Rising interest rates, the return of inflation and diversification benefits are the key reasons that investors should consider adding commodities exposure to their portfolios, according to Lazard Asset Management’s Terence Brennan.
Despite a long period of uninterrupted economic expansion in most parts of the world since the global financial crisis, commodity prices have failed to keep pace with other faster-growing asset classes such as equities and bonds.
Commodities – as represented by the Bloomberg Spot Commodity index – have lagged the returns available from equities over the past decade with a 32 per cent gain, in US dollar terms, compared with a 219.87 per cent total return for the S&P 500, as can be seen from the chart below.
Performance of indices over 10yrs
Source: FE Analytics
However, veteran investor Terrence Brennan says that may all be changing as market conditions become more supportive of commodities.
“Commodities provide protection from rising interest rates and they actually protect from inflationary costs and pressure,” said Brennan, who manages the $36m Lazard Commodities fund. “They also provide event risk protection, whether that be a hurricane or floods or geopolitical risk that we see going on with oil and the Iran sanctions.
“Any kind of unexpected event that could affect supplier demand.”
More importantly, commodities offer the benefit of diversification that other traditional asset classes, including stocks and bonds, don’t.
“That’s very important in the environment we’re in today, where we’re slipping from quantitative easing [QE] to quantitative tightening [QT] or a more normal market,” added Lazard manager Brennan.
The fund manager said that commodities have always been a traditional component of portfolio construction because of its diversification benefits, representing between 5-10 per cent of portfolios.
However, the onset of the global financial crisis and extraordinary monetary policy in the form of QE saw that diversification benefit break down.
“That changed,” said the fund manager. “The diversification benefit was lost during QE and that lasted from 2008 really until 2015 when the Federal Reserve was the first to raise rates.”
Rolling 1yr r-squared of indices vs Bloomberg Spot Commodity over 10yrs
Source: FE Analytics
“What happened, because they weren’t paying a yield, they lost their diversification benefits and there wasn’t really a reason for commodities,” said Brennan.
The investment environment has changed again, however, with rates being raised from ultra-low levels by central banks around the world and inflation likely to increase as unemployment falls.
Another positive for the asset class is that the cost of owning commodities has fallen more recently.
Contango – where the spot price of a commodity is lower than the forward price – is now closer to zero having widened out to 10 per cent as recently as 2015.
“If you traded passively it cost you 10 per cent just to own it,” he said. “It forced the commodities investor to buy above spot and sell lower as it gets to spot. What we see happening now is the cost is coming down and commodity prices seem to be at a bottom.”
Instead the commodities curve is moving towards backwardation where the spot price is higher than the forward price, allowing investors to buy low and sell high.
Prices have bottomed out, according to Brennan, because commodity producers have started to reign in investment in the supply-side, resulting in inventories being drawn down as demand remains stable.
He added: “The way we describe it is as ‘the best cure for low price is low price’ because we’re not going to consume any less if prices are low but producers will produce less.
“We think that’s setting up the next cycle. This underinvesting pattern is important because it’s setting up the interest rate protection when rates are rising coming out of ultra-low levels of QE but as inventory is looking to deplete there is going to be pipeline [inflationary] pressure.”
Furthermore, the need for greater infrastructure spending is likely to put inflationary pressure on commodities, according to Brennnan, who said $41.9trn globally is needed.
The potential for strengthening commodity prices is also good for listed producers, as was seen during the most recent correction in markets during October.
Performance of indices in October
Source: FE Analytics
“Commodity-related equities also re-rate and we saw this in the last ‘taper tantrum’ and we’re seeing it now with – I don’t know what October is going to be called – what we saw in the first week of November,” he said.
“A lot of industrials, materials and energy equities are starting to re-rate now. Performance is coming back because they know commodity-related equities are intrinsically linked to the commodity.”
While the Lazard Commodities launched earlier this year, Brennan has 28 years’ investment experience most recently managing commodities strategies at Deutsche Asset Management. Brennan is joined on the fund by Eduardo Gonazalez and Michael Bernadiner.
The fund invests both in commodities directly and commodity-related equities to maximise alpha with lower volatility. As at the end of September direct commodities represented 76.8 per cent of the portfolio with equities representing 20.8 per cent.
The offshore fund has an ongoing charges figure (OCF) of 0.95 per cent.