price outlook. Since we do not expect much higher inflation and not much lower short-term interest rates in the foreseeable future, gold currently doesn't have much upside potential as a long-term investment.

That said, central bank and safe haven buying will occasionally disguise the impact of inflation and real interest rates.

How do emerging markets equities come into play?

We have already discussed the economic interactions between emerging markets and commodities. In addition, the political cracks in some countries which were long covered up by easy profits from commodity production are now being revealed as prices fall continuously, with Brazil, Russia and South Africa all suffering.

Investors are responding in the traditional way to a strengthening dollar and declining commodity prices: they are re-allocating money away from emerging markets equities. A good question to ask is whether this has gone too far.

At some point prices will overshoot, and it will be time for contrarian investors to step in. After all, emerging markets stocks are more attractively priced than those in the developed world on almost every measure.

A short term wrinkle: El Niño

Meteorologists across the world reckon that current emerging changes in temperature of Pacific currents – the weather phenomenon popularly referred to as El Niño – is building up to be the strongest on record. The impact that this can potentially have is as varied as it is unpredictable in severity and location. Common weather phenomena that emerge in its wake, however, are droughts and excessive flooding in different parts of the globe. Depending on the stage of the crop-cycle in which they strike, both can be unfavourable to prospective crop harvest yield volumes.

The emergence of the strongest El Niño on record, then, raises the prospect of intermittent crop failure and exogenous supply shocks to the agricultural commodities value-chain. This is important for several reasons. For one, unexpected supply shocks, particularly in food-grain and agricultural commodities, have a direct bearing on broad-based cost of living and inflation measures. Inflation spikes can disrupt the orderly evolution of interest rates in bond markets and also erode policymakers’ commitment to, and comfort with, accommodative monetary policies of the kind currently being pursued by the world’s major central banks. Higher interest rates, or the expectation of less accommodating monetary policy, are not supportive of generous levels of risky asset valuations.

At a micro-level too, rising commodity prices influence – however briefly – companies’ operating profit margins especially in situations where these commodities form an important part of the raw material cost-base. The knock-on effect on cash-flows and distributable surpluses can weigh on investors’ expectations of profits growth and dividend distribution. This is again not supportive of risky asset valuations.

And finally, at the household level, rising commodity prices – particularly agricultural commodity prices – can have an out- sized impact on the outgoings of average household consumers in terms of non-discretionary staple consumption spending. Inevitably, this will have to be balanced off against a drop in discretionary, non-staple spending on larger-ticket items like holidays, durable goods purchase, entertainment etc., with knock-on effects on the consumption-spending element of GDP growth. Again, the effect of this on investor sentiment, the outlook for growth and appetite for risky assets cannot possibly be favourable.

Conclusion

The current supply overhang and other disadvantageous fundamentals of crude oil, unleaded petrol, heating oil, natural gas, copper, cotton, soybean and cocoa should drive prices even lower into 2016.

Nickel, aluminium, zinc, lead, palladium and coffee should start a recovery during the next twelve months. Wheat and corn trends might be interrupted by weather and El Niño.

After the present window for stabilisation has closed, gold prices will continue to ride even lower as real interest rates in the UK and US eventually move up in small steps.

Important Information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this report are our in house views as at  29th July 2015 and should not be relied upon as fact and could be proved wrong.

The information contained in this webpage has been derived from sources which we consider to be reasonable and appropriate.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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