Peter Carvill surveys the commodities landscape, and asks which sections of the asset class offer the best value

The German writer Goethe once wrote: “The smallest hair casts its shadow.” The financial markets often work in this way, forever directed by world events. This philosophy applies strongly to the commodities market. Traditionally small allocations within a fund’s portfolio, commodities are influenced frequently and directly by day-to-day events. This is borne out by market reactions to recent geopolitical tensions.

A number of people involved in the commodities market were interviewed for Pensions Age. Separately, they posited similar views of their market, its challenges, and its future.

Cardano client manager Phil Page points to Chinese industrialisation as being prescient. “I think one of the big issues is to do with supply and demand in the long term, particularly in emerging markets. China, in particular, is a big consumer of commodities, and it’s whether, in the long term, they will continue to consume as much as they have in manufacturing and production, and whether that increases or continues at the same pace.”

Vontobel’s portfolio manager for its Belvista Commodity Fund Jeremy Baker takes up the Chinese angle. “We’ve had the recent release of import and export data. The import data for base metals such as copper or aluminium are pretty good, given the numbers. But we believe that that data hasn’t reflected the slowdown in terms of what we saw over the Chinese New Year.”

He adds: “We believe that that data is going to slow down in the next two to three months. Everyone is focused on China, given its decline and with what the central government is saying in terms of GDP – there’s clearly a concern there.”

China aside, concern is building among commodity investors through the West’s increasingly fractious relationship with Iran. The Financial Times reported recently that Iran’s oil production had hit a 10-year low, following trade sanctions imposed on it by the US over its nuclear programme (‘Sanctions choke off Iran oil output’). Almost concurrently, Bloomberg ran a story (‘U.S. May Sanction India Over Level of Iran-Oil Imports’) that the Obama administration may impose trade sanctions on India due to that country’s purchase of Iranian oil.

“You’ve got this great demand, still, from China and other developing countries,” says LSE.co.uk’s director Scott Grant, “and yet you have these threats from Iran on the supply side. These are the most interesting elements at the moment in commodities. Oil is the most interesting but you’ve also got a lot of counter-investment in places like Africa in order to find other oil supplies.”

There was a broad consensus among those interviewed that UK pension funds are under-invested in commodities. Says Baker: “With the UK markets, from the people I’ve spoken to and the information that I’ve gotten – and I’ve spoken to quite a few sources – there’s a general indication of an under-allocation to commodities.”

Grant’s comments expand on this view. “In some senses, pension funds are underweight and commodity investment has certainly retreated as funds look for more stable returns. For them, volatility is not a happy sideshow.”

Ethical investing has become increasingly topical in relation to commodities. On 16 May 2011, The Guardian posted an entry on one of its blogs by Alex Cobham entitled ‘Rising Food Prices: The Role of Pension Funds’, which drew heavily on the report Hungry for Justice: Fighting Starvation in an Age of Plenty.

Cobham wrote: “In its new report Christian Aid says it is not primarily the hedge funds that are behind this trend. More pertinent are the activities of institutional investors such as pension funds looking for a safe place in which to grow their money following the burst of the dotcom bubble and collapse of the property boom.”

The report Responsible Investment in Commodities outlines how institutional investors have increased their commodities investments. Its author, Ivo Knoepfel, writes: “Because of their positive contribution to risk-adjusted returns and portfolio diversification, commodities investments are expected to grow considerably in the coming years. According to Barclays Capital, around $320 billion of institutional and retail money is now invested in commodities, compared to only $6 billion a decade ago.”

However, Hungry for Justice offers this cautious summation of the market’s effect on world food prices: “The evidence that exists is not conclusive, for these are early days – research into the global pull of today’s economic forces on the price of food is at a nascent stage.”

Grant says that the issue of ethical investing in commodities has come to the fore more often in recent times. However, he takes the view that increases in food prices are not solely the fault of institutional investors, referring to “intrinsic problems along the whole supply train”.

Like Grant, Baker takes a more granular view of ethical investment in commodities. “This is often a discussion we have with clients,” he says, “and
it tends to centre around investing in food commodities. I’ve done a lot of work on this and it’s an issue with some funds. But the roles of indexes, indexed money, and speculators are needed ones in the market. There’s a misguided perception that they are the ones causing the price increases.”

Ethics aside, what targets within commodities provide the best returns? Schroders fund manager Michael Spinks says that his company’s current favourite sector is the energy complex.

“About 50 per cent of our commodities exposure is in energy. The other issue is how you assume what’s best in commodities. If you look at 2009-10, the oil price doubled and if you were invested in just the straightforward front future, you would have gained about 10 or 12 per cent. So thinking about investment, or the cost of investment, is important.”

Page sees gold as a wise investment, as the metal has a “good long-term story”. He explains: “In an uncertain macro-economic environment like we have today, where equities and even government bonds look risky, gold has been seen as a safe investment. When you get fear in the markets, gold is an attractive investment. If we get high levels of inflation, it’s possible that it will do well as a real store of value.”

The future of commodities looks difficult in the short term with the Iranian situation and a possible China decline. This follows on from last year, which Grant says was “pretty dire” with severe falls in investment flows. Whereas in the past, he says, commodities were held up as diversifiers and non-correlated assets, the last few years have been too close for comfort. As for 2012 and beyond, he says: “I don’t think that crude oil is going to see huge returns but, of course, the demand is there so anything where you have the greater demands, basic economics tells us that prices continue to rise if it’s been as popular as it’s been in the past. If you look at the US and Mexico, they’ve had droughts that have affected corn harvests so that scarcity may lead to a bull market there.”

“I think in the next year or two, there will probably be no big change in the demand from the emerging markets,” says Page. “It’s more of a long-term thing so, on the demand point, I don’t expect it to be huge. On the supply side, the thing with Iran and the oil market is a serious one and could hurt us in a year or two. We could have a reduction in supply because of uncertainty in those countries and the price of oil could go up. When oil goes up, it pushes the price of other commodities up due to transportation costs.”

Page adds that a return in confidence to the stock market or in government bonds could hurt the market. “While the long-term prospects for gold may be positive,” he says, “you may find that if the world becomes a calmer place, some commodities are hurt because they are no longer considered a safe haven.”

Written by Peter Carvill, a freelance journalist

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