Tuesday, March 6, 2018

Commodities - A good time to hold or increase at this point in the business cycle

Where are we in the business cycle? This is never an easy question to answer but we might get agreement to the fact that we are in a new expansion in later stage business cycle. We are in a new expansion since we have seen surprise upside in growth around the globe in the last year, but we also are in the later stages of the business cycle given the time since the last recession and the fact that central banks are leaning toward tightening. Time by itself is not a good indicator of a business cycle reversal, but as the business cycle lengthens there is greater likelihood for price and inventory tightening. 

This point in the economic cycle is usually a good time for holding commodities. Coupled with the large dispersion between stocks and commodity price levels, commodities are also attractive relative to financial assets.

There is additional value with holding commodities through futures given the positive roll characteristics with the largest market component of most commodity indices - crude oil. The reason for holding commodities is only enhanced if more markets are in backwardation. In fact, the research, which has focused on the advantages of holding a commodity index, shows that the gain from backwardation or commodity carry is one of the key drivers for futures index returns.

Looking back in history since the Financial Crisis would suggest that holding diversified commodity would be a bad bet, but the critical thinking is to look beyond any poor performance over a three or five year period and focus on the opportunity going forward. A forward-looking analysis coupled with expectations that inflation may continue to rise makes holding commodities attractive as an opportunity for  diversification and return enhancement.

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