Silver under a cloud
Should investors revise their commodity positions in the light of market movements in recent weeks? This depends on the reasons for investing and involves making a judgement call on whether the falls represent a short-term correction or a reversal in trend.
If commodities were chosen in order to diversify risk, the sell off provided a useful reminder of the inherent volatility of the asset class and its close relationship with other risk assets. In fact, commodities have been positively correlated with equities since 2008, both influenced by investors delivering and demand destruction in the slowdown. Commodities and equities are further entwined because of shared currency influences.
Investors need to pay attention to the information that can be gained from commodity markets, even if not investing directly. It is difficult to generalise across the asset class because there are distinct groupings in commodities - precious metals, industrial metals, energy and agricultural commodities - which move in different directions for different reasons. The physical commodity markets for industrial metals, for example, can provide information about the state of the global economy. Gold prices are based more on sentiment, representing a safe-haven against uncertain equity markets, political risk or US dollar weakness. There are also influences affecting individual commodities. If individual commodity markets are trading together it should flag that the asset class is not trading wholly on fundamentals. This could be because sentiment and speculative influences are dominant.
Bubble characteristics vary considerably between individual commodities. The extent of recent falls in certain commodities, such as silver, in response to five increases in collateral requirements in the space of a few months, suggest that there was substantial speculative element in the price, particularly as the supply and demand fundamentals had not changed significantly in the space of a few days. Similarly, the speculative component in the oil price has been estimated as high as $30, coupled with new evidence of high inventory levels, a correction was on the cards. This means that investors also have to watch what the speculators (often the big investment banks or hedge funds) are doing or saying about commodities. If they change their bets, the price could move substantially.
Commodities carry no income stream so investing directly is a bet on future price appreciation. If this is done using futures there are costs associated with rolling from one contract to the next so the price movement would also have to compensate for this. Standard Life Investments prefers to invest in sustainable yield, so the lack of income is a serious drawback; we would look for other ways of investing, using either stocks or commodity-related currencies, to exploit gains from commodities. Another route is to invest in the technology or means of production rather than the commodity itself. Examples would include investing in fertiliser or irrigation rather than agricultural commodities, or investing in geophysical surveys or oil services or even in the companies that make the huge tyres used for mining trucks.
In the medium term there are good reasons for taking a constructive view of commodities. Among the more interesting are those in short supply that have a role to play in the future, for example platinum and palladium, which are used in catalytic converters for petrol and diesel engines, respectively, to make them more energy-efficient. The less interesting ones are those where supply is abundant, there are alternatives that can be used and the value they add is limited. This includes some of the industrial metals.
Tight markets today may be more indicative of speculative involvement than physical supply and demand conditions. In that case, investor psychology can be used to second-guess the big market players either by following their lead (trading on momentum) or betting against them (contrarian belief that markets will correct towards fundamental value). Alternatively, investors can stand back and monitor commodity markets to glean information from them while investing in related stocks or commodity-related currencies to secure an income stream that will provide at least a partial hedge against future falls.
Frances Hudson, Global Thematic Strategist, Standard Life Investments
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