Investors should abandon long-term commodity bets

Investors should abandon long-term commodity bets

Guest writer | Dec 19 12:48 | 17 comments | Share

This guest post is from Mark Haefele, Global Head of Investment at UBS Wealth Management, and his colleague Chris Wright, Cross-Asset Strategist.

A key rule in financial markets is that rational investors should not take unnecessary risks. It is strange, then, that some savvy investors still allocate to commodities over a long-term, five-year-plus horizon. The assumption is that commodities diversify portfolios, hedge against inflation, and, in the case of gold, offer a safe store of value. But our research suggests these justifications for long-term bets on commodities are illusory.First, the correlation between commodity and other asset price changes was near 20 per cent in the 1980s and 1990s. Commodities were better placed to diversify investment portfolios and hedge against risk. Today, however, the correlation is closer to 60 per cent. During the financial crisis, when markets plunged and investors most needed uncorrelated assets, commodities printed a peak-to-trough fall of almost 55 per cent, compared with less than 45 per cent for equities.

Second, price movements in individual commodities have also exhibited correlations with more mainstream assets. Over the past few years, for instance, gold has been correlated with equities and more recently with treasuries, as a result of gold’s changing reaction to quantitative easing, or QE. First, gold reacted positively to QE due to concerns that the latter might cause inflation. But more recently any hint from the US Federal Reserve that it will scale back QE has sent gold tumbling along with bond prices.

Third, while it may be true that commodities initially kept pace with US inflation after the US abandoned the gold standard in 1971, this effect only lasted for a decade. Prior to this, and during the 1980s and 1990s, commodities lost value when adjusted for inflation. It wasn’t until emerging market demand started pushing up commodity prices in the early 2000s that commodities began to make up lost ground.

Fourth, in the case of gold, investors will long remember 2013 as the year that their precious shiny metal ceased to be a safe haven. In April, gold plummeted 14 per cent in two days, including 9 per cent in a single day. And this was only the fifth largest one-day fall since the end of the gold standard. No asset with this kind of volatility should be considered safe.

Finally, putting history aside, our analysis suggests the outlook for commodities is bleak. At various points in recent years, loose central bank policy and fears of inflation have stoked commodity demand. Talk of tightening policy affects this in two ways.

First, commodities pay no income, unlike equities and bonds. When interest rates and incomes from financial assets rise, commodities will look less attractive. Second, the boom in the sector in the 2000s prompted investment in commodity supply. New commodity supply takes a while to reach the market – it takes a lot longer to build a mine than implement QE, for instance. The market will likely be oversupplied in coming years, putting downward pressure on prices. Moreover, economic growth in emerging markets, a key engine of commodity demand, is likely to be lower than it was during the boom years as well. And on top of this, investors in the asset class have to bear the cost of physical commodity storage, or of rolling over commodity futures contracts, which can significantly eat into long-term returns.

Investors have long looked to commodities to answer specific needs in their portfolios. But we find it hard to justify any long-haul allocation to the asset class. Over the next five years, our financial models show that commodities will generate equity-like volatility of about 18% on average with returns of under 2 per cent a year. According to our medium-term outlook, this gives commodities an expected risk-adjusted return that is inferior to all other asset classes. Although investors can still generate gains by investing in commodities on a tactical basis, we feel the benefits of strategic holdings in the asset class have waned to the point of non-existence.