Hold your nose and buy industrial commodities!

Tom Traill - 21 September 2017

There is a fashionable bearishness about commodities that should immediately arouse suspicion. The China slowdown narrative is trotted out as the clinching argument to refute the expectation of further commodity price gains or commodity fund appreciation. The problem here is twofold: there is no meaningful deceleration in the official data for Chinese real GDP growth and there is clear recent acceleration in nominal GDP growth, which arguably is the measure that is relevant for commodity prices. In addition, the One Belt, One Road (OBOR) initiative underscores an ongoing bias in Chinese economic development towards natural-resource-hungry visible trade, industrial output and construction.    

After a storming recovery in energy-led commodity returns in 2016, the following six months brought mostly disillusionment.  The retracement of the oil price was sharp and swift, and oil’s weightings meant that those looking for commodities index returns have been largely disappointed. The price lows of 2016 were meant to create the platform for abundant returns, not just in 2016 but for years to come.  Hopes that co-ordinated global economic expansion would carry the entire commodities complex higher have not yet materialised. Where now for commodities?

The valuation gap between commodities and equities has rarely been as enticing as it is today (figure 1). Despite the horrendous bear market, which saw Diapason’s global commodity composite index halve in the 5 years to the start of 2016, there remains a grudging enthusiasm for the asset class as investors can find little value in equities or bonds.

The commodities indices are weighted aggregates of several components: 24 in the case of the Goldman Sachs Commodities Index (GSCI). Within this aggregate crude oil plays a large role – in the GSCI WTI crude oil represents 22.8 per cent in 2017 and Brent crude oil, another 16.49 per cent. The oil price crash of 2014-15 has had a dominant effect on the total returns of the commodities index (figure 2), with poor oil returns masking the fact that the other components have made net positive contributions for the past year and a half.

Those wary of investing in commodities argue that some metals look technically over-bought, and that the Chinese pre-plenum push is fading out. However, within the context of 3 per cent annual real global growth, there is an ever-increasing need to grow food crops, build houses, propel vehicles and planes, manufacture goods and heat buildings. These all require raw materials at some stage in the process, implying that there should be growing markets for the great majority of these products.

It should not be overlooked that China has also clamped down on polluting vintages of iron ore smelters and other heavy plant. An accurate assessment of supply destruction and economic obsolescence is critical to the commodity price outlook. The accumulation of strategic reserves of energy and metals is another factor that could mitigate the impact of future demand weakness. There are some interesting developments already underway, and, from a low base, profit multiples are undemanding. For the courageous, commodities can still offer some attractive opportunities.

Figure 1: 

Data source: Thomson Reuters Datastream

Figure 2:

Data source: Thomson Reuters Datastream

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