A Contrarian View on Commodities

Through most of the past decade there seemed to be a consensus amongst investors that commodities were going through a “supercycle” driven by growth in demand from emerging market consumers and increasingly constrained sources of supply. With demand growth having slowed following the financial crisis, and with key new technologies bringing down the cost curves in energy and steel sectors, many have called an end to the supercycle.

The carnage in the commodity sector seems to support this view. Prices in many commodities are down significantly from their highs, with the ThomsonReuters-CRB commodity index down 23% since March 2011, and numerous active commodity fund managers have had to close shop due to poor performance.

While holding nearly any type of long-only commodities exposure from their highs in 2011 has detracted from returns, we believe it is still sensible to maintain a strategic long-term position in commodities. In fact, we believe that the decline in commodity prices over the last two years presents an attractive entry point.

Our rationale is simple. First, while infrastructure investment in China – a key driver of demand for certain commodities (such as iron ore, coal and steel) – has slowed down significantly, consumer spending in China continues to grow at double-digit rates. Inevitably this will drive demand for other commodities (such as oil, gas, aluminium and copper), as the world’s largest middle class tries to catch up to developed market standards of living over the coming decade.

Second, while technology will continue to lower production costs in various commodities, many of the new sources of supply discovered in recent times are in geo-politically unstable regions. This compounds the usual risks to supply such as weather and government regulations. In the short-to-medium term, we believe these compounded risks could outweigh the benefits derived from technology. Should we see any major disruptions to supply, long-only commodity exposure would serve as a valuable hedge in the portfolio.

Third, with the four largest central banks in the world simultaneously debasing their currencies, we believe that inflationary pressures may build up and ultimately be expressed in part through commodity price increases. The trigger point for this will occur when industries that rely heavily on commodities get a whiff of rising inflation and rush to lock in their future costs.

As such, we continue to maintain long-only commodities exposure in portfolios, viewing the correction over the past couple of years as an opportunity more than an omen of what is to come.