Our Insights

About personal finance, investments and markets.
August 1, 2015

Should you buy commodities after the recent price decline?

We recommended in November last year that „investors should stay away from commodities“. Since then, the price of the commodity index (Bloomberg) has dropped by more than 30% and it has reached the lowest level since 2001. Generally we like to take a closer look at an asset class that has fallen so much in value and seems to be out of favor. Would we therefore recommend to long-term investors that they should buy commodities here? The answer remains a resounding ‚No‘. Commodities are for traders, not for long-term investors.

Including cost of roll, commodities returns drop 1999 level - Bloomberg Commodity Index

5 reasons to avoid commodity investments

1. Poor long-term track record of commodities relative to equities and bonds

The historical evidence on the real return of spot commodities is overwhelming: there is no real return potential. For proof, consider the following 130-year chart by SocGen.

SocGen Engl

The lack of real return is no surprise: commodities generate no income  and only produce storage costs. To bet on price increases due to scarcity is pure speculation, not a long-term investment. It is also a bet against human ingenuity as over the long-run, technology tends to make extraction cheaper.

2. Commodity prices are inversely correlated to the US Dollar

Many investors may not realize it, but their commodity investment is nothing but a bet on a lower US Dollar. But historically, commodity prices have weakened during times of US Dollar strength, which is exactly what we are seeing right now. The fact that we have witnessed this week 52 week lows for some very diverse commodities such as gold, copper, platinum, oil, coffee, sugar and oats, shows that there is an overarching catalyst that is pushing commodities lower.

Negative correlation to US Dollar V2

3. Commodities were also a bet on China – but China is slowing

Unfortunately many investors find it easier to believe in a simple story than to study the facts. The story used by the proponents of commodity investing can be summarized in one word: China. It went something like this: there are 1.4 bn Chinese who are moving from the country-side to the cities and they aspire to our western lifestyle which will drive demand for commodites for years to come. While there is some truth to it, once the cities were built and the flats had their first frigde, the demand for commodities inevitably had to slow down. This can best be shown with the following graph: in 2014 China accounted for nearly half of global demand for all the major commodities. This was simply unsustainble because China only accounts for 20% of the global population and 13% of global GDP. Never let facts get in the way of a good story….

COtVrIEWgAAYZ_n.jpg-large

4. Hard to justify from a portfolio construction point-of-view

Commodities are irrelevant to a portfolio in small amounts. In large amounts they are outright dangerous and irresponsible as there is no historic evidence of a their real return potential.

5. Most investors already have some exposure to commodities

Investors can gain exposure to commodities in the equity market if they buy the commodity producers. In the end, the value of oil companies is driven by the oil price, the value of iron ore producers is driven by the price of iron ore. Investors who own globally diversified equities therefore are already exposed to commodities. For example the MSCI World has a 12% exposure to commoditites (energy and materials). It his therefore not necessary to increase the exposure to commodities directly. In addition, we have shown previously that the much beloved commodity ETFs are a very poor proxy for commodity prices because their price can deviate significantly from the underlying commodity spot price (see discussion here).

Sector weights

Summary

We do not include commodities in our asset allocation stratgies for our clients. Our investment approach is evidence-based and the evidence speaks clearly against owning commodities for the long-term.

http://www.visualcapitalist.com/china-consumes-mind-boggling-amounts-of-raw-materials-chart/

https://www.msci.com/resources/factsheets/index_fact_sheet/msci-world-index.pdf

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