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A market strategist once said that “if you buy commodities, you are betting against the ingenuity of people”. When natural resources become too expensive, human resources step in to find alternatives, says multi-asset investment head Lukas Daalder.
Investors focus on the main asset classes of equities and fixed income, but what about the prospects of alternative forms of investment? In this new series we focus on six segments that may be worth considering: commodities, infrastructure, real estate, hedge funds, absolute return funds and private equity.
“Most asset classes have a cycle: equities go up in times when the economy is booming and down in a recession, and so on,” says Daalder. “Commodities have a super-cycle. They start off with a normal cycle, where commodities do well in the early stages of a recovery as people start to build things again, and then go down when the cycle ends. The super-cycle is a much wider, bigger and longer phenomenon which is driven by scarcity and investments.”
“The oil price, for example, goes up in the recovery cycle but at some point will become so expensive that it triggers the use of alternatives such as solar energy, which then become economically viable to tap into. And this takes time: you need to invest in new projects, and conduct R&D, etc. So it creates a super-cycle where if oil gets too expensive, people will look for cheaper alternatives.”
“It means that you are betting against the ingenuity of people. Basically, if you think that people are smart and will solve everything in the end, they will always find a replacement for commodities. Therefore, they will always ultimately decline in price. If you take a basket of 10 commodities, in 10 years from now, the value of it will probably be lower. Ingenuity means people get smarter and find alternatives in the super-cycle outside the normal economic cycle.”
A major issue with commodities is that there are so many different types with different characteristics, from ‘hard’ materials such as metals and ‘soft’ agricultural products – though there is one elephant in the room. Oil.
“Commodity prices are dominated by the sheer size of the oil market, so people will normally just ask where we are in the stage of the oil super-cycle,” says Daalder. “Since 2014, there has of course been a dramatic decline in the oil price, which is related to the rise of US shale oil. And it doesn’t feel like we’ve hit the bottom yet, even though oil prices have recovered somewhat, because fracking is still in development and has not yet peaked.”
“Added to shale, it is clear that solar energy is becoming more competitive as the costs have been driven down immensely. Solar is set to become a serious competitor for oil, so we’re not yet at the bottom of the super-cycle for oil.”
‘Solar is set to become a serious competitor for oil’
Buying into commodities can therefore be a riskier investment than other asset classes, but without necessarily getting the returns needed to justify the extra risk, says Daalder. “The risk profile of commodities is a bit like equities, but the volatility is higher, while the return profile is lower. Over the past 25 years, depending on which index you look at, commodities have yielded returns somewhat in excess of (risk-free) US Treasury bills, but at much higher volatility. Equities on the other hand have offered superior results over time. Part of this weak return is linked to the fact that you continuously need to roll over future contracts when investing in commodities, which is a costly exercise.”
“You may wonder why you want to invest in commodities, in that case. Traditionally, there are two arguments: diversification and timing. The diversification argument used to be that commodities added returns at times that equities didn’t. However, this argument has lost a lot of its shine over the past couple of years, as stocks and commodities became much more correlated during the 2009 crisis. The other argument is timing: as long as you are able to make a correct call on the super cycle, you can beat equities. But you need to have the knack of spotting the start of this cycle.”
The market can also suffer from liquidity problems, where it may be difficult for an investor to exit if things turn sour. “Liquidity depends on each commodity. The oil market is very liquid, and it’s easy to get in and out. However, if you move into natural gas, you can see some strange price moves at times, which is partly a result of liquidity problems, as well as transport and storage costs” says Daalder.
‘If you can make a correct call on the super cycle, you can beat equities’
This lack of liquidity in some areas can also translate into lower transparency, he says. “Given the illiquid nature of some commodities and the fact that many are linked to the weather, where one bad summer can badly affect production and prices, returns are unpredictable. So it may be a transparent market on the whole, but some of these commodities are pretty erratic, and go up and down quite heavily according to certain events,” he says.
“Commodities do tend to be a good inflation hedge, but there is a question here of causation and correlation. The two major inflation shocks that we have had over the past 60 years have been due to oil prices, and was therefore the cause of the inflation. It became a hedge against the inflation that it had created.”
Subsequently, commodity investing has fallen off the radar, and is no longer offered by Robeco. “The trend overall in the last five years has been that people have been less inclined to be invested in commodities. Added to that is the fact that the longer-term returns are not that interesting,” says Daalder.