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COMMODITIES enjoyed significant interest from investors from year 2000 onwards. The turn of the century, as one of the largest sector bubbles started getting deflated, coincided with a secular low in commodities, when gold hit a two-decade low of US$250 per ounce.
The bull market in commodities that followed peaked in 2011, among calls that young university graduates should consider becoming farmers, rather than bankers.
While investors have largely written off commodities as the "lower for longer" mantra on interest rates and inflation has become well-ingrained, a study of long-term asset class cycles over the last 100 years would show three clear conclusions.
First, the bond bull market that started in 1982 is the longest ever seen, and is clearly on its last legs as interest rates start to move higher. The final top will only be known in hindsight, and we may have already seen it in mid-2016 when euro-denominated sovereign debt had negative yields for 10-year durations. Irrespective of where the final top of this bond bull market is, long-dated bonds are negatively correlated to interest rates, and it is impossible to repeat the move in interest rates down from 20 per cent in 1981 to 0 per cent.
Second, commodities are the only asset class currently in a bear market that started in 2011. Just as economists and market commentators are terrible at calling market tops, bear markets, or anything else really, changes in inflation are likewise difficult to predict with any degree of accuracy. Since all major asset classes move in cycles that last a decade or more, and equities, bonds and commodities experience bull/bear markets at different times, with bond markets peaking and equity valuations stretched in developed markets, the next major bull market should be in commodities.
Lastly, commodities have very different underlying economic drivers as compared to equities and bonds, and are actually far better diversifiers to an equity portfolio than bonds. The fact that the sector is far more volatile than bonds does not discredit this inherent diversifying benefit, especially when the current bond valuations are taken into account.
The exact timing of the start of the commodity bull market cannot be predicted with accuracy, but the fundamental drivers of higher inflation are already being felt. US unemployment is approaching historic lows, and while wage pressures haven't been felt yet, leading indicators are pointing to higher wages a year from now. From a valuation perspective, equities of commodity producers are near multi-year lows, having dropped significantly from their highs six years ago, while most equities are near all-time highs.
A ratio of commodities versus the S&P500 is now at the same level last seen in 1971 and 1999, both of which were near commodity bear market bottoms and peaks in equity markets.
Of particular interest is the oil sector, where the prevailing view is that US shale oil has put a permanent lid on higher oil prices, given the flexibility of rigs to be switched on as oil prices climb higher, thereby significantly boosting supply. The reality is that US shale-oil reserves, efficiency and sustainability of the wells are all likely to be significantly overstated. With many of the companies having taken on significant amounts of leverage over the last few years, cracks in the US shale-oil thesis are becoming clearer, with many of the smaller companies having already gone bankrupt, or being on the verge of it.
While value investors should find many interesting investment ideas within the commodity sector, there are always a number of risks. If we are indeed near the end of the commodity bear market that started in 2011, this would have been the shortest one on record, as the analysis of cycles shows that major asset class bear markets also historically last a decade or more. The conundrum of low inflation, low interest rates, and low wage pressures may well continue for years to come, which would be positive for equities and negative for commodities. Lastly, any sharp equity bear market over the coming 1-2 years, due to elevated valuations which are not fully supported by growth in underlying earnings, would push commodities down in the short term, as equity bear markets are deflationary in nature.
Investors would be well-served to consider the diversification benefits of having commodities in a portfolio, especially after analysing current valuations of major asset classes in the context of long-term cycles. W
AL Wealth Partners is an independent Singapore-based company providing fund management and advisory services to accredited investors.