Why commodities’ stale performance looks odd in 2017

One intriguing trend of note this year is the turgid performance of the Bloomberg Commodities index, a basket of 22 raw materials, encompassing energy, industrial metals, precious metals, and agricultural commodities, ranging from grains to crops to livestock.

The Bloomberg Commodities index has meandered even as the Baltic Dry index has steamed sharply higher in 2017

Source: Thomson Reuters Datastream

It certainly looks odd in the context of a recovery in the Baltic Dry shipping index, which covers 23 shipping routes and the cost of carrying materials such as grain, coal and iron ore around the world, even if the improvement here could lie as much with supply-side discipline as it does an improvement in demand.

Commodities’ soggy year also fails to tally with a strong performance from equities and a weak year from bonds, in sterling, total returns terms.

That pattern suggests investors are buying into the concept of a globally synchronised economic acceleration, as US GDP growth once more reaches 3%, Japan enjoys its best run of growth for a decade, Europe keeps surprising on the upside and Asia and Latin America show improving momentum for good measure.

Such a scenario would point toward a clear preference for stocks over bonds and this is how 2017 looks to be panning out as the year draws to a close.

Global equities have offered the best total returns in sterling terms in 2017 to date

Source: Thomson Reuters Datastream

It would normally support a dash for “real” assets too, but perhaps central bank policy in the West (and maybe China) is having an impact.

The US Federal Reserve’s switch from Quantitative Easing (QE) to Quantitative Tightening (QT) seems to be putting a lid on gold, while other key central banks seem keen to try and extricate themselves from their ultra-loose monetary policy experiments. The Bank of England has put through its first rate rise for a decade, the European Central Bank is tapering its QE scheme and even the Bank of Japan has begun to drop hints that it may start to tinker with its QE and bond-yield control schemes.

The prospect of greater discipline and less liquidity could be weighing on demand for inflation protection in the form of “real stuff,” although a fresh reversal in copper could also suggest that someone, somewhere is not entirely convinced by the economic recovery narrative.

Dr Copper has started to look a little peaky again

Source: Thomson Reuters Datastream

Perhaps China has something to do with this, especially as the Li Keqiang index has lost some ground of late. This is based on three indicators which the Prime Minister is believed to follow in preference to official Government growth statistics. This trio comprises:

• Demand for loans
• Rail cargo traffic
• Electricity consumption

The Li Keqiang index made a comeback in China in 2017

Source: Bloomberg, Thomson Reuters Datastream

It very much represents old, industrial China rather than the new, technology, e-commerce-led one and thus may give some hint as to Chinese demand for raw materials.

A slip in the Li Keqiang index has coincided with a wobble in Chinese stock markets in the wake of the 19th Communist Party Congress, amid warnings from the People’s Bank of China about excess debt and a possible Minsky moment.

This suggests investors may need to be wary of the prospect of stop-start growth in the Middle Kingdom, as the Party remains keen to use fiscal stimulus on one hand to meet growth targets but remains wary of bubbly markets and too much leverage on the other.

If “Dr. Copper” can be one good way of taking the global economic pulse then oil can be another. Helped by a surprising amount of supply-side discipline from OPEC and non-OPEC members alike, crude has gone back above the $60-a-barrel mark and this trend must be watched.

The next graphic plots year-on-year changes in the oil price against year-on-year changes in global GDP growth. Oil has risen by 50% or more six times and on four occasions the global economy slowed markedly (the exceptions were 2002 and 2005-06). This makes sense as higher oil and fuel prices represent a big increase in costs for corporations and consumers alike, almost like a tax increase.

A 50% year-on-year advance in the first quarter of this year was shrugged off, which does at least suggest the global growth picture does at least have some resilience to it.

The global economy seems to be coping with higher oil prices very well, at least for the moment

Source: Thomson Reuters Datastream.

Ways to play

The lack of a yield and their price volatility may still deter many investors from seeking exposure to commodities and they may not be suitable or appropriate for everyone. Those who do feel raw materials may offer some useful diversification in a balanced portfolio still have to address the question of how best to address the asset class.

The first option is to pick a specific commodity and access that via an exchange-traded commodity (ETC), as few investors will want to go to the trouble of storing or insuring their raw materials, even if this is feasible (which in the case of livestock, crops, oil or uranium is unlikely).

However, selecting the “right” commodity and avoiding the “wrong” ones - to ensure wealth is created and not lost - is the devil’s work. This table of the performance of 20 leading commodities suggests as much and to select rhodium, palladium, lead and zinc and avoid natural gas, sugar, uranium and cocoa for example, would have required a powerful crystal ball.

Rhodium is the best performing raw material in 2017, natural gas the worst

Source: Thomson Reuters Datastream

Moreover, investors are unlikely to have the time or inclination to research the finer points of supply and demand for each raw material, let alone the weather or political situation in key supplier countries.

This suggests that an exchange-traded fund (ETF) which tracks and delivers the performance of a broad range of commodities, minus the running costs of the fund, may be a less risky way forward.

The table below shows the top five performers over the past five years (and no-one will miss how badly they have done), although it is fair to say these are specialist tools and they are quite small. Several more instruments have subsequently been launched within this time frame.

Best performing commodities exchange-traded funds (ETFs) over five years

Source: Morningstar, for Commodities Broad Basket category
Where more than one class of fund features only the best performer is listed.

Time to take stock

A further option is to invest in stocks which specialise in commodity exploration, production, distribution or trading. A quick glance at the leading sectors in the FTSE All-Share so far in 2017 suggest this can be a successful strategy, as the Industrial Metals & Mining sector has done well, ranking second out of 39 within the All-Share.

Commodity equity sectors have been mixed performers in 2017

Source: Thomson Reuters Datastream

However, Mining ranks 15th, Oil & Gas Producers 28th and Oil Equipment & Services stocks a dismal 38th, so the recovery seen in 2016 has seemingly fizzled out quickly in 2017.

Commodity equity sectors largely returned to the doldrums of 2011-2015 in 2017

Source: Thomson Reuters Datastream

Spotting a sector that may be on the rise does not solve the problem of which stocks to pick, and this is where a skilled fund manager will look to add value. There is a wide range of options of both open-ended funds and closed-ended investment trusts.

Best performing Global Natural Resources funds over five years

Source: Morningstar, for Sector Equity Natural Resources category
Where more than one class of fund features only the best performer is listed.

Best performing commodities and natural resources investment trusts over five years

Source: Association of Investment Companies and Morningstar, for Commodities and Natural Resources category

Investors seeking a lower-cost passive option can also look to ETFs which track baskets of companies who specialise in agriculture, timber, energy, industrial metals and precious metals, while multi-asset funds will also use commodities as part of their armoury.

Russ Mould, Investment Director, AJ Bell