In a low-return world, high-yielding commodities have become the siren song of the asset-liability mismatch. Well supported by seemingly powerful fundamentals on both the demand (i.e., globalization) and the supply sides (i.e., capacity shortages) of the macro equation, investors have stampeded into commodity-related assets in recent years. Once a pure play as a physical asset, commodities have now increasingly taken on the trappings of financial assets. That leaves them just as prone to excesses as stocks, bonds, and currencies. This is one of those times.
Previously, I argued that Chinese and US demand were both likely to surprise on the downside - outcomes that would challenge the optimistic fundamentals still embedded in commodity markets (see my 15 September dispatch, "Whither Commodities?"). I also hinted that the asset play could well reinforce this development - largely because commodities have now come of age as a legitimate asset class in world financial markets. This companion note develops the asset-driven adjustments that could well lie ahead in commodity markets.
Why have commodities gained in popularity?
The sociological context is key to this dimension of the issue: Virtually every major institutional investor I visit around the world - from pension funds and insurance companies to mutual fund complexes and hedge funds has a large and growing commodity department. The same is true of foreign exchange reserve managers and corporate treasury departments of multinational corporations. One major Wall Street firm is now run by a former commodity executive, and another has turned over management of its global bond division to the architect of its thriving commodity business.
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Like all such trends, the expansion of the commodity culture is rooted in performance. It's not just the physical commodities themselves - most commodity-related assets in cash and futures markets have also delivered outstanding relative returns. For several years, the so-called commodity currencies of Australia and Canada have been on a tear, and big commodity producers like Russia and Brazil have led the recent charge in high-flying emerging markets. Within the global equity universe, the materials sector has been the number-one ranked performer over the past year - up 14%, or double the 7% returns of second-ranked financials. And, of course, there is the growing profusion of commodity-related ETFs. Meanwhile, Commodity Trading Advisors (CTAs) now collectively manage over $70 billion in assets - more than three times the total three years ago - and the IMF reports inflows of approximately $35 billion into commodity futures last year alone." (See the IMF's September 2006 Global Financial Stability Report).
Significantly, the consultants are now urging institutional investors to implement a major increase in their asset allocation weightings to commodities. A recent Ibbotson Associates study recommends that commodity weightings in a multi-asset balanced portfolio could be increased, under conservative return and risk-appetite assumptions, to a high of nearly 30%. That would be more than three times current weightings and greater than seven times the estimated $2 trillion value of current annual commodity production (see T.M. Idzorek, "Strategic Asset Allocation and Commodities," March 2006, available on www.ibottson.com). The Ibbotson analysis praises commodities for their consistent outperformance and negative correlations with other major asset classes - going so far as to praise commodities for actually providing the protection of "portfolio insurance." It concludes by stressing "there is little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period."
Laboring under the constant pressure of the asset-liability mismatch, yield-starved investors can hardly afford to ignore this enthusiastic advice. As a result, with multi-asset portfolios likely to have ever-greater representation from commodities, the financial-market dimensions of the commodity trade are likely to become increasingly important.
The transformation of commodities
This transformation from a physical to a financial asset alters the character of commodity investments. Among other things, it subjects the asset to the same cycles of fear and greed that have long been a part of financial market history. From tulips to dot-com and now probably US residential property as well, the boom all too often begets the bust. Yale Professor Robert Shiller puts it best, arguing that asset bubbles arise when perfectly plausible fundamental stories are exaggerated by powerful "amplification mechanisms" (see Shiller's, Irrational Exuberance, second edition, 2005).
That appears to have been the case in commodities. In this instance, the amplification is largely an outgrowth of the China mania that is now sweeping the world - the belief that commodity-intensive Chinese hyper-growth is here to stay. That's why I blew the whistle on this one: Not only do I believe that the Chinese authorities will make good on their efforts to cool off an over-heated economy, but I also suspect they will succeed in engineering a well-publicized shift toward more efficient usage of energy and other commodities (see my 2 June essay, "A Commodity-Lite China").
Will demand for commodities fall?
The potential for post-housing bubble adjustments of the American consumer could well be the icing on this cake - not only lowering US commodity demand through reductions in residential construction activity but also by reducing end-market demand in China's biggest export market. The recent data flow hints that such adjustments are now just getting under way - underscored by reports of a meaningful slowing of Chinese investment and industrial output growth in August and a continuing stream of bad news from the US housing market.
Meanwhile, the performance of commodity-based financial assets is starting to fray around the edges. That's true of energy funds as well as those asset pools with more balanced portfolios of energy, metals, and other industrial materials. While most of these investment vehicles have outstanding 3- and 5-year performance records, the one-year return comparisons are now solidly in negative territory for many of the biggest commodity funds. And this is occurring at the same time that the MSCI All-Country World index has delivered a 14% return for global equities over the past year. Underperformance for a few months is hardly cause for concern, but for both relative- and absolute-return investors, negative comparisons over a 12-month period are raising more than the proverbial eyebrow.
As usual, the "hot money" has been the first to head for the exits, but more patient investors may not be too far behind. Shiller-like amplification mechanisms could well compound the problem. Just as they led to near parabolic increases of many commodity prices in March and April, there could be cumulative selling pressure on the downside - taking commodity prices down much more sharply than fundamentals might otherwise suggest.
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For my money, there is far too much talk about the globalization-led commodity super-cycle. It gives the false impression of a one-way market, where every dip is buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment. As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess. That's very much the case today. After three years of extraordinary outperformance, denial over the possibility of a sustained downside adjustment in commodity prices is very much in evidence - underscoring the time-honored sociology of an asset class that has gone to excess. Meanwhile, China and US-housing-related fundamentals are going the other way - setting up increasingly tender commodity markets for unpleasant downside surprises on the demand side of the global economy. The herding instincts of institutional investors could well magnify the price declines - when, and if, they emerge. All this suggests there is still plenty of life left in the time-honored commodity cycle.
Barton Biggs always used to chide me that "Dr. Copper" was his favorite economist - possessing an uncanny knack to provide a real-time assessment of the state of the global economy. I suspect that the good doctor has now taken his or her finger off the pulse of the real economy and spends far more time looking at Bloomberg screens. Pity the poor patient - to say nothing of the doctor!
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
