Commodities had delivered outsized returns compared to most other asset classes since the start of the millennium until the financial crisis. Insatiable demand from China and other emerging nations fuelled the unprecedented rally in commodities, leading many analysts to call it a commodities “super-cycle”.
Underperformance in the last couple of years, mainly due to increased output and economic slowdown in emerging markets, left investors wondering whether the commodities “super-cycle” was dead. (Read: 3 ETFs that Hit & 3 That Flopped)
This year a combination of supply constraints and rising demand seem to have resulted in brining commodities back in focus. Many commodities have delivered stellar returns year-to-date and many still look poised to outperform going forward as well. Here are some strong reasons investors should look at commodities this year.
Declining Correlations = Better Portfolio Diversification
One of the reasons for investor interest in this asset class is the recent decline in correlation with equities. Correlations had spiked during the financial crisis and continued to be high after that, leading investors to question the diversification benefits of commodities.
Among the main reasons for rise in correlations were, rise in inventories prior to crisis and predominance of risk-on/risk-off trading subsequent to the massive monetary stimulus. (See: Sell in May and Go Away with these Inverse ETFs)
With the gradual withdrawal of QE and increase in volatility, correlations have been on the decline for some time. Currently, correlations of commodities to other asset classes are down to pre crisis levels.
The 12 month correlation between the S&P 500 and S&P GSCI at 0.26 is lowest since November 2008 and continues to head down further.
Backwardation Suggesting Higher Returns
Commodity investors need to understand the role of the structure of futures curve in the return. Every month when future contracts mature, fund managers need to sell the maturing contracts and buy new contracts to replace them.
When the new contracts are more expensive then the maturing ones, or in “contango”, rollover results in losses. On the other hand, if the new contracts are cheaper than the maturing ones, or in “backwardation”, the rollover results in positive returns.
Thus, investing in commodities via futures introduces the “roll yield” and the return from underlying collaterals in total returns calculations. (Read: 3 Low Correlated ETFs Surging in Shaky Markets)
According to Hermes Fund Mangers outlook for commodity investors is the best it has been in a decade due to sustained broad backwardation seen in the last few months.
Usually backwardation indicates low inventories and supply disruptions for the commodities and positive returns going forward.
According S&P DJ Indices, 2013 was the first year commodities have been in backwardation in a decade. During 1984-1991—the last long streak of backwardation, S&P GSCI had positive returns every year through 1990 for a total return of 221%.
Unusually Dry Weather Causing Supply Disruptions
Unusually dry weather in various grain growing regions in the world has led to a sharp increase in the price of coffee, cocoa and wheat this year. Arabica coffee has more than doubled in price this year due to crop damage caused by drought in Brazil. Beef saw its biggest monthly recently, mainly due to tight supplies resulting from drought.
Additional many analysts predict that the “El Nino” may return this year, pushing the prices for a number of commodities further on the upward trajectory. El Nino causes weather disruptions in many regions around the world, including drought in some and flooding in others due to abnormal warming of the Pacific Ocean.
In particular, it is likely to impact sugar and rice crop in India and wheat crops in Australia. Coffee, soybeans and cocoa may also see supply disruptions.
Nickel prices--which are already surging this year due to import restrictions in Indonesia--may spike from dry weather in the country.
Geopolitical Stress Pushing Prices Up
Heating up of tension between Russia and Ukraine, coupled with potential trade sanctions on Russia, has caused turbulence in commodity markets. Many investors sought refuge in gold as violence in the region escalated.
Almost 40% of global supplies of platinum and palladium come from Russia and fear of disruptions has supported these two precious metals.
Russia is one of the largest producer and exporter of oil and natural gas in the world and both Russia and Ukraine are major wheat exporters. Ukraine is also an important producer of many other grains too. Political unrest has pushed grain prices and exports from the US up this year.
ETFs provide a convenient and low cost exposure to commodities. Below are some ETFs that provide exposure to a broad basket of commodities.
United States Commodity Index Fund (USCI - ETF report)
USCI tracks the price performance of portfolio of 14 commodity futures, reformulated each month from 27 possible futures contacts representing six sectors including metals, energy, livestock and softs. The contracts are selected on the basis on price performance including backwardation and are equally weighted.
PowerShares DB Agriculture Fund (DBA - ETF report)
Investors looking to benefit from surging food prices could consider DBA that invests in widely traded agricultural commodities through futures. Top futures holdings in the index are corn, soybeans, sugar and live cattle-each with a 12.5% weight.
GreenHaven Continuous Commodity Index Fund (GCC - ETF report)
GCC invests in a basket of17 equal weighted commodity futures. This ETF is a suitable option for investors who want reduced impact of contango or backwardation. It employs a dynamic contract roliing
Because of the equal weighting, GCC offers significant exposure to grains, livestock, and soft commodities and a lower energy weighting than many of its peers. In addition, GCC is rebalanced every day in order to maintain each commodity’s weight as close to 1/17th of the total as possible.
Slowing growth in China and some other major emerging markets will remain a concern for commodity investors. Investors also need to remember that commodities are usually more volatile than most other asset classes .
The Bottom Line
Commodities provide diversification benefits and as well as a hedge against inflation. Further, various factors discussed above suggest that a positive outlook for commodities this year. Thus investors should consider a small allocation to commodities in their portfolios.
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