Should a pension hold commodities?

You have got to be kidding, a rationale for holding commodities at this point in the commodity cycle? The commodity markets have not performed well over the last few years. Right now 18 of 22 markets  in the Bloomberg commodity index are in a bear market with declines of 20% or more. Any uptrend  in the commodity super-cycle is over and the gains in financial asset markets from QE have not been seen in the commodity markets. This is different from 2008 when the commodity market crashed on a decline in demand. Now we are seeing a crash on oversupply. The long-term demand trend never really came back and the producers continued with supply hoping for a better day that has and will not likely arrive. Rationalization on the producer side has to continue and this takes time.

The commodity markets have moved in a different direction than equities. There is a growing divergence between these two asset classes and this cannot continue. Commodity producers are a smaller portion of the overall market capitalization but there will be a further spill-over to earnings and credit quality.

With all of this negative performance, the question is why should investors hold commodities in their portfolios. Diversification seems like a good idea, but the return drag has made this decision a costly proposition. Inflation may have seemed like a good idea to hold commodities, but again, it has not been realized. In a sub-2% inflation environment, there is little that long-only commodity trading will generate for investors.

There are a couple of issues that have to be highlighted for potential commodity investing of a longer period. First, many forecasters expect that growth with pick-up in 2016. Raising rates is never good for commodities, but if it serves as a signal of stronger growth, there could be a case for commodities. Second, supply tightening will start to occur as we move through time with these low prices. Commodity expectations have to suggest that prices have fallen and will say down for some time.  Supply responses are adaptive and slow.

The fact that oil has fallen a second time to low levels will start to impact producers. That impact does not help any investor in the short-run; however, a reduction in excess supplies and increased demand will allow for price behavior that makes more sense with respect to fundamentals. Finally, with commodities still having high volatility relative to other asset class, there is an opportunity for better relative value trading. This should apply both within the commodity sector and across other hedge fund styles that are chasing low alpha in a stable environment. The water may not be fine but weather can change and for those with a tilt to relative value, there can be some good opportunities.