OCEAN CITY — Broad commodity index prices are higher this year, along with those of equities and bonds. The growth reverses last year’s decline and stands in contrast to disappointing returns for commodities since prices of most asset classes bottomed in 2009. However, institutional investors continue to underweight commodities by about 15%, according to the latest Global Fund Manager Survey from BofA Merrill Lynch (BofAML) Global Research, which found allocations remain well below the 10-year average.
We see an opportunity to revisit commodities as fundamental drivers are improving. We believe a focus by commodity investors on oil and gold misses the real story in 2014, which is the dispersion of returns of individual commodities. A transition to a more fundamentally-driven market, one where supply and demand for the individual sector drive performance, may present opportunities for active investors.
Commodities are usually viewed as pro-cyclical and closely tied to the business cycle. During economic slowdowns, when capital expenditures are postponed, demand for commodities weakens.
In contrast, during recoveries commodities usually benefit from improving levels of personal consumption and investment. The axiom “express elevator on the way down, escalator on the way up” typically applies as the reaction is swift on the downswing but gradual in the recovery stage. This is where the differentiation among commodity prices becomes more pronounced. For more tactical investors, we believe there will be targeted opportunities in commodities beyond the indexes.
Industrial and precious metals, as well as energy, should remain the most sensitive to cyclical economic growth.
We believe fundamentals of supply and demand are likely to drive an increasing differentiation in commodity performance going forward. The start of the year gave a boost to agricultural commodity prices as the harsh weather boosted prices, but recent growth in supply coupled with weaker demand have put downward pressure on prices. While supply has grown inconsistently across commodity markets over the past few years, our BofAML Global Research Commodities team sees more favorable factors driving demand for base metals, including lead, zinc and nickel, particularly as growth has picked up in China.
Energy markets will always be sensitive to geopolitical factors. If the current factors fade, however, a stronger U.S. dollar will likely cap gains in oil prices. More crucially, increased supplies over the next year or two should temper appreciation in global crude oil prices. Our BofAML Commodity team expects the supply of Brent crude oil to outstrip demand this year, in turn pushing Brent prices lower.
Commodities generally underperformed equities and bonds over the past few years while exhibiting an uncharacteristically strong correlation to both asset classes. Recently, the correlation between commodities and traditional asset classes such as stocks and bonds has moved closer topre-crisis levels. We contend that commodities continue to play an important role in a diversified portfolio. Broadly speaking, they remain a hedge against geopolitical events and an unexpected rise in inflation.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)