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Commodities as an asset class have become more popular form of investment in recent years. The most common times when investors flock to commodities is during times when commodities become very cheap and are considered as a value play. The other time is when commodities are hitting multi year highs and investors want to catch the trend.
However, it is no Jack's play to invest in this asset class if you really don't know what factors drive the prices and the key for success while investing in commodities. Let us assess, the current state of global economy factors driving the commodity play and whether it is the right time to invest in this risky asset class.
Starting with the US, after adding more than $3.5 trillion to the Fed's balance sheet, an amount roughly equal to the size of the German economy, the biggest emergency economic stimulus (QE3) in the history came to end in October 2014. It was an extraordinary effort by the Federal Reserve to restart a recession-deadened economy. Even after the taper, the Fed has continued to support the economy the old fashioned way, by holding its interest rates near zero.
The talk of winding up of QE itself stirred the markets, and when it finally ended, it resulted in to correction of the asset class called commodities. Since dollar and commodity prices are inversely co-related, stronger economy, resilient GDP growth, growing labor and housing sector boosted the confidence in the economy which in turn boosted the dollar index by a whopping 21.5 percent in past one year.
In the same time frame, WTI crude oil and Nymex natural gas lost significantly by around 53 percent and 37 percent while precious metals (gold and silver) lost their value by around 14.5 and 8.5 percent. Nickel is the top loser in the base metals pack declining by 12.19 percent. Although the commodity specific fundamentals were at play, the strengthening dollar played its crucial role.
In the Euro-zone, the staggering economy sent alarming signals across the globe and there were questions about its survival. However, the ECB turned in to action and cut interest rates to record lows, lent banks billions of Euros in cheap funds and begun buying sovereign bonds with a monthly budget of € 60 billion to try to bolster the euro zone economy and bring inflation back from zero to its target of close to 2 percent. This action by the ECB will weaken the Euro in turn creating an upsurge in dollar index.
China has been the most important factor in commodities demand in the past decade. The commodities "super cycle" that started in the early 2000s was largely driven by the country as investment in infrastructure, property, and factories producing exports for the globe required increasing imports of raw materials. Beijing's 2009 stimulus further prolonged the demand, with loose credit encouraging the use of metal as collateral for loans. China grew from consuming about 12 per cent of the world's metals in 2000 to near 50 percent today.
However, current scenario looks starkly different as the economy is going through its worst phase in 24 years. Not only this, string of weak economic data from the biggest commodity driver only adds to expectations of broader based stimulus measures. Massive stimulus is expected as PBoC has already announced a number of rate cuts which failed to spur economic activity.
Outlook
The talk of the town is when will the Federal Reserve raise its interest rates? Global markets would react, and in fact currencies and stock markets in emerging markets fell steeply in mid-January 2014, as investors prepared for U.S. interest rates to rise. However, markets rebounded, interest rates stayed low and the Fed stuck with its plan and delayed the rise at-least till its June meeting.
The mere anticipation of ECB stimulus has led to a fall in the euro exchange rate, reduced borrowing costs, increased expectations of inflation and increased credit growth, in turn boosting "economic confidence" in the region. This bodes well for commodities as Euro Zone is amongst the biggest consumers of commodities.
Metals are more sensitive to developments in China, where the bulk of the bad news is already priced in as seen sharp plunge in prices. Also, gold markets, more than 40% of demand last year came from consumers in China and India for whom the nuances of US monetary policy are practically irrelevant.
Besides, commodities pack is witnessing a number of developments on a standalone basis. In particular, the price of crude oil is still expected to recover as supply responds to the previous sharp falls. The slump in the number of active drilling rigs is already being reflected in slower growth in US production and outright declines are likely to follow soon.
Over a period of decades, commodities typically keep pace or exceed the rate of inflation. Therefore, our advice to investors is to buy and hold strategy makes sense, regardless of when an investor buys commodities. It is advisable to keep at least 10-12 percent of the entire portfolio in the gold. As far as crude oil goes, it is trading well below its cost of production (average $65). Hence, price rise in the coming months is imminent. In the base metals pack, Nickel will outshine as Indonesia ban on ore exports and strict anti-pollution laws in China will magnify the supply constraints in turn supporting prices.
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