Dec 03, 2013 08:46 AM IST | Source:

Return to growth will bring next twist for commodities mkts

One of the few certainties is that consumers will complain that they feel the effect of commodity price rises almost immediately but seldom see the benefit of any fall.

Has the much vaunted super cycle in commodities finally come to an end? Or is it only taking on a different form in response to the narrative unfolding in commodities markets? There are as many answers to these questions as there are informed opinions in the underlying industry.

One of the few certainties is that consumers will complain that they feel the effect of commodity price rises almost immediately but seldom see the benefit of any fall.

Some industry specialists express sympathy for this latter view, but point to a number of factors to explain it away. They cite the role played by growth in the global population, combined with changes in palate, for example, as a market like China develops economically and acquires new eating habits based on meat rather than rice. More mouths need more food, and the meat that some of them want to begin eating requires greater calorie input per pound weight of consumption than does their traditional staple diet (one commonly quoted ratio of grain to meat is 8:1).

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This drives supply/demand equilibrium prices to ever higher levels, suggests Jason Lejonvarn, a strategist at Hermes Fund Managers. "You need higher prices to incentivise growers," he observes. Otherwise, in the short run, as well as the long run, we are all dead.

Any suggestion that returns from commodity markets have proved disappointing over the past five years, and that investors have withdrawn money in significant scale, must be placed firmly in context, say those who make a living from commodity investment decisions.

While recent returns might have been disappointing in absolute terms, the greater disappointment arises from the relative performance of other asset classes. "Commodity returns have stayed positive, albeit modestly positive," says Mr Lejonvarn.

Little is straightforward in the world of international finance, though; some players question the use of passive investment indices as a guide to the true nature of the commodities markets.

"Passive indices are losing assets, yes," says Hakan Kaya, portfolio manager in the quantitative investment group at Neuberger Berman. "But these indices are not representative of commodities. Some exhibit fundamental flaws in their construction by heavily weighting the commodities that are produced most and this does not make logical sense. We refuse to invest in ample commodities; we look for scarce commodities."

He is not alone. Harry Tchilinguirian, global head of commodity market strategy at BNP Paribas, says: "Passive investment in commodities is no longer a winning solution."

Andrew Walsh, head of UK exchange traded fund sales at UBS Global Asset Management, is not a subscriber to that school of thought. For him, the method used to access commodities can be more important than the commodities that investors choose.

He highlights the benefits of "second generation" commodities indices, which can help mitigate the effect of negative roll yield from which many first generation indices suffer.

While arguments swirl around the validity or otherwise of the established international indices, what is not in doubt is that they have underperformed equities. Even this observation comes, though, with a clearly understandable caveat: equity prices have largely been driven up by the quantitative easing programmes being carried out by the world's major central banks to increase liquidity.

The biggest impact in 2013, as measured by the Barclays Commodity Investor, has been the withdrawal of money from precious metal exchange traded products. As estimated by Barclays, a commodities investment total that started the year at USD 418  billion had fallen to USD 343 billion by the end of September. That was almost entirely accounted for by the amounts held in precious metal ETPs, which dropped to USD 105 billion by the end of September from the USD 173 billion recorded by Barclays at the start of the year.

Looking to the future rather than to the past, the industry glimpses a range of possibilities ahead.

Gary Dugan, chief investment officer for Asia and the Middle East at Coutts, the private bank, believes that "2014 will be easier for commodities; China will still be growing and countries that struggled this year will return to growth, which will push up commodities". He identifies food as one area in which large countries will want to build inventories.

Colin Hamilton, global head of commodities research at Macquarie, predicts that, in the longer term, commodity prices will rise because raw materials are being depleted faster than technology is advancing. "The low-hanging fruit has gone," he says. "People will have to use more to achieve the same result." he says.

In the short term, however, commodity prices are going nowhere. "They are trading at levels that keep supply from the market, which is where we should be," he adds. "Gold and copper should trend lower, and a good US harvest means that grain is heading lower. Oil is fair value, perhaps a bit low. Copper has been supply constrained for the last 10 years and is trading above the cost curve, making it risky, and there is very strong downside in coffee because of strong harvests."

Poor performers will be those affected by surplus supply, says Ed Smith, global strategist at Canaccord. "Avoid copper, aluminium and nickel," he advises. He is also negative on gold.

Clive Burstow, director, natural resources, at Baring Asset Management takes a more positive view on industrial commodities. His focus is on commodity equities rather than commodities themselves.

"Copper supply will be tighter than expected and iron ore has proved investors wrong in terms of more robust demand than expected this year, coupled with ongoing supply constraints," he says.

"We are seeing stronger fundamentals which should translate into stronger pricing; we see a more positive environment and believe 2014 will be a good year in resource equities."

Richard Davis, a fund manager in the natural resources team at BlackRock, shares this view on copper. He also identifies platinum group metals as a potential beneficiary if Chinese auto production holds up, still more so if European auto production recovers. He even finds an encouraging word for gold. "The strength of Chinese jewellery demand might not push gold back to its peak levels of just over two years ago, but could help set a new floor," he concludes.

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