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Commodities Revisited By: Nelson Louie, Managing Director, Credit Suisse Asset Management
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| Introduction
An allocation to commodities may have strategic as well as tactical benefits in the current investment environment. Aside from the long-term diversification benefits, low correlation to traditional assets, and inflation-hedging properties of commodities, there can also be tactical benefits. This seems especially true when considering the prospects of unprecedented monetary stimulus measures throughout Europe and Asia, the potential shift in U.S. Fed policy, and with the world generally consuming more raw materials in the face of increasing geopolitical instability and challenging climate conditions.
The Strategic Advantage
Commodities have historically exhibited low correlation to both stocks and bonds. As a result, allocating a portion of a portfolio to commodities can help to diversify portfolio risk by providing a hedge versus traditional investments.
In addition, commodities have exhibited high correlation with unexpected inflation, which is the difference between projected and realized inflation rates. Historically, they have provided protection against rising inflation because commodities are directly linked to the components of CPI. Accordingly, commodities exposure may outperform investments in stocks and/or bonds and help protect against one of the primary risks to an investment portfolio, which is when inflation rises unexpectedly.
Lastly, sources of geopolitical instability may lead to price increases in the Energy, Industrial Metals and/or Agriculture sectors and to increased demand for Precious Metals as safe haven assets. In many emerging economies, where commodities production is a primary driver of economic viability, unstable government regimes may enhance political instability and lead to supply disruptions. As an example, while oil output has been increasing from nations such as Iraq and Libya, the ISIS conflict appears to be spreading and fighting has centered on these country’s strategic assets.
Weak Supply Fundamentals Make Way for Production Cuts
For many commodities, supplies have generally increased over the past few years. In the Energy sector, U.S. shale oil and gas production has grown and OPEC appears unwilling to cut production in favor of maintaining market share. In many Agricultural commodities, high prices have induced farmers to increase plantings, leading to outsized crops. For example, the total supply of global grains increased from 2,932 million metric tons in 2013/2014 to a forecast of 3,005 million metric tons in 2015/20161. Finally, years of increased capital spending on mining projects have led to significant declines in base metals prices. These investments in new production have occurred over a period where global economic growth has been low and commodity demand has been weak. However, the reduction in prices has negatively impacted producers and many companies have been reducing capital investments, shedding non-core assets in favor of improving cash flows and focusing on core operations. In crude oil, recent oil rig count data cited the 28th consecutive week of declines. Also, expectations are that producers will cut spending by an estimated 25% or more during 20152. Falling rig counts and announced project deferrals may slow production growth and ease the surplus in global oil inventories.
The Macro Economy – Will Demand Return?
Meanwhile, the U.S. economy continues to show signs of steady improvement, while the outlook for Europe and Asia has been mixed. Despite signs of strength, amplified uncertainty surrounding Greece and the Eurozone may cause the U.S. Federal Reserve to remain more cautious than it otherwise would to prevent disrupting a potentially fragile recovery. However, Asian and Europe central banks continue to undertake stimulus efforts with the goal of inflating their way out of their economic doldrums. The differentiated path of the U.S. central bank versus the rest of the world has resulted in a recent strong U.S. dollar, which has impacted commodity prices negatively. However, the long-term implications of central bank stimulus, if the U.S. economy is any indication, may be positive for commodities demand.
Despite challenging supply conditions for some raw materials, long-term demand trends remain upward. For example, Chinese soybean imports increased from 28.3 million tons in 2005/2006 to 2015/2016 USDA forecast levels of 77.5 million tons3. The USDA projects that China’s imports of soybeans will rise to 112.0 million tons by 20234. Also, consumption in emerging markets continues to trend toward higher quality proteins, as base-level demand for livestock products in China has increased since 2007 due to high feed, labor, and land expenses. As a result, many emerging markets are increasingly looking to secure food sources amid growing populations. While agricultural supplies have also increased to meet rising consumption, challenging weather conditions in conjunction with concentrated production centers poses a potential risk to food supplies.
The current market presents a unique opportunity for investors to access the asset class while commodity prices are at low levels. Investors continue to value commodities as a strategic diversifier as inflation concerns mount, geopolitical concerns remain elevated, and low interest rates prompt investors to seek returns from riskier assets.
For more information on these and related topics, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
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| Nelson Louie, Managing Director, is Global Head of the Commodities Portfolio Management Team and the Volaris Team within Credit Suisse Asset Management. Mr. Louie re-joined Credit Suisse Asset Management in August 2010. From May 2009 to August 2010 he was an Executive Director in the Commodity Index Products area at UBS Securities, LLC. From June 2007 to May 2009 he was a Managing Director at AIG Financial Products responsible for North American Marketing of commodities- based solutions. From April 1993 to June 2007 he held various positions within Credit Suisse Asset Management, LLC. He was a senior portfolio manager overseeing a team that was responsible for enhanced commodity and equity index strategies, option based hedging solutions and option arbitrage products. He was a team member of the commodity funds from their inception through June 2007. Mr. Louie holds a Bachelor of Arts degree in Economics from Union College.
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| 1. Source: U.S. Department of Agriculture World Agricultural Supply and Demand Estimates, June 10, 2015
3. Source: U.S. Department of Agriculture Foreign Agricultural Service, China Oilseeds and Products Annual Report, March 3, 2015
4. Source: Fred Gale, James Hansen and Michael Jewison, U.S. Department of Agriculture, “China’s Growing Demand for Agricultural Imports”, Economic Information Bulletin Number 136, February 2015
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