In July of 2018, we wrote about the improved outlook for commodities as we saw it. This followed the completion of a commodities super-cycle driven by the rise and fall of Chinese demand. China remains the world’s largest consumer of commodities by far. However, the second-biggest national economy is facing up to a number of challenges now. As Chinese demand waxes and wanes, commodity prices and investments will be affected. So while we don’t expect another super-cycle, our analysis suggests that commodity prices have largely reached their long-term low points and are set to rise over time. But this is likely to be a bumpy ride.
The century began with the dot.com bubble which propelled technology stocks to ridiculous highs. The correction that inevitably followed sent stock prices below their new highs until the excesses of the housing bubble sent stocks to new highs in 2007.
As the demand for and price of bonds rises, their yields fall. Many investors suffering as equity values fell moved money into lower-risk rated opportunities such as Treasuries. That sent the price of Treasuries up and their yields down. And that’s why bond yields fell steadily, reflecting the lower demand for equities.
After 2003, confidence in equities began to return sending investors out of bonds. That sent bond prices down and their yields up until things went too far.
Meanwhile, China was becoming the world’s factory floor, exporting huge volumes of goods and investing heavily in infrastructure. That led to an unprecedented hike in the demand for everything from aluminium to zinc. Chinese demand dictated market prices of commodities.
The so-called “Great Financial Crash” of 2007-2009 ensued. Too many people, companies, governments and financial institutions had borrowed, lent or guaranteed too much without sufficient governance or thought for the future.
The reckoning left huge debts and a reversal of economic growth. Equity values slumped as investors tried to recalculate the true value of the remaining companies. Huge volumes of money were withdrawn from company stocks and put into Treasuries and other lower-risk rated opportunities.
This continued the common correlation between the prices of stocks and bonds; in very simple terms, when higher-risk rated stocks become more popular their prices rise while, at the same time, lower-risk rated bond prices fall.
But such was the parlous state of affairs for all parts of the financial and economic system that central banks had to intervene to keep things ticking along. They did this by buying lower-risk rated bonds in vast numbers. That pumped cash into the system but also sent bond prices on a super-cycle of their own.
The flood of cash and low interest rates created a business-friendly environment. By 2016, the corporate environment was positive with profits being generated and share prices having largely recovered.
Then US President Donald Trump was elected on a growth-friendly ticket that included tax cuts. The expectation and arrival of these tax cuts drove stock prices to new record highs in 2018.
Meanwhile, the demand for bonds had created a parallel rise in their prices. This can be seen by the way in which bond yields fell rather than rose with stock prices (remembering that the price and yield of a bond move in opposite directions).
By 2017, central banks had begun to slow or even reverse their bond-buying programmes. As this process continues, subject to economic and inflationary growth allowing, the probable long-term future is for bond prices to fall. However, short-term surprises (such as geopolitical events including Brexit and international trade negotiations) are likely to send investors out of higher-risk rated investments and into lower-risk rated ones.
But what of commodities?
In the aftermath of the financial crisis, the Chinese government unleashed a huge spending spree on infrastructure. The demand for commodities was renewed which sent their prices back up but also spurred some reckless borrowing and spending in China.
A combination of policymaker caution in China and the natural slowing of demand for yet more houses, roads and bridges sent demand for commodities down. By 2015, the commodities super-cycle was over; prices were back to where they’d been at the beginning of the century.
Indeed, the momentum of falling prices continued, bringing commodity prices down to a lower bottom level. And that has given many investors cause to re-introduce commodities to their portfolios.
But that’s not the only reason.
The prices of bonds and stocks are inter-related “. and the consequence for investors is that a portfolio consisting of just bonds and equities is vulnerable to a correlated move in the prices of both stocks and bonds.
Commodities are much less correlated to bonds or equities. This element of diversification can provide mitigation against correlated moves in other assets.
Our analysis suggests that the inclusion of extra diversification is very timely. Equity prices have been heading upwards since their second correction over the past 14 months or so. Bond prices are also under downward pressure as inflation picks up and central banks try to withdraw from providing stimulus. This brings us to a further potential benefit of including an allocation to commodities.
There is a historic correlation between inflation and commodity prices. Inflation is beginning to recover from extreme lows following the financial crisis while bond prices appear set for a long-term decline and equity prices are elevated. With other assets facing an uncertain medium-term outlook, the potential to mitigate inflation is timely as it might help to counter the potential erosion of value in other assets that rising inflation could cause.
With all these factors in mind, we think that it is appropriate to consider seriously the inclusion of commodities in a balanced investment portfolio.
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 March 2019 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document 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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