The Weekly - Commodities, a worthwhile investment?

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30/07/2019
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We are all consumers every day, whether you like it or not. Your morning might start with a coffee, orange juice or perhaps a bacon roll. These are all commodities, and some might be surprised to know, are tradable through a variety of securities. However, most investors will not have a direct commodity in their investment portfolio. Is it time this changed?

Our attention has been drawn to this sector due to the escalating trade tensions between the US and China that have been rumbling on for some time now. Throughout the trade dispute we thought that China had more to lose than the US - after all the US is the largest importer of goods in the world. If it doesn’t buy from China, then it can take its business elsewhere. This might be true in some cases, however, if China is the main producer of a specific commodity the US is heavily reliant on, then it is understandable that China would like to use this as a bargaining chip on any future trade deal.

While everyone might be familiar with commodities such as coffee and orange juice, not everyone might be as familiar with commodities such as terbium, cerium, neodymium, dysprosium or praseodymium. If you have a smartphone, though, then you probably use them every day, because the chances of finding these metals in your phone is extremely high. They are collectively known as rare earth metals, and interest in investing in this area seems to be growing. According to the US Geological Survey, China produces around 170,000 tons of rare earth metals every year and accounts for just over 70% of production worldwide.

Donald Trump has taken this threat very seriously, so much so that he has given an order to Congress to investigate the most practical method for improving capacity for rare earth metals in the US. Despite the name given to these collections of metals, the truth is that they are not particularly rare. They are found throughout the earths crust, but the trouble is finding enough of them to make mining economically viable.

There are several quoted companies that mine rare earth metals, but due to the high cost of production/mining, these types of investments would be highly speculative. Of course, rare earth metals in China are controlled by the state and so, unfortunately, you cannot invest in the largest producer. No exchange traded funds (ETFs) operate within the rare earth mineral sector. This is probably a good thing given that prices would not necessarily be controlled by supply and demand, but rather what the largest producer deems the price to be!

Of course, there are other commodities that are more freely available and readily tradable. These are oil, coffee, gold and wheat to name but a few. There are some advantages of investing directly within the commodity as opposed to a company that deals specifically with a certain commodity. Firstly, you eliminate company specific risk. For example, the price of oil was largely unaffected by the BP Deepwater Horizon oil spill, however the same could not be said for the share price of BP! So, by investing in a commodity directly it does provide investors a certain amount of diversification away from company specific risk.

The counter-argument of investing in a commodity directly is you are simply speculating in the future price of the commodity. If the price of the commodity decreases in value, then so does your investment. If you instead decide to invest in company, then any decrease in the value of commodity does not necessarily reflect in the value of that company’s stock price. If anything, it will increase the value of a company, because as we all know a falling oil price doesn’t always reflect at the pumps when we fill up our cars. A good, but imperfect, example of this is looking at the price of coffee, which has decreased in value by 40% over the last five years (Source FE Analytics). This hasn’t affected what we pay for a cup of coffee at any of the high-street outlets.

The most common way of investing directly in commodities is via an ETF, and as mentioned it would be pure speculation on its future value. Depending on the ETF they will track the price of the commodity either physically (storing the underlying commodity) or synthetically (using derivatives to gain exposure). These create whole new risks that investors need to consider.

Commodities also don’t pay dividends for investing in them directly. It might seem we are being critical of investing directly in commodities, but we think it is important to point out the reasons why commodities might not always be a suitable investment for a portfolio. Like most who invest people’s money, we must take a long-term view of what the markets might be doing in a year, five years or even ten years’ time and invest accordingly.

Perhaps a case can sometimes be made for investing in gold. Gold is one of the known safe havens some investors flock to in uncertain times. However, most still choose to hold cash during market downturns. During 2008, the last financial crash, gold rallied by 42%, whereas the FTSE 100 fell by 28% (Source FE Analytics), so gold effectively outperformed the FTSE by 70% in one year. However, despite the recent strong performance of gold, we don’t believe a market hedge into gold would be beneficial to investors, or any commodity for that matter. Commodities unfortunately don’t allow for the same rigorous analysis of a company or fund that we choose to invest in – it is more a case of strap in for the ride!

 

Equity markets enjoy accommodative policy moves 

Equity markets made gains last week as major central banks all-but-confirmed moves toward a more dovish stance to combat headwinds to the global economy. The US S&P 500 index added +1.7% whilst the UK’s FTSE 100 rose +0.5%.

The European Central Bank (ECB) sent its strongest signal yet that it could cut interest rates in September and potentially revive its quantitative easing program if further stimulus is warranted. This latest policy shift has been coming for many months amid weakening economic data, particularly within export industries that are suffering from global trade disputes. Germany's manufacturing Purchasing Managers Index (PMI) fell to 43.1 in July, its lowest level in seven years and well below the 50 level that separates growth from contraction. European equity markets though have been strong in recent months, taking strength in the prospect of more accommodative policy.  Germany’s DAX 30 index went on to add +1.3% last week, whilst the French CAC 40 also climbed +1.0%. 

In addition, a 25-basis point cut to US rates is forecast this week. The Fed meets this week and is due to publish a statement on Wednesday evening. A more sizeable cut now looks to be unlikely given more resilient economic data in recent weeks; including Q2 economic growth numbers released on Friday which came in a shade higher than most expectations with stronger consumer spending able to more than offset a decline in business investment.

Russia and Turkey also cut interest rates last week as further evidence of a growing global shift back towards loose monetary policy.

On home soil, the new Prime Minister’s cabinet overhaul dominated the headlines whilst economic data was scarce. Sterling remains influential in valuing the UK’s polarised stock market as overseas earners continue to outperform domestic companies.  The pound remains sensitive to the likelihood of a no-deal outcome which is perceived to have risen despite broad opposition within Parliament. As the gridlock continues, a general election arguably becomes increasingly likely which adds further uncertainty. Sterling depreciated -0.96% versus the US Dollar and -0.19% versus the Euro last week, adding to a trend that has seen Sterling give away more than 4% against both currencies over the last three months.

 

The week ahead

All eyes are on the Federal Reserve’s policy meeting on Wednesday, as the US policy makers look set to announce its first interest cut since the Global Financial Crisis.  The central bank has been gradually raising rates from near zero over the last three and a half years to its present level of 2.5%.  Anything other than 25 basis point cut would likely come as a surprise to markets where futures have now fully-priced in this week’s anticipated move.

In addition, the first Friday of a new month brings the latest US Labour Report. Critics of the Fed’s likely move on rates have pointed to the strength of the jobs market which continues to appear robust. The unemployment rate is expected to stay unchanged at just 3.7%.

The Bank of England is scheduled to hold its own Monetary Policy Committee meeting this week (Thursday), though no change to policy is forecast.  The bank is simultaneously scheduled to release its latest Inflation report, giving an updated assessment of the state of the economy.

 

 

The value of an investment with Rowan Dartington may fall as well as rise. You may get back less than the amount invested.

Past performance is not a guide to future performance.

Source: FE Analytics (information correct as at 29 July 2019)

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The information contained does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective investment. Opinions provided are subject to change in the future as they may be influenced by changes in regulation or market conditions. Where the opinions of third parties are offered, these may not necessarily reflect those of Rowan Dartington.