Commodities - MARCH 11, 2015

How low can they go?

by Sheila Hopkins

Because the commodities assets class is uncorrelated with other investment classes, it is often used to diversify a multi–asset class portfolio. If the stock market goes down, commodities could very well remain up. Unfortunately, the converse is also true. A rising equities market doesn’t mean a rising commodities market — as we are now seeing.

While most of the country is cheering falling oil prices, a strengthening dollar and bumper grain crops, commodities investors are watching their investments fall off the cliff. Good news for the economy doesn’t translate into good news for commodities.

In its January Commodities Markets Outlook, the World Bank fretted that we might see a rare occurrence — a decline in all nine key commodity price indexes: energy, beverages, oils and meals, grains, timber, other raw materials, fertilizers, metals and minerals, and precious metals. We are now in the middle of March, and it looks like the Bank’s concern was well warranted.

Oil markets seem to have stabilized at just under $50 per barrel from their 2014 free fall, which saw prices drop 59 percent from mid-June 2014 to the end of January 2015 ($108 per barrel to $44 per barrel). However, because none of the factors that caused the drop have changed, it is unlikely we will see an increase in prices any time soon, and could very likely see further erosion. The World Bank forecasts prices will average $53 per barrel in 2015 — but we haven’t come close to that mark yet, so the forecast might well be lowered when the next quarterly report is released.

Three other indices — agricultural raw materials, energy, and metals and minerals — have experienced a much slower and less dramatic slide, but a slide nonetheless. These indices began to fall in early 2011 and have continued slowly but steadily downward ever since. Again, since the factors that led to the decline in the first place — ample supplies, weak demand and strengthening dollar — haven’t changed, there is no reason to believe these three indices will change course this year.

China will play a huge role in what the metals markets do. In 2013, the country was responsible for 45 percent of the metal demand. If China experiences a dramatic economic slowdown — or even a nondramatic slowdown — the price of metals will follow.

Food commodity prices, which have declined by 20 percent since 2011, are projected to drop another 4 percent in 2015. Farmers are just too good at growing, and we are seeing good crop prospects for grains, edible oils and meals, and beverages (led by coffee) in the 2014–2015 season.

As if supply and demand pressures on the commodity product itself weren’t bad enough, the indices are also under pressure from investment funds, which — after years of negative returns — are selling off their commodities positions, resulting in falling share prices. The oil price collapse is likely to accelerate the outflow from funds invested in commodities. Commodities might be attractive for their low correlation to other asset classes, but investors aren’t going to hold losers in their portfolios just to balance off the winners, despite the admonitions of portfolio theorists.

There is an argument to be made that commodities have become a financial instrument and are more affected by interest rates and the strength of the dollar than by physical demand for the product. This has the advantage of making commodities a very liquid market, but it also adds volatility to an already volatile asset class. In addition, it adds correlation where none existed before, similar to the intertwined financial relationships in the real estate industry that were instrumental in bringing the whole world down in the great financial crisis.

So is there any good news?

Contrarians definitely see light at the end of the tunnel. In their view, commodities tend to fall at the beginning of a recovery while equities rally, and then begin to rebound in the later stages of a recovery. The United States is definitely in those later stages, so if this theory is correct, it’s time for a rebound.

And if commodities don’t rebound in the near future? Well, it’s hard to believe prices can fall much further. If you aim to buy low, now might be the time. There doesn’t seem to be anywhere to go but up — though commodity prices could very well continue to bounce along the bottom for quite some time.

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