A commodity is something that is supplied in several different places without any qualitative difference. For example: gold, crude oil, copper, wheat and so on. Therefore, barring man-made taxes and transportation costs, their prices would be broadly similar in all locations. So there is a thriving market for commodities worldwide—unlike equities, which are usually country specific. And in the recent past, commodities have become an accepted asset class with significant chunks of smart money being invested in commodities markets worldwide.
Given the global growth in GDP, we remain in the early stages of a multiyear bull market in commodities. It is clearly a consumption-driven story, with the leading players being China and India and followed by a host of other fast developing nations.
Besides, there is the argument frequently made that “commodity prices cannot go to zero” and thus are, in a sense, bounded on the upside as well as on the downside. In other words, rising input costs of raw materials, labour or even capital will force supply and demand responses so that price increase is controlled. It may be pertinent and topical to note at this point that crude oil has gone to $100 per barrel levels but the experience of just a decade ago shows that high prices fed by high demand eventually led to a downward spiral with low prices and low demand brought about by lower consumption due to high prices.
So if there is no guarantee that prices will continue going up, then where is the guarantee of returns? Well, just as in equity trading, markets can and do move both ways. The trick is to use not only the futures markets but also the spot markets for getting returns commensurate with the perceived risk. However, futures markets, unlike spot markets, are a virtual zero-sum game and work using leverage (only a margin of 5-25% of the contract value typically has to be deposited to take the ‘position’). Sure, there is a lot of money waiting to be made in the commodity markets over the next decade, but all trading needs care, identification of sources of return and learning more and more about the markets as an ongoing process.
Like all markets, commodity markets are meeting places of buyers and sellers and the commodity exchanges in India mainly trade bullion, base metals, energy and agricultural produce. Unlike developed countries, foreign currency and stock indices are not part of our commodity markets and are unlikely to be integrated in the near future.
One clear and useful economic function that commodity markets perform is that they provide a platform for price risk management for both producers and consumers. Commodity prices typically move in tandem with inflation and as demand for goods and services increases, the price of goods and services usually rises too, as does the price of the commodities used to produce those goods and services.
In India, trading in futures remains the most popular way to invest in commodities. In developed commodity markets, managed accounts, individual trading accounts and mutual funds are usual ways to trade. In India, managed accounts as well as commodity mutual funds are yet to get regulatory approval. Besides, commodity indexes are not yet traded or even followed as a benchmark in India as the currently ones are not considered representative of the market or sector movements unlike the Goldman Sachs Commodities Index, or GSCI, which is long only and the Dow Jones AIG Commodity Index, or DJ-AIGCI, in the US.
Commodities add value to your investment
Commodities have low to negative correlation to traditional asset classes like stocks and bonds. A correlation coefficient is a number between -1 and 1 that measures the degree to which two variables are linearly related. The correlation coefficient of 1 means there is a perfect linear relationship. A positive correlation means that when one variable increases, so does the other.
A coefficient correlation of -1 means there is a perfect negative relationship between the two variables. A negative correlation means that the two variables move in opposite directions. A correlation coefficient of zero means that there is no linear relationship between the variables. Therefore, low or negative correlation with your usual investments in stocks and bonds means that investment in commodities is a real portfolio diversifier, leading to lower risk.
International experience shows that while stocks and mutual funds are closely related to each other (since mutual funds typically invest in stocks anyway) and tend to have positive correlation with one another, commodities are a bet on inflation and have a low to negative correlation to other asset classes. Adding diverse asset classes to their portfolios allows investors provide variable downside protection and upside potential which depends on the correlation coefficients of the asset classes vis-à-vis one another. In general, commodities have a positive correlation with inflation and therefore a negative correlation with stocks and bonds and are therefore a well-advised addition to almost every long-term investment portfolio.
Commodities have offered decent returns in the past but they are still considered more volatile asset classes though that remains a statistically debatable issue. But there is no doubt that by adding commodities to a portfolio of assets that are less volatile, you actually decrease the overall portfolio risk due to the negative correlation and are likely to increase your overall expected return. But to get the real benefit of portfolio diversification, the investment must be in direct commodities rather than mining or commodity stocks to cut out the noise of management quality and cash flow issues in companies.
Individual commodity futures are an investment for more sophisticated, mature and experienced investors. For most investors, the most suitable way to invest in commodities would be through a mutual fund that is not yet allowed in India.
Risky at the best of times, here’s a synopsis of the situation today and how it is likely to pan out in the years to come.
The positives are that Asian demand remains high and growth is expected to continue well into the next decade. Even in the shorter term, the US dollar weakness and the rising popularity of investors willing to use commodities as a hedge against inflation are expected to keep prices stable. In fact, Asian demand—led by China and India—could outweigh concerns of a US slowdown. Besides, compared to China, India’s per capita commodities’ consumption is still abysmally low and promises to spur the next growth curve in commodities.
Having said that, it is true that concerns of a US slowdown seem to point to a commodity consumption slowdown over the longer term. And risk-averse investors may want to exit commodity investment as they are considered more volatile and risky, as well as to cover their losses in other markets such as equity.
Recent highs in gold, crude oil and wheat have been on the back of dollar weakness, inflationary pressures and supply shortages and also increased risk perception of the worldwide geo-political situation. Dollar-denominated commodities increase in price as the US dollar falls because that makes is cheaper for other currencies to buy into the commodity. Of all commodities, gold is most closely linked to the US dollar.
But the final word is that while no investor likes to miss out on a good opportunity, the prices in any free market are ultimately a function of supply and demand. The last few years have given handsome returns to buy-and-hold investors internationally. The way to do that in India is to enter the futures markets and keep rolling over your position to the next contract cycle.
The bull run should continue till high prices curtail demand. And there is no real way to know when the line is crossed—just as $80-plus crude oil prices seem to have been well absorbed by the growing prosperity worldwide. But an eye should also be kept on China for any sign of change in demand which could be a reaction to high prices or even man-made. For example, if the government raises interest rates to curb growth. Speculative money too has entered the markets in a big way and could be a factor causing short-term price movements.
The longest bull-run is likely to be in agricultural commodities (not good news for our government!). In fact, investment guru Jim Rogers has gone on record to say that the commodity bull run could go on till 2022, particularly in agricultural commodities. But if prices tumble, he will have the right explanation too—which will not necessarily help the investors!
One logic being bandied about is that world food consumption in the last few years has increased more than supply, probably for the first time in history—and that’s with no drought and no-supply disruptions. Technology, exploration and mining lead times may also help non-agricultural commodities like oil and copper prices in the immediate term, though their cycles are likely to be shorter.
The previous commodity bull markets can historically be seen to have been during the industrial revolutions of Great Britain, America and, most recently, Japan. That trend seems set to continue with China India Brazil, Russia and several other countries worldwide looking at double-digit growth for the last few years as also the next few years to come.
Given that the growth parameters of this set of countries is likely to be far larger than that of the aforementioned countries on account of their sheer population, it seems a good bet that the commodity supercycle will truly ensure a permanent place for commodities in the portfolio of every investor.
For example, the Chinese and Indian infrastructure development within the next couple of years will exceed, in certain respects, that of America in the last few decades. That means copious consumption of steel, copper and other commodities. The real assets to invest in today are therefore commodities as well as in India and they are inter-related. Investors would be well-advised to give to give a long, hard look to commodity investment via their preferred commodity broker.