From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, iShares, the world's largest ETF provider addresses tjhe 'commodity conundrum' and asks whether commodities can stay strong without inflation.If you are interested in Morningstar featuring your content, please provide your details and/or submit your article here.
While many cyclically oriented commodities have been under pressure, and are likely to remain that way given further weakening of the global economy, we continue to believe that investors should consider maintaining a strategic weight to commodities as an asset class.
Although individual commodity prices can be extremely volatile, over the past 25 years the volatility of a broad commodity index has been in line with that of developed market equities. Furthermore, across a long-term horizon commodities are diversifying and have historically helped improve the risk/return characteristics of a portfolio. Finally, while the lack of a dividend or income stream makes commodities difficult to value, we find little evidence to support the notion that the entire commodity complex has entered into a bubble.
That said, the future trajectory for commodity returns will largely be determined by the macro environment. Over the long term, commodities, and gold in particular, have historically benefited from inflation and a weak dollar. In addition, the returns of more cyclical commodities like industrial metals are influenced by economic growth.
However, arguably the greatest determinant of commodity performance is likely to be the level of real interest rates. Historically, commodity prices have benefited the most not from inflation, but from low or negative real rates, which lower the opportunity cost of holding an asset that produces no income. Perversely, as long-term interest rates fall, even in the face of stabilizing inflation, this is arguably supportive for commodities. To the extent long-term rates remain low or negative -- even in the context of a slow growth economy -- this may be the most important consideration for the asset class in general, and for gold in particular.
“The next shock? The price of oil has fallen by half in the past two years, to just over $10 a barrel. It may fall further.” The Economist, March 4 1999
Out of Favour to Flavour of the Decade
The Economist was not
the only famed institution to get its commodity call wrong. About two
years after The Economist famously suggested that crude oil was going to
$5/barrel, the Swiss National Bank was in the process of dramatically
reducing its gold stocks, mostly replacing them with paper currencies.
Between May 2000 and September 2001, the Swiss National Bank sold 320
tons, averaging 20 tons a month. At the time, gold prices averaged about
$270/ounce; so much for the market timing skills of central banks.
In fairness to both The Economist and the Swiss National Bank, by the late 1990s many had long since abandoned commodities as an asset class. The notion of holding physical assets as a strategic part of a portfolio would have been considered eccentric, if not irresponsible, even a decade ago. Of course, as was the case with equities in the early 1980s, that was the opportune moment to buy. Since the lows in 1998, a broad commodity benchmark – the CRB Index –is up approximately 150%. For many of the better known commodities, the gains have been much more spectacular. Over the same time period, gold is up approximately 500%, copper has gained around 550%, and crude oil has advanced by 800%.
Today, both institutional and retail investors have been increasingly allocating to this asset class. This newfound fascination with physical assets is even more interesting when you consider that commodities are typically viewed as an inflation hedge, and the last decade has been characterized by the lowest inflation rates since the early 1960s.
Click here to see a chart of net speculative commodity interest 1930 to present.
In evaluating whether investors should continue allocating to the asset class, we focus on three aspects of commodity investing. First, we look at the risk characteristics, i.e. how risky and diversifying are commodities? Second, we attempt to answer the question, are commodities in a bubble? Finally, we examine the macroeconomic conditions that have historically impacted commodity prices. As we’ll highlight in the final section, contrary to popular wisdom, inflation is not the single most important variable.
