Monday 22 January 2018

Commodities losing their allure as hedge against volatility

James Saft

BUYING commodities in order to diversify your portfolio might not be such a bright idea.

A new study from the Bank for International Settlements disputes the idea that adding commodities to a portfolio can lower the volatility of returns. Considering this has been the bedrock idea underlying the buying and selling of commodities as an asset class over the past 15 years, this is big news.

Taken in combination with trends negative for commodities markets such as the migration of manufacturing back to developed markets and 3D printing, there may be fewer reasons for investors to consider the asset class.

The study, by Marco Lombardi of the BIS and Francesco Ravazzolo of Norges Bank, looked at correlations between returns in commodities and equities and found that, having been about zero for a decade, they have increased markedly from 2008 to now.

Rather than moving in different directions, commodities markets have been moving along with equities, creating more volatility for portfolios.

Lower volatility, or a return that does not jump around as much, is a key concept in investing, as it allows you to take on more risk and get a higher overall return since you have a lower chance of being caught short by a sudden move in markets.

Unfortunately, that simply does not seem to be true any more for commodities and, ironically, it seems as if the huge rush of investors into the asset class in recent history is a big part of the reason why.


Returns in commodities markets in the past were driven more than they are now by market-specific issues. Think about a refinery fire or a drought. Now, however, since more of the market is owned by investors rather than driven by users and suppliers, there is a higher chance of prices being driven by a pass-through from shocks to the real economy. As those shocks also drive equity prices, correlations rise.

The authors do make the case for commodities investment, but based on evidence they see that you can predict commodity prices using information from equity markets, thus allowing you to better time allocations in and out. That seems to me dangerously close to saying that if you can predict equity prices you can predict commodity prices. Frankly, if you can market time (hint: you can't), you ought not to be bothering with commodities or academic research at all.

The great thing about diversification is that it is not predicated on knowing the future, only on making sensible decisions about risk. If that is gone, a major support for commodities investment is gone with it.

This is also happening at a time when some other long-running trends may be beginning to darken the long-term outlook for commodities prices.

A variety of trends may be bringing more manufacturing back to the US from China and elsewhere – the "onshoring" process. This is partly because the discovery of new energy resources in the US is lowering costs, and partly because wage differentials between the countries, while still large, have narrowed in recent years.

Production in the US is less commodity-intensive, due to lower travel and energy costs, but also because US infrastructure is relatively better developed than in China or Thailand or India, making for fewer huge energy-intensive development projects.

Also, as Morgan Stanley economist Manoj Pradhan pointed out, higher labour costs act as an incentive to minimise commodity use, reinforcing the commodity-negative impact of onshoring.

The development of 3D printing, a manufacturing process in which objects are literally sprayed into existence rather than mass-produced, could also be hugely negative for commodities prices. In part, this is because 3D printing is not all about massive scale, the way the assembly line is, allowing you to locate small manufacturing sites close to clients.

Well-known futurist and investor Esther Dyson (below) makes some interesting points about the implications of this, arguing that it will hit transport and logistics companies hard, as there will simply be less moving of stuff around in a 3D world.


Dyson also notes that the rise of 3D printing will lower the inventories that companies are forced now to hold on hand. As US goods inventories total about $1.7trn – about 10pc of annual GDP – the transition from assembly lines to on-demand 3D printing will at the very least be a one-off shock to commodities prices.

There are many specialist investors who make, and will continue to make, good money investing in commodities.

Given the high costs of active management of commodities investments, though, and the compelling reasons to think these are markets heading for a shock, now might be a good time to narrow our focus. (Reuters)

Irish Independent

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