Uncertain outlook brings return to volatility

Commodity markets are hugely volatile as sentiment switches back and forth from optimism about a recovery to fears of a double dip recession. As each new set of data points one way or the other, prices of copper, aluminum and other key metals fluctuate accordingly.

However, the big challenges, the sovereign debt crises and lacklustre growth, have both taken a turn for the worse. Economic growth, for example, has faltered as the huge government stimulus projects and loose monetary policy that had helped spur industrial restocking last year, draw to a close. Metals such as copper and aluminum have fallen by about 20 per cent since the start of April while mining stocks such as BHP Billiton and Rio Tinto, which had been in favour in the initial post-Lehman recovery, have fallen by similar amounts.

Fund managers are split on whether China’s growth will slow in the second half. The Chinese Government has tightened monetary policy to keep the lid on inflation, while its $580bn (€474bn) stimulus package is coming to an end.

David Field, commodities portfolio manager at Carmignac Gestion, is currently overweight gold at 30 per cent, largely reflecting difficulties in Europe, but he does not anticipate a double dip in global growth.

Emerging market growth

“We are still getting good signals on inventories from China,” says Mr Field. “For the first time in eight to nine months, copper stocks are consistently falling. Copper is the bellwether of base metals, the best indicator of industrial growth, while in comparison for example nickel’s price can be influenced by purchases of small amounts of inventory. So physical demand indicators are good and I am confident in the outlook for the next 12-18 months,” he adds.

“Long-term trends in emerging markets are extremely supportive,” says Mr Field. “We saw above trend growth and prices in commodities for a long period in the 1960s owing to Japan industrialisation, but China is much bigger than Japan ever was and should support prices for longer. This considerable growth is based on the urbanisation and modernisation of China but following on behind are India, Indonesia, Brazil and Argentina, and Russia as well, so this is very comforting for the long-term.”

Others make a comparison with the 30-year cycle to rebuild Europe at the end of the First World War.

Fund managers are most bullish about bulk commodities such as iron ore, coking coal, and copper, which looks well supported, and least bullish about aluminium, because there is already significant capacity, and steel, because China has boosted its capacity and some of that steel could end up in export markets.

Mr Field points out that iron ore producers have a very strong bargaining position. Some 75-80 per cent of the seaborne iron ore trade is concentrated in the hands of just five players. Three players, Rio, BHP and Vale Operations in Brazil, control 65-70 per cent of the market and are implementing big price hikes.

However, steel prices have fallen for seven consecutive weeks as the more fragmented steel industry faces a slump in demand for its finished product. The China Iron and Steel Association has warned that steel production will fall in the second half. Both miners and steel producers could face a further wave of downgrades once this impasse is factored into their long-term forecasts.

“The fundamentals are still strong but we’re going through significant macro-economic headwinds, which are affecting the valuation of equities but are outside of their control,” insists Evy Hambro, joint chief investment officer at BlackRock. “These companies are trading on valuations that do not reflect their underlying profitability. Prices of gold, platinum and copper are up, yet share prices do not reflect this and there are surprising extremities in valuations.”

One headwind is the proposed 40 per cent Australian super tax on the profits that miners make from their Australian assets, which has frustrated big mining groups whose high margin, old assets would take the biggest hit.

Companies in profit

Mr Hambro takes comfort, however, from falling inventories, which have come down quite substantially after the de-stocking two years ago. Copper for example peaked at 18 February but its inventory is down 16 per cent (or 100,000 tonnes) since then.

“One of the most visible indicators of the demand is the premium paid for immediate delivery of metals such as stainless steel or aluminium,” he says. “The profits these companies are making are real, and their balance sheets are now very conservative, so we’ve been surprised to see such volatility.” Evidence suggests investors are taking advantage of the current sell off.

Joanne Warner, fund manager of the First State Global Resources fund, agrees there is value in traditional mining names, such as Xstrata, which have taken a beating in recent weeks. “Stocks are currently pricing in significant falls in commodity prices, making these valuations particularly attractive on a three to five year basis,” she says.

David Field, Carmignac Gestion

“Some of these businesses have reached an attractive point in their lifecycles, having gone through consolidation, particularly in the coal sector, and emerging as big regional players that can optimise their infrastructure and enjoy a lower cost structure going forward.”

Beyond bulk commodities, the picture is mixed. In the benign oil price environment, Jonathan Blake, manager of the Baring Global Resources Fund, is looking to invest in those companies that can grow their reserves, such as Exploration & Production companies Tullow in the UK and Dana, and integrated oil producers with production growth opportunities such as Rosneft and Chevron.

BP’s problems will drive up the cost of oil production, and a stricter regulatory environment will require refurbishment of offshore and deepwater rigs. A requirement for independent verification of operating systems and equipment could shift the balance in favour of onshore assets where it is easier to deal with difficulties.

In other sectors, particularly sustainable fuels, such as wind farms and fuel cell companies, Ms Warner warns against bubble-like tendencies. “At certain times there can be a lot of money chasing a particular sector which can distort valuations,” she says. When oil prices reached record highs a few years ago, oil sands companies such as Suncor were the flavour of the month and valuations became inflated, but the time to get out is when the proverbial taxi driver starts talking about it.

Limited availability

The same is happening in agriculture, where the universe of large cap stocks is limited and has consequently been chased up. Fertiliser companies may be particularly overpriced. Monsanto is on a PE of 20x, for example. Yet the agriculture cycle is very much a secondary derivative of the urbanisation of emerging economies – essentially a function of rising incomes and changing diets.

Carmignac Gestion’s Mr Field likes fertiliser markets, however, and particularly potash stocks such as PotashCorp, but only as a long-term play. He is wary of overproduction in the short-term, as farmers baulked at the high potash prices last year, buying just 32m tonnes compared with 54-55m tonnes in 2008. A marked rebound at some time is inevitable, he predicts.

Physical foodstuffs are a different story. Prices have stayed at the bottom of their trading ranges for a few years, and managers say there are plenty of opportunities to take bets on single agricultural stories, such as coffee. For example, Peter Königbauer, senior portfolio manager at Pioneer Investments, predicts a good harvest in corn and soya bean as a consequence of the benign weather and planting processes being ahead of schedule, putting crops in a better position to survive the hot summer months.

Gold has soared as one of the few assets that is insulated from the ongoing sovereign debt crisis in Europe, and is currently trading at $1,250 an ounce compared with $950 a year ago.

Baring’s Mr Blake, who has invested 16 per cent of his fund in precious metals, says gold miners have struggled to improve production but there is still demand from central banks in emerging economies, exchange traded commodities and jewellery manufacture. In years past, gold miners hedged their production (ie sold it forward at guaranteed prices), but these positions have been unwound over the last four to five years, so they are in a better position to boost their margins.

Gold has the ability to perform in both an up market and a down-market. Should the world’s economic fears on sovereign debt spill over into the financial world, then gold would act as a safe haven. On the flipside, if there is a strong rebound then easy global monetary and fiscal policy could result in the medium term in higher inflation, and gold traditionally does well in an inflationary environment.

Mr Field invests primarily in gold miners, which are better able to generate returns than exchange traded commodities. “A company with rising production, margins and cash balances should outperform the underlying commodity,” he says.

“We have certainly seen this elsewhere, for example, in the copper mining industry in 2009, when the metal rose 100 per cent but the best copper miners rose 200 per cent, or even 300 per cent.”

Sophisticated investors turn to active management

Commodity investment has ballooned over the last decade culminating in record inflows in 2009 with year-end assets under management of $260bn (€212bn), according to Barclays. The bulk has been into indices and exchange traded products.

However, there is a pronounced new appetite for active commodity funds. “In the past clients would be likely to invest in indices or exchange traded commodities (ETCs) but many clients feel they do not have time to follow this market themselves and keep abreast of developments in all commodity asset classes,” says Jean-Philippe Olivier, head of commodity investments at BNP Paribas Investment Partners. “Investors may also see arbitrage opportunities as more money flows into this asset class, deforming futures curves. Term structure optimisation is one way to play the market.”

“As investors have gained knowledge about this asset class, they require more sophisticated products,” says Jeremy Baker, a portfolio manager at Vontobel Bank in Zürich. “The current shape of the future curves, (most commodities are in contango), has increased the need to look at active positioning of commodities along the curve, to reduce the negative roll yield generated and so create alpha versus the benchmark.

“Exchange traded fund (ETF) products for commodities will most likely remain a dominant factor in the market but limited to specific commodities; for example precious metal products physically backed by gold, silver or platinum,” he says. “ETF products in commodities such as agriculture are more susceptible to seasonal patterns and less likely to gain traction due to the potential for returns to be deflated by negative roll yields. Investors have been willing to invest into ETF-related products on natural gas, but this is a clear sign that the retail client still does not fully understand the dynamics of the term structure.”

As an example of the practice of active funds to manipulate term structure, General Electric Asset Management in May launched its GE Active Commodities strategy to a wider market. “We employ spread or pair trades on up to 30 per cent of the collateral using futures,” says portfolio manager Nick Koutsoftas. “For example, we may short the front of the forward curve and long the back of the forward curve, harnessing patterns and shifts in the curve, or we might long/short different commodities. We have recently been long gasoline and short heating oil, as there is a glut of heating oil while gasoline demand has remained fairly resilient.”

Funds with a long tail of smaller stock holdings can have particular attractions in difficult markets. For example, First State Global Resources fund’s top ten stocks represent the market leaders, but the portfolio also has up to 60 small growth positions, in producers, exploration and pre-development companies, providing access to emerging stories. “The large stock holdings meant we knew in the financial crisis that we could liquidate a large percentage of the portfolio if we had to and clients knew it too, which gave them peace of mind,” says fund manager Joanne Warner, “while meetings with the managements of the growth companies and visiting their key assets meant that in the crisis it was easier to evaluate any news flow for what it was.”