Tuesday, January 19, 2016

Long-only commodities - the worst asset allocation decision of the decade

There will be fads in asset management industry just like the fashion industry. Look back at the fashions in the 70's or 80's and you may just shake your head and ask, "What were you thinking wearing that?". The time has already come for investors to shake their heads about holding a commodity index and ask the same question. What were investors thinking?

That said, the big dislocation between equities and commodities came after the Financial Crisis as evidenced by our graph between the S&P 500 and the Bloomberg commodity index. Commodities peaked in 2008 and tracked equities through the middle of 2011. Since mid-2011, equities and commodities have had a significant divergence. This was the post-QE2, beginning of the slowdown in China period.

Commodities were a good trade when you were riding the wave of the up-cycle. The case for commodities ran through this long up cycle and seemed like a natural portfolio diversifier. Shortages and peak supply were the underlying stories for holding many commodities. With growth in emerging markets, demographics showing continued population increases, and the belief that technology would not provide a complete solution, commodities seemed to be a good long-term allocation decision. Add the fact that backwardation dominated a majority of the commodities markets and it seems like commodities as a good stand-alone investment and inflation hedge made sense as a stock and bond alternative.

You could not have been more wrong since the Financial crisis and especially the last five years.
  • Inflation has never arrived. Deflation has become the story of the day.
  • Cheap money did not lead to inflation but to an environment of continued investment and over production.
  • Technology through shall oil solved one of the key peak commodity problems and served as a catalyst to the current price decline  in energy.
  • Emerging market growth as slowed and reduced demand for commodities. This has especially been the case for China.
Some could argue that this was a perfect storm of negative supply and demand price shocks, but many of these shocks will extend for years. Demand from emerging markets will not change quickly. Technology will not reverse. Production shutdowns are necessary to offset past capital expenditures.

However, an investment policy of avoiding commodities may be going to the other extreme. Commodities may offer significant opportunities but not from long-only investing through indices. Investor need to rethink the purpose of holding commodities and what are the correct return expectations. If the cycle for commodities is truly different from bonds and stocks, then the process for allocation also has to be different. 

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