A positive if volatile outlook

Commodities have bounced back since the start of the year, with copper up 60 per cent, zinc up 30 per cent and even aluminium, the laggard, up 18 per cent. The Reuters/Jeffries CRB index, which measures a basket of commodities, rose 13.8 per cent in May, its strongest rally since 1974. Most fund managers are generally positive on the sector’s outlook for 2009, believing the asset class could increase by 20 per cent or more this year, but with high volatility. Long-term, the big structural drivers in commodity prices we have heard so much about in recent years still hold good. Supply will continue to be constrained as the mining industry deals with geological and political challenges, while the development of emerging economies with western tastes and other demographic changes will create unprecedented demand. China encouraging In the immediate future, however, further recovery in the commodities market will depend on a resumption in growth in both China and the western world, running concurrently as in 2004-5. But while the news coming out of Asia is encouraging, the pick up in the US is slow. First China. Here, there are grounds for optimism. In just a decade, the People’s Republic has moved from accounting for 2 per cent of global demand to 20-45 per cent, depending on who you believe. In 2007, emerging markets equalled the demand of developed markets, but given their relative resilience during 2009 they now probably account for a larger share. To demonstrate China’s scale, the annual growth in its demand for copper is equivalent to the absolute amount consumed by India. Encouragingly, therefore, its recent record iron ore, copper and coal imports have done a great deal to compensate for the slowdown in the western world. Catherine Raw, a member of BlackRock’s natural resources equity team, points out that the Baltic Dry Freight index, a measure of the price of bulk shipping and an indicator of the trade in commodities from Brazil to China, fell over 90 per cent from a peak in May last year to September, revealing the severity of the situation when the mining world went from operating at maximum capacity to suddenly drying up. But the Dry Freight index is now up nearly 450 per cent from its low, indicating that trade has returned, albeit from a low base. “China is a command economy and the fiscal stimulus is consequently already trickling down to the real economy in a way not seen in the US,” says Ms Raw. She adds that 4600bn renminbi in Government-driven lending in the first quarter is a huge expansion in lending. “Chinese GDP growth for the first quarter is up 6.1 per cent from a year ago. That’s instead of around 10 per cent last year but it’s a stronger number than it appears. Goldman Sachs recently upgraded growth in China this year to 8.3 per cent, up from its earlier projection of 6.0 per cent. “The decoupling theory is still there. The question is, is this a restocking event or a fundamental return to growth? The next three months will be critical,” she explains. The drivers of the economy in China are very different, Ms Raw believes. “The Government needs to keep its people in business, and policies are changing. Rural land reform, for example, should give farmers more rights over their land, enabling them to borrow from banks using their land as collateral, increasing spending and boosting growth over the next decade.” A cloudy view Visibility on the US economy is murky. In recent months this has created a shift towards agriculturals, seen as the sector that is least impacted by the economic situation. “We favour agriculture and specifically corn and soybeans during the second half of this year,” says Manfred Schraepler, head of fund structuring at Deutsche Bank. “This reflects strong Chinese demand in the case of soybeans and a decline in corn acreage in the US. We expect the gains in crude oil and copper will be unsustainable into the second half of the year, based on our view that the US will not post positive growth until January 2010, the S&P500 will stage another downleg and GDP growth in China will slow markedly into the fourth quarter of the year. In addition we view the rally in many commodity prices during Q2 as more flow driven than reflective of underlying demand,” he explains. Inventories have been kept under greater control than in previous downturns, with mines slashing high cost operations and reducing capacity, which has cut coking coal production by 13 per cent, nickel by 22 per cent, chrome by 65 per cent and platinum by 12 per cent. For example, 17-18m tonnes of copper is produced globally annually but last year 4m tonnes was from secondary sources that are only viable when the price is high. David Field, fund manager of Carmignac, reckons that 1-2m tonnes has disappeared from supply that had been worthwhile recovering when copper was $3-4 lb but not when it bottomed out to $1.3. Copper inventories therefore came down faster than expected. Although base metal inventories have increased, the fact that they have stabilised at or below the absolute levels seen at the bottom of the last cycle is positive. If we take copper as an example, inventories are currently at around 4 days of global consumption compared with three weeks during the previous bear market. Nevertheless, agriculturals are very much the flavour of the day, underpinned by the ‘3 Fs’ – food, feed and fuel. For example, Chris Eibl, founder of active manager Tiberius in Zug, likes coffee for its independence from the business cycle and says demand is increasing steadily. Again, stock levels are low and farmers in Brazil have had problems in obtaining finance and buying fertilisers, while demand is still increasing, even if consumers are trading down in their beverages. “Agricultural commodities are attractive against a background of the increasing global demand for food, but they present risks too,” warns Martyn Surguy, head of UK portfolio management, at Deutsche Bank Private Wealth Management. “They are very volatile - it is relatively easy to turn land over to agriculture when prices have risen. Over the very long term commodities should trade at the marginal cost of production but where there is a supply demand imbalance you can have protracted periods where that is not the case. That is what we have to identify and exploit for client benefit.” A mine of opportunity From their peak in May of last year to the low in November, mining equities fell over 76 per cent. Since that low, the mining sector is up over 100 per cent but share prices are still only half their peak levels, which makes them cheap if you believe in the long term fundamentals. Fund managers are also adding to their positions in related stocks such as oil services companies like US-listed Schlumberger, which specialises in secondary recovery, seismic data and reservoir enhancement. “An oilwell’s best day of production is its first day as every subsequent day reservoir pressure diminishes,” says Carmignac’s Mr Field. “Seventy per cent of current oil production comes from fields more than 30 years old. A lot of mature fields need recovery enhancement.” He also likes offshore drilling companies such as Transocean. “Every time a major oil company tries to improve its production they need a drilling rig and new oil discoveries are predominantly offshore in deep water such as the Gulf of Mexico or offshore Brazil,” he adds. Each rig costs $550-600m and there are only around 80 in the world. In the agricultural space, fertiliser potash is most constrained on the supply side amongst the three major fertilisers, giving producers a degree of pricing power. Just 5-6 companies control 85 per cent of the market. Most equities in the sector are trading at mid double digits on this year’s earnings and low double digits on next year’s forecasts. “In commodities, the traded price is what you make,” says Jonathan Blake, fund manager of the Baring Global Resources Fund. “If you invest in commodities indices, most are in contango, when the futures’ price is above the expected future spot price, which is a drag on performance. “In equities, you can make a capital return, and also a return from dividends. Many mining stocks and large energy shares are currently yielding 3.5-7 per cent. A third source of returns is the potential for reratings as the economic recovery takes hold and the cost of capital declines. There can also be a further return from currency as commodities are generally priced in dollars.” Investors have been keen to put money back into the markets and this sector has been a prime beneficiary. The first quarter was marked by huge inflows into gold as a safe-haven investment. “But going into Q2, the market has seen a substantial increase in allocations to long-only, beta and enhanced beta commodity indices, mainly from investors aiming to position themselves for a recovery in commodity prices,” says Mr Schraepler. The Pioneer tracker is such a fund, based on the broad and diversified basket of commodities combined in the DJ-UBS commodity index.

Research and expertise vital in volatile sector “Clients have been interested in the boom stories in China and other emerging markets such as Brazil,” says Tom Fekete, head of investment products, Barclays Wealth. For commodities, Barclays Wealth generally prefers actively managed funds. “Expertise in physical commodities trading, depth of economic and sector research and ability to invest in upward and downward price trends are critical in this volatile and supply demand-driven asset class,” Mr Fekete adds. Barclays Wealth often recommends BarCap’s Corals, a Ucits fund which invests across 12 of the most liquid commodities, and can go short or long in each individual commodity. This is similar to the DB Platinum Commodity Euro fund. The manager also engages with clients on selecting tactical investments and recently suggested the Schroder Agriculture fund which proved popular. Many wealth managers are cautious about exchange traded funds (ETFs) as they can introduce credit risk through swaps, although most are happy to use ETCs for gold exposure. “ETFs that are collateralised with the underlying asset are as close as you can get to holding the physical asset and are very liquid, so they’re an attractive vehicle for our managers,” says Martyn Surguy, head of UK portfolio management, at Deutsche Bank Private Wealth Management. “ETFs are ideally suited because they enable us to move nimbly and cost-effectively between various commodities.” The firm increasingly uses ETFs to access soft commodities as well, moving away from their traditional use of specialist managed funds to access softs on the grounds of expense. “We also occasionally use structured notes,” adds Mr Surguy. “Commodities are obviously volatile, and this can offer clients protection from potential downsides if their risk appetite requires that. “Deutsche has also been at the vanguard in creating commodities indices. Over time the performance of commodities tends to be mean reverting; these indices, among others, have allowed us to identify good and poor performers against their sector mean, moving client money out of those commodities that have had a good run into those that have performed badly to capture early gains,” he explains. Investments in commodity futures are often blighted by the cost of the roll, caused by contango, where the investor receives a lower price for selling a maturing futures contract than he pays for buying the next contract. Fabien Weber, senior portfolio manager at Julius Baer, notes that providers have been developing products that are diversified across a range of maturities to avoid excessive rollover costs.