Commodities: Why Now? An Investment Case


Commodities: Why Now? An Investment Case

Executive Summary

Commodities fuel the world's economy. Raw materials like copper or crude oil are essential for industrial processes in all sectors of all markets, from Buffalo to Beijing. As such, commodities offer a unique opportunity to invest in economic growth at its most elemental level.

After the commodities bubble burst in 2012, however, many investors exited their commodities positions, either in part or in total. Still others shied from the asset class altogether.

But the investment benefits of commodities haven't changed. Commodities can serve as a powerful tool in the investor's toolbox, offering the means not only to diversify portfolios and potentially lower overall risk, but may also help to stave off the wealth-eroding impact of inflation.

In this paper, we explore the investment case for commodities as an asset class, including:

  • Why cyclicality in the commodities markets matters to investors
  • Why signs point to now as an ideal re-entry point to the asset class
  • The two roles commodities should serve in every investor's portfolio

Putting Commodities in Context

With Commodities, History Repeats Itself

The commodities market is famously cyclical, characterized by protracted bull and bear markets that are intimately tied to global industry. As economic growth picks up, commodity stockpiles tend to decrease, boosting prices. These shortfalls rev producers into higher gear, which adds to supply and depresses prices once more. That in turn encourages more industrial growth. And so the process repeats over multi-year periods, a tug-of-war that underpins the entirety of the commodities market.

The mid-2000s, however, saw a rally of extraordinary proportion. Buoyed by demand from emerging markets—primarily China and India—commodities prices roughly tripled between 2000 and 2011. Crude oil, copper, steel, and aluminum all struck record highs.

Then, in 2012, the bubble burst, due to two main factors:

  • China began scaling back its manufacturing sector and restructuring toward a service-based economy, decelerating growth. The country's demand for all kinds of raw materials fell.
  • The US shale oil industry came of age, flooding the market with cheap alternatives to Middle Eastern crude oil. This led to chronic oversupply in the energy markets, as traditional oil producers were slow to reduce their output.

The one-two punch of slowing Chinese demand and the crude oil glut depressed prices across the commodities market. Even grains and other foodstuffs suffered, as investors fled the asset class just in time for better-than-expected crop yields to exacerbate oversupply.

Ever since, commodities performance has languished. But in these markets, one thing is certain: What goes up must come down – and back up again.

Why Commodities Now?

Several favorable supply/demand fundamentals suggest that commodities may be on the verge of their next big bull market phase:

  • An increasing consumer base Each year, the global population rises by 1.11% 1 , and thus, 80 million new commodity consumers enter the market. These consumers will need not just foodstuffs, but also energy sources and industrial metals to power the goods, appliances and devices essential to life in the 21st century.
  • The urgent need for infrastructure Even as emerging markets like China undertake a massive build-out of new infrastructure, developed markets are in dire need of infrastructure repairs, replacements and upgrades. Both kinds of construction will require plenty of raw materials, especially metals and fuel.
  • Rebounding world growth Currently, the Organisation for Economic Co-operation and Development (OECD) projects that over the next two years, the global economy will grow its fastest pace in six years, rising from 3.1% in 2016 to 3.5% in 2017 and 3.6% in 2018. As the global industrial engine picks up, then so too should its expected demand for commodities.

Understanding the Role of Commodities in a Portfolio

All else held equal, investors generally prefer asset classes offering higher, not lower, expected return. Though commodities' recent performance has been underwhelming, history shows that over long time periods, the asset class has generated significant returns for investors.* Research by Yale economists 2 found that over a 60-year period, commodities returns vastly outpaced those of bonds and even remained on par with equities, but with less expected volatility.

Because of the cyclicality of commodity markets, however, it's important to think of this asset class in terms that go beyond expected return. For investors, especially for those with long time horizons, commodities serve two important portfolio functions:

  • As a potential hedge against inflation
  • As a diversifier to other assets, such as equities or bonds

We examine each of these roles in turn.

Commodities as an Inflation Hedge

Inflation is one of the biggest threats to long-term accumulation of wealth. It dilutes the real value of money, especially over long periods of time, ensuring that each dollar spent buys less than the one before it. Worse yet, inflation is hard for investors to predict or even plan for.

Historically, commodities have provided a powerful hedge against inflation, as the two are co-linked to economic cycle 3 . As the economy expands and generates inflation, demand for raw materials also rises, which in turn pushes commodities prices higher.

*Past performance does not guarantee future results

When inflation increases, so too do commodities prices; though the correlation is not perfect, it has held true over many time periods. As Table 1 reveals, commodities were one of the few asset classes that worked as an effective inflation hedge in both the 1990s and 2000s:

Table 1: Asset Class Correlations to the CPI in 1990s and 2000s

Asset Class Correlation to CPI – 1990s Correlation to CPI – 2000s
Commodities 0.15 0.35
Gold 0.14 0.05
U.S. Equities -0.31 0.05
International Equities -0.21 0.07
Emerging Market Equity -0.04 0.08
U.S. Bonds -0.06 -0.20

Source: Bloomberg, Monthly correlation from Dec. 31, 1989 to Dec. 31, 1999; and from Dec. 31, 1999 to Dec. 31, 2009. Data series used include commodities: S&P GSCI Index, U.S. equities: S&P 500 Index; U.S. bonds: Bloomberg Barclays US Aggregate Index; International equity: MSCI EAFE Index; Emerging market equities: MSCI Emerging Market Index; Gold: Spot Index

This relationship holds true even today. Over the past 15 years, commodities have exhibited a positive correlation to inflation that far exceeds that of any other asset class, even gold (see Table 2):

Table 2: Asset Class Correlation to the CPI, 2002-2017

Commodities U.S. Equities International Equities U.S. Bonds International Bonds Real Estate Gold
0.41 0.06 0.10 -0.03 -0.23 0.06 0.06

Source: Bloomberg. Monthly correlations from 6/30/02-6/30/17. Data series are same as above, except in the following cases: International equities: MSCI ACWI Ex-US Index; International bonds: Bloomberg Barclays Global Aggregate Index; Real estate: DJ US Real Estate Index

Though in recent years inflation has remained anemic, it appears to be revving back up again. In the U.S., the CPI struck a five-year high in February 2017, rising 2.7% over the 12 months prior. Looking more broadly, the OECD recently found that in January 2017, the annual inflation rate in developed markets had jumped to 2.3%, or its highest rate in roughly 5 years.

As expected, commodity prices have also begun to creep higher. Crude oil prices have rebounded from sub-$30/barrel to roughly $50/barrel in 2017, based on emerging market demand growth, reduced Middle East production, and lower global stockpiles. Food prices are also on the rise, with grains and softs inching higher from their multi-year lows.

The next inflationary period is not a matter of if, but when. Commodities may help investors make sure their portfolios weather the storm.

Commodities as Portfolio Diversifiers

Correlations 4 are the secret sauce of a well-diversified portfolio. By combining assets with low correlations to one another, investors may lower their portfolio's expected volatility without negatively impacting returns. Over the fifteen year period ending June 2017, commodities exhibited low correlations to other asset classes, such as stocks and bonds (see Table 3):

Table 3: Commodity Correlations to Other Asset Classes, 2002-2017

U.S. Equities International Equities U.S. Bonds International Bonds Real Estate Gold
0.33 0.48 0.26 -0.03 0.19 0.31

Source: Bloomberg. Monthly correlations from 6/30/02-6/30/17. Data series are the same as in Table 2.

Commodities move independently of other assets because the forces driving their supply and demand patterns are unique. Production of most commodities, for example, is highly sensitive to weather and geopolitical strife, both of which tend to have limited effect on the typical blue chip or Treasury bill.

In the wake of the financial crisis, correlations between the asset classes collapsed, and commodities began to move in tandem with equities and other assets. This led many investors to fear that the traditional intra-asset correlation relationships no longer applied.

In recent years, however, the historical supply/demand fundamentals have quietly reasserted themselves, and commodities have regained their independence as an asset class. Commodities' correlations to other asset classes have reverted to historical norms.

Conclusion

Commodities have their ups and downs. But for investors who may have been wary in the past, today's favorable market fundamentals suggest now might be an ideal re-entry point into the asset class.

GraniteShares provides investors with innovative exposure to the commodities market. These ETFs follow the same basic three-point philosophy:

  • Low Cost: GraniteShares ETFs are lower cost than nearly all other competing products tracking the same indexes.5
  • No K-1 Filings: Likely fewer delays at tax-time or surprise income to declare.
  • Familiar Product Structure: 40 Act structures may be familiar to advisors and investors and may avoid certain risks that may be associated with partnerships or other exchange traded products.

Among GraniteShares funds are the GraniteShares Bloomberg Commodity Broad Strategy No K-1 ETF (COMB) and the GraniteShares S&P GSCI Commodity Broad Strategy No K-1 ETF (COMG).

1 Source: World Bank, 2016
2 Bhardwaj, Geetesh; Gorton, Gary; and Rouwenhorst, Geert. Facts and Fantasies About Commodity Futures Ten Years Later". Yale International Center for Finance. 2015. PDF available at: http://ssrn.com/abstract=2610772
3 In fact, commodities and inflation are so intertwined that commodities are baked into the very definition of inflation, which is commonly measured via the Consumer Price Index (CPI). The CPI's basket is one-quarter comprised of foodstuffs and energy stocks, and it is these two commodity subclasses that primarily drive the measure's day-to-day volatility.
4 Correlations measure how closely the performance of two assets are linked. A correlation of +1.0 indicates two assets that move up and down in perfect sync. A correlation of -1.0 indicates two assets that move perfectly opposite of one another: When one moves up, the other moves down the same amount. A correlation of 0.0 indicates perfect non-correlation: Each asset class moves independently of the other.
5 ETF.com, July 2017
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