When 2016 is history and we reflect on the year that was, the gyrations in the price of commodities, and the companies that produce them, will undoubtedly be one of the key areas of focus. At the start of the year, commodities were deeply unpopular and unloved yet have been dramatically rehabilitated in the view of market participants.
This is evidenced by the sharp recovery in spot prices, related share prices, positive fund flow data and a significant drop in those speculating on further falls. Despite this sharp change in sentiment, commodity investment remains largely unpredictable in the short-term and volatility numbers remain abnormally high on most measures. Amidst the ongoing struggle to identify an equilibrium price post-recovery, it is difficult to see a reversal in this volatility anytime soon.
The most notable example of both the recovery in sentiment and ongoing volatility is the price of gold, which has increased 23.43% for the year. Despite the strong rise, it is the share price movements in gold mining companies that have witnessed enormous divergence. Across the past year, the three biggest gold miners – Barrick (ABX), Newcrest (NCM) and Goldcorp (G) – have increased 159%, 71% and 17%.
Supply and Demand Under the Spotlight
Underpinning this volatility are some noteworthy supply and demand dynamics. From a supply side, we have not seen any substantial changes to gold mining production which is important as it represents 73.9% of total output with the remainder coming from recycling and hedging supply according to data from the World Gold Council.
Hence, with gold supply appearing reasonably stable it is natural to look to changes in the demand for gold as the key driver of the recent price change and possibility for future strength.
Here the news is less encouraging for those seeking to benefit from further rises in the price of gold. As figure 2 indicates, we are witnessing a major shift towards speculative buying behaviour as evident by the increase in ETF holdings of gold, shown by the red line. In contrast there appears to be a falling desire for gold jewellery and central bank purchases, shown by the black and green lines, which account for a combined 70.2% of the total gold demand. The question remains whether this builds a case for potential future weakness.
If we dig another layer deeper, we can also see where the changes reside by geography. On a trend basis, we see a picture of potential concern, as India’s consumer demand for gold, down -17% year-on-year to June 2016, is falling quite sharply, only marginally worse than China, down 14%.
To many, this seems rather paradoxical given India and China have two of the fastest growing economies in the world; and thereby requires a gold buyer to carefully consider whether the cultural progression in these countries might mean lower jewellery demand is a more permanent shift.
To illustrate the importance of India and China on the gold price, they currently account for 25.1% and 30.4% of total consumer demand while the United States and United Kingdom only account for 5.5% and 1% respectively.
An additional point to raise is the relationship between gold, inflation, interest rates and the US dollar. The price of gold often moves in the opposite direction to the dollar reflecting the fact that many regard the yellow metal as an alternative currency. The use of gold in this way is especially attractive in the current low interest rate environment as the opportunity cost of owning gold, the interest rate paid on bank deposits plus the cost of safeguarding gold) is unusually low.
We suspect this is behind the current populism of gold ETF speculation, however it is important to remember that while gold is generally seen as an inflation hedge, it is rising real yields that will eventually become the enemy.
Is Gold a Good Addition to Your Portfolio?
With the supply backdrop stable and the demand backdrop facing a potentially structural shift, it makes the long-term investment case increasingly difficult to fathom. This in turn highlights the key challenge of investing in commodities. As these commodities have no intrinsic value, returns are governed by the balance of demand and supply together with the degree of speculation present in the market. These factors are all extremely difficult to predict and as a consequence, investment in this area has a low probability of success.
Rather than engage in this speculation, the investment team at Morningstar focus on fundamentally attractive valuation-implied outcomes. This means our analysis of the commodity cycle is purely valuation-driven and leads to a preference for assets that are undervalued relative to a conservative estimate of the cash flow they generate. Currently this approach is leading us to regional equity holdings in selected areas within Europe and the emerging markets.
