Why commodities are forging a comeback in 2016

One intriguing trend of note this year is the recovery in the Bloomberg Commodities index, a basket of 22 raw materials encompassing energy, industrial metals, precious metals and agricultural commodities, ranging from grains to crops to livestock:

The Bloomberg Commodities index has rallied sharply

Source: Thomson Reuters Datastream

This runs counter to the ongoing surge in the bond market, which smacks of deflationary fears and suggests the markets are leaning more toward an inflationary outcome, following fresh rate cuts and Quantitative Easing from the Bank of England. This came on top of expansive, ongoing monetary easing at the Bank of Japan and European Central Bank and fresh fiscal stimulus in China. A pause in its tightening cycle at the US Federal Reserve may also be helping.

In addition, ever-louder calls for fiscal stimulus in the West may also be stoking thoughts of future inflation, with Prime Ministers Shinzō Abe of Japan, Matteo Renzi of Italy and Justin Trudeau of Canada all openly championing such programmes. Elsewhere, Britain’s Theresa May has raised the issue of infrastructure bonds and tacitly begun to back away from her predecessor’s austerity drive.

This makes a dash to ‘real’ assets understandable, especially if advisers and clients believe central banks are moving from tacitly inflationary policies to ones that are overtly so. After all, low unemployment figures, resilient retail sales, a weak pound and increases in consumer price, retail price and especially producer price inflation have elicited no comment at all from the Bank of England. The wise owls at Capital Economics still expect a further interest rate cut, to 0.1% from 0.25%, in November.

Someone, somewhere seems to be positioning themselves for, and perhaps seeking protection from, more easy central bank money.

Commodities are the best performing major asset class in the year to date.

Source: Thomson Reuters Datastream.

This suggests a long run of marked underperformance, relative to equities and bonds, may be finally coming to an end – although it should again be noted the downward plunge in bond yields does not sit easily with such a scenario.

The chart below shows how commodities’ annual performance ranks, as benchmarked by the Bloomberg index, against equities, investment grade corporate bonds and high yield bonds. The best performer each year was ranked one, the worst five.

Commodities are rebounding after five years in the wilderness

Source: Thomson Reuters Datastream

Ways to play

The lack of a yield and their price volatility may still deter many advisers and clients from seeking exposure to commodities and they may not be suitable or appropriate for everyone. Those who do feel raw materials may offer some useful diversification in a balanced portfolio still have to tackle the question of how best to address the asset class.

The first option is to pick a specific commodity and access that via an Exchange-Traded Commodity (ETC), as few advisers and clients will want to go to the trouble of storing or insuring their raw materials, even if this is feasible (which, in the case of livestock, crops, oil or uranium, is unlikely).

However, selecting the ‘right’ commodity and avoid the ‘wrong’ ones, to ensure wealth is created and not lost, is the devil’s work. This table of the performance of 20 leading commodities suggests as much and to pick silver and zinc and avoid cocoa and corn, for example, would have required a powerful crystal ball.

Silver is the best performing raw material in 2016 so far, uranium the worst

Source: Thomson Reuters Datastream

Moreover, advisers and clients are unlikely to have the time or inclination to research the finer points of supply and demand for each raw material, let alone the weather or political situation in key supplier countries.

This suggests that an Exchange-Traded Fund (ETF) which tracks and delivers the performance of a broad range of commodities, minus the running costs of the fund, may be a less risky way forward.

The table below shows the top five performers over the past five years (and no-one will miss how badly they have done), although it is fair to say these are specialist tools and they are quite small. Thankfully, several more instruments have subsequently been launched within that time frame.

Best performing commodities Exchange-Traded Funds (ETFs) over five years

Source: Morningstar, for Commodities Broad Basket category

Time to take stock

A further option is to invest in stocks which specialise in commodity exploration, production, distribution or trading. A quick glance at the leading sectors in the FTSE All-Share so far in 2016 suggests this can be a successful strategy, as raw materials plays top the list of 39 industry categories:

Commodity sectors currently lead the way in the FTSE All-Share in 2016

Source: Thomson Reuters Datastream

However, this comes after a long period in the doldrums. This next chart shows how the Mining, Industrial Mining, Oil & Gas Producers and Oil Equipment and Services sectors have ranked from 1 (the best performer) to 39 (the worst) within the All-Share over the past decade. The past few years have been bleak, although this may only fire the ardour of natural contrarians, especially if they feel central bank policies mean the ultimate endgame is inflation:

Commodity equity sectors were out in the cold during 2011-2015

Source: Thomson Reuters Datastream

Spotting a sector that may be on the rise does not solve the problem of which stocks to pick, and this is where a skilled fund manager will look to add value. There is a wide range of options of both open-ended funds and closed-ended investment trusts.

Best performing Global Natural Resources funds over five years

Source: Morningstar, for Sector Equity Natural Resources category
Where more than one class of fund features only the best performer is listed.

Best performing commodities and natural resources investment trusts over five years

Source: Association of Investment Companies and Morningstar, for Commodities and Natural Resources category

Advisers seeking a lower-cost passive option can also look to ETFs which track baskets of companies who specialise in agriculture, timber, energy, industrial metals and precious metals, while multi-asset funds will also use commodities as part of their armoury.

Oil and gold

Within the commodities world, there are still one or two signals which do question the current run. The Baltic Dry shipping index, which measures the cost of shipping coal, iron ore and grains across 23 routes, is still flat, seemingly in choppy waters:

Baltic Dry index is still finding the going tough

Source: Thomson Reuters Datastream

Meanwhile, oil may be perky, but Dr Copper, that well-known barometer of economic health, is still looking peaky. Oil’s latest spike seems to owe a lot to hints dropped by the new Saudi Arabian energy minister, Ali Al-Naimi, that OPEC is to host an ad hoc meeting in late September to discuss methods to bring supply and demand into a healthy balance.

That traders have so willingly bought into such a narrative is a little surprising. April’s Doha meeting led nowhere and neither informal summits nor the regular scheduled meetings in Vienna have a great record of reaching agreements, or sticking to them on the rare occasion there is an accord.

Oil and copper are sending conflicting signals about the global economy

Source: Thomson Reuters Datastream

Ultimately silver and gold both sit near the top of the commodity performance tables, to suggest the asset class’ renaissance owes more to record-low interest rates and QE programmes, and fears of long-term monetary debasement and inflation, than hopes for improved economic growth.

Gold peaked north of $1,900 an ounce in September 2011 in dollar terms. It then plunged as it looked as if the global economy was about to pick up pace and interest rates rise.

Neither of those scenarios has come to pass and the precious metal has rallied. This chart shows it in dollars, but the next three show gold in sterling, euros and finally yen.

Note that they began to recapture their footing in spring 2013, just when Tokyo’s Prime Minister, Shinzō Abe, and Bank of Japan Governor Haruhiko Kuroda announced Japan’s launch of its latest Quantitative Easing programme.

Gold has begun to advance smartly in dollars ....

Source: Thomson Reuters Datastream

…. tread water in yen after a good run ....

Source: Thomson Reuters Datastream

…. but is potentially gathering pace in euros …

Source: Thomson Reuters Datastream

…. and has rocketed in sterling terms this year.

Source: Thomson Reuters Datastream

It can be argued gold has also done solidly enough in euros and badly in sterling, so at least a theme can be discerned. The precious metal is doing well where central banks are running QE at full throttle - creating electronic money out of thin air - and less well where QE programmes have been called to a halt (at least for now).

In this respect, gold bugs will argue it is doing its job, as a store of wealth and source of protection against the debasement of ‘fiat’ currency. It will be therefore interesting to see what gold does if Europe stops its QE scheme on time in September 2016 and if Japan ever presses the ‘stop’ button (not that the Bank of Japan seems inclined to do so at the moment). It will be equally interesting to see what it will do if the US and UK ever raise interest rates – in theory it should fall – although they seem in no hurry either. The battle lines between fans and haters of gold therefore remain as clearly drawn as ever.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.