Commodities have a well-deserved reputation for volatility. You only need to glance at the U.S. Global Investors’ return chart covering 15 commodity categories going back 10 years. A sector can be flying high one year — such as lithium in 2018 — only to find itself in the cellar the next year, and then back on top 24 months later. In 2021, only four sectors ended up in negative territory. Conversely, during the first half of 2023, only two sectors are currently posting positive returns.
Yet, for all its ups and downs, commodities sectors also have a well-deserved reputation for smoothing portfolio returns by providing diversification and hedging characteristics not found in other classes.
INTEREST COMES AND GOES
Just as commodity returns ebb and flow, interest in this alternative investment class ebbs and flows. Commodity investment products are primarily used for inflation hedging, diversification away from stocks and bonds, and positive returns. Thus, when inflation is low or commodities are struggling, investor interest naturally wanes.
“For 10 years prior to 2021, there was really no inflation, so investors did not need commodities in their portfolios to hedge that risk,” explains Kathy Kriskey, commodities ETF strategist at Invesco. “Equities were doing great, so few people looked for diversification products. In addition, commodities didn’t have positive performance, so this asset class got little attention.”
This all changed after the pandemic. In 2021, people were emerging from their homes. Demand for everything from gasoline to food to building materials was growing, while supply remained constrained. Prices started to move upward. By 2022, inflation was surging, and the Ukraine crisis had added a geopolitical risk premium to prices. Investors turned to commodities to diversify and hedge their portfolios, as well as increase returns.
And for awhile this worked. The S&P Goldman Sachs Commodity Index climbed 37 percent in 2021 and added another 44 percent in the first half of 2022. But then commodities reverted to their volatile form and dropped 25 percent in the second half. They ended the year up 9 percent, but that was a far cry from the heady previous 18 months. 2023 has continued to see the index come off its 2022 high, with an additional loss of 5 percent since the beginning of the year as of August. Currently, only two sectors — lithium and gold — are realizing positive returns, in contrast to 2021 when 12 out of the 15 sectors tracked by the interactive Global Investors’ chart finished the year with positive returns. However, the types of factors that influence commodity supply and demand seem to be lining up for a change in direction.
“The second half of 2023 is shaping up to be much better than the first half for commodities,” says Kriskey.
One of the major influences on commodity prices is China’s strategic emphasis on economic stimulus, which is actively shaping the trajectories of crude oil, agriculture and metals. This strategic direction is effectively spurring demand for these sectors. Concurrently, a surge in macro risk-on sentiment is observable among investors, predominantly fueled by the prevailing perception that the Federal Reserve is finalizing its series of interest rate hikes and is potentially considering rate reductions in the upcoming year.
Factors at the micro-level are also contributing to the reversal of the downtrend. Within the commodities sphere, the interplay of supply and demand dynamics is tightening, thus propelling prices in an upward trajectory. An example is the recent performance of the sugar market, which has surged by over 50 percent year-to-date. This surge can be attributed to reduced sugar supplies from India, the globe’s second-
largest sugar producer.
Present agricultural trends are influenced by two pivotal factors: weather patterns and geopolitical tensions. Unprecedented global heatwaves, coupled with the El Nino weather phenomenon, are imposing significant pressure on the availability of diverse grains and soft commodities. Geopolitically, the Russia-Ukraine conflict centered on the Black Sea Grain Initiative has injected an elevated risk premium into agriculture-
centric commodities, particularly impacting the wheat market.
The convergence of these elements, encompassing both conflict and climate, has spurred heightened interest in exchange-traded funds and other financial instruments that can capitalize on ascending commodity prices due to constrained supplies.
VIVA LA DIFFERENCE
We often talk about commodities as if they were a homogeneous group. They aren’t. Commodities are defined as natural resources or agricultural products that are grown, mined or processed and are critical inputs in the production of food, energy and clothing. So, we are placing soybeans and gold and natural gas all in one really big basket. To make the assets a little more connected with each other, the basket is divided into soft and hard commodities. Soft commodities are grown or reared, such as livestock and meat, together with agricultural commodities, such as coffee, wheat, soybeans, cotton and corn. Hard commodities are mined or extracted, such as energy products — crude oil, natural gas and coal — and precious and industrial metals, including gold, silver, palladium, copper, lithium and aluminum. In other words, soft commodities have a life and live in the sunshine, while hard commodities spend their time hiding underground.
These differences mean that even if commodities, as an asset class, are down from recent highs, specific segments are still thriving, and likely will continue to thrive.
Although the World Bank expects commodity prices to continue their downward slide, forecasting that prices will fall by just about 21 percent this year and remain broadly stable in 2024, growing geopolitical tensions, stronger-than-anticipated growth in China and supply disruptions could yet trigger another rise in prices.
“In the short term, supply constraints and geopolitical developments may lend support to petroleum and agricultural commodities,” predicts Kevin Baum, CIO at USCF. “In the longer term, the energy transition megatrend offers an exciting opportunity for battery and electrification metals [i.e., lithium, copper, etc.], given increasing adoption rates of electric vehicles and the build-out of renewable energy infrastructure.”
The energy transition is certainly going to impact demand for minerals, but other trends are also emerging as factors over the long term.
Darius McDermott, managing director of advisory firm Chelsea Financial Services, believes that agriculture could be “perhaps the greatest long-term story of all.” With the world’s population predicted to reach nearly 10 billion by 2050, “Feeding the world is going to be a major task that will require significant long-term investment,” he adds.
And agriculture isn’t just for food.
“Agriculture commodities are an integral part of the sustainability-focused future, as they are now viewed as ‘energy crops.’ For example, corn and sugar are used to make ethanol, and soybeans are used for renewable diesel,” explains Kriskey.
In addition to agriculture products, a few of today’s out-of-favor metals might also find themselves in more demand in the future, particularly copper.
“Copper is currently under pressure due to a lack of demand out of China,” Kriskey continues. “China’s building sector has not yet bounced back, and fear of a deep recession is reducing demand for copper in building in the U.S. and E.U. However, copper is a key commodity for the energy transition. Currently 80 percent of copper is used for building, but it is estimated that by 2025, demand for copper will be split 50 percent for building and 50 percent for green demand. It can be challenging to hold copper now, but long term it could be interesting.”
COMMODITIES IN A PORTFOLIO
Investors often look at the headline-making volatility and wonder why they should add it as an alternative to their portfolio. There are several good reasons.
“A compelling feature of the commodities asset class is that individual commodities exhibit distinct volatility characteristics; however, broad-based commodity exposure exhibits little to no correlation to financial assets,” explains Baum. “Hence, a diversified basket of commodities offers compelling, long-term return potential with vitally important inflation hedging and portfolio diversification benefits when added to a portfolio of stocks, bonds and real estate.”
Commodities have proven to be an attractive investment when interest rates are rising. In fact, according to Invesco research, commodities have been the best-performing asset class in a rate hike environment since 1991.
“Commodities tend to be the most efficient hedge for inflation, as they are strongly related,” says Kriskey. “We have analyzed the ‘beta to inflation’ for different asset classes and found that broad-based commodities ETFs have the highest beta to CPI or sensitivity to inflation. For this reason, a small allocation to commodities through a diversified ETF has proven to be an efficient and effective hedge for inflation.”
Finally, for investors who are willing to take a chance, this might be a once-in-a-lifetime period to invest. Many believe that the industry is at the beginning of a commodity supercycle, with the potential to extend for a decade or more. Analysts contend that this supercycle began in 2020, and the ongoing price correction is merely transitory, with the upward trend in prices re-emerging soon and expected to continue for several more years.
INVESTOR BEWARE
Diversification and sometimes eye-popping returns make commodities an attractive investment, but they are also one of the more challenging investments because they face a wide variety of risks.
According to the World Bank, disappointing global growth is the major downside risk for the next year or two. But there are additional challenges that are often overlooked, particularly when commodities are performing well. Some of these challenges come from the same place that the major opportunities spring from, such as with the energy transition.
“The energy transition requires tremendous amounts of critical metals and minerals,” says Baum. “This can result in geographical supply concentration risk. China mines 60 percent of rare earths; two-thirds of cobalt extraction takes place in the DRC; and Russia, Indonesia and the Philippines dominate nickel production. Even more alarming is the dependence on China for the processing and refining of most critical metals and minerals. For many of these metals, China currently processes 35 percent to 90 percent of global volumes.”
Other risks associated with investing in commodities pretty much run the gamut of risks. Recession could bring demand destruction. Oversupply and undersupply both affect prices. Government actions and regulations, such as strategic petroleum releases or California’s Prop 12, which requires hogs to be treated a specific way, always need to be considered. Add in extreme weather, changes in consumer buying behavior (e.g., the shift to EVs or more fuel-efficient cars), and a black swan here and there, and it is obvious that commodity investing is not for the faint of heart. However, there are ways to make investing more accessible and profitable for the retail investor.
HOW TO INVEST
One way to invest in commodities is to buy the commodity in physical form, although this comes with challenges in terms of storage and trading. It’s the rare investor who is able to store palladium or soybeans in their basement.
Alternatively — and vastly more commonly — investing in commodity-
based shares and funds can provide indirect exposure.
On the public side of the roster, exchange-traded funds (ETFs) and exchange-traded commodities (ETCs) are a popular low-cost way of investing in commodities. ETFs typically track the performance of a basket of investments or an index, while ETCs track commodity prices. As they’re traded on the stock market, investors can buy and sell them the same way they would any public equity. According to Trustnet, there are more than 450 commodity-related exchange-traded products to choose from.
Another way to invest indirectly in commodities is to buy shares in companies that produce, mine or process commodities or related businesses. Investors can buy shares in specific companies if they are publicly listed, or through commodity-based funds and investment trusts, which pool money from investors to invest in a range of companies.
BOTTOM LINE
The past few years taught investors the importance of portfolio diversification, and commodities can be a major addition to that diversification. However, it’s important to note that investing in commodities comes with its own set of risks, including price volatility, supply disruptions and geopolitical factors that can impact global markets. Therefore, thorough research, risk assessment, and a well-considered investment strategy are crucial when venturing into this asset class.
While commodities investing requires careful consideration and risk management, the potential benefits of portfolio diversification, inflation protection, and exposure to global economic trends make it an attractive option for investors seeking to broaden their investment horizons.
In addition, commodities are a familiar part of our everyday lives, covering everything from food to energy to clothing to building and manufacturing materials. The product is understandable. It feels like investing in family — even if that family is sometimes a bit challenging.
Sheila Hopkins is a freelance writer in Auburn, Ala.