[LONDON] A slowdown in China, a strong dollar and high inventories will limit the upside for commodity price performance in coming months, although leading fund managers still see pockets of value in areas such as refined oil products.
The bearish cocktail could choke off resurgent investor interest in commodities. Net inflows topped US$7.8 billion in the first half of the year, Barclays data showed, the highest in four years.
Commodity price performance has also been relatively strong, with the S&P GSCI, a well-followed commodity index, up almost 9 per cent in the second quarter.
But fund managers have generally failed to replicate this performance, with the average actively managed fund in the Lipper Global Commodity sector only just scraping into positive territory, up 0.57 per cent.
Those managers who did outperform in the second quarter became wary going into the third quarter, as a sell off in the Chinese stock market hammered commodities in early July , and the Greek debt crisis boosted the dollar.
"Generally we are cautious," said Nicolas Robin, co-manager of the Columbia Commodity Strategy Fund and the Threadneedle (Lux) Enhanced Commodities Portfolio, which came fourth and sixth in the Lipper league tables.
"The Greek story is leading to dollar strength, which is negative for commodities, but it's the sell-off in Chinese equity markets that is potentially more problematic."
Any weakness in China is generally negative for base metals as it still accounts for such a large proportion of demand.
Mr Robin said underweights in aluminium and copper helped the funds outperform in the second quarter, and he is trimming this allocation further.
"Copper is one of the commodities that is most affected by China and we are still bearish there," he said.
The funds also benefited from an overweight position to the energy sector, particularly gasoline, one of the strongest performers in the benchmark in the year-to-date.
Going into the third quarter, Robin has trimmed some of this sector allocation given the potential for a sell off in crude if a deal is reached with Iran, allowing it to export oil again.
But he is maintaining a large overweight to gasoline for the time being: "Demand has been very strong out of the US and elsewhere. We see the most value in the products," he said.
He added that US refineries had been running flat out to take advantage of strong margins, increasing the likelihood of outages, which would also be supportive.
"We haven't had that many hiccups yet but the odds of having production issues are quite high," he said.
A higher weighting to energy versus the index also helped the Schroder AS Commodity fund outperform in the second quarter. This long-only fund came fifth in the Lipper league table, helped by rallies in Brent and US crude, and the strong gasoline performance.
But the overweight has not been maintained into the third quarter.
"Although energy demand remains strong, driven in part by lower prices, the price of crude oil has already gone up so it isn't quite as clear a directional bet as it used to be," said Christopher Wyke, commodities product director at Schroders.
The fund also benefited from an off-benchmark position in cocoa, which Mr Wyke said was the best performing agricultural commodity in the second quarter, up more than 21 per cent. Wheat and soybean oil also delivered double-digit returns.
"Individual selection in agriculture helped. Most of our competitors would have been closer to the index," he said.
An underweight to metals was also maintained, with Schroders taking the view that Chinese economic growth is slowing and industrial metals inventories are still quite high.
Both Mr Wyke and Mr Robin thought that lower commodity prices could attract fresh investment, with Wyke pointing out that equities and bonds looked expensive in comparison.
"The upside for bonds from here is quite limited. But commodities have fallen in price over the last four years - it's one of the few cheap investment sectors," Mr Wyke said.